57 Review and Practice

 

Summary

In this chapter we examined the role of the public sector in the market economy. Since 1929, both the size and scope of government activities in the market have expanded considerably in the United States.

We examined markets in which some form of government price control keeps price permanently above or below equilibrium. A price floor leads to persistent surpluses because it is set above the equilibrium price, whereas a price ceiling, because it is set below the equilibrium price, leads to persistent shortages. We saw that interfering with the market mechanism may solve one problem but often creates other problems at the same time. We discussed what some of these unintended consequences might be. For example, agricultural price floors aimed at boosting farm income have also raised prices for consumers and cost taxpayers dearly, and the bulk of government payments have gone to large farms. Rent controls have lowered rents, but they have also reduced the quantity of rental housing supplied, created shortages, and sometimes led to various forms of “backdoor” payments, which sometimes force the price of rental housing above what would exist in the absence of controls.

Economists insist that individuals do not make choices willy-nilly. Rather, economists assume that individuals make choices in a purposeful way, one that seeks the maximum value for some objective. We assume that consumers seek to maximize utility and that firms seek to maximize profits.
Whatever is being maximized, choices are based on the marginal decision rule. Following this rule results in an allocation that achieves the greatest degree of utility or profit possible.

If utility- and profit-maximizing choices are made in the context of a price system that confronts decision makers with all of the costs and all of the benefits of their choices, the allocation of resources will be efficient. An efficient allocation is one that maximizes the net benefit of every activity. The concepts of consumer and producer surplus show us how this net benefit is shared. Equity is a separate issue, one that calls for a normative evaluation of the fairness of the distribution of income.

The allocation of resources will be inefficient in the absence of competitive markets. It will also be inefficient if property rights are not exclusive and transferable. These two conditions break down when there are public goods, common property resources, or external benefits or costs. In each of these cases, public sector intervention may improve the efficiency of resource allocation. When a market fails to achieve the efficient solution, net benefit falls short of the maximum possible. Deadweight loss is the amount by which net benefit falls below the net benefit possible at the efficient solution.

People demand government participation in three areas of economic activity. First, people may want correction of market failure involving public goods, external costs and benefits, and inefficient allocation created by imperfect competition. In each case of market failure, the shift from an inefficient allocation to an efficient one has the potential to eliminate or reduce deadweight losses. Second, people may seek government intervention to expand consumption of merit goods and to reduce consumption of demerit goods. Third, people often want government to participate in the transfer of income. Programs to transfer income have grown dramatically in the United States within the past few decades. The bulk of transfer payment spending is not means-tested.

Government activity is financed primarily by taxes. Two principles of taxation are the ability-to-pay principle, which holds that tax payments should rise with income, and the benefits-received principle, which holds that tax payments should be based on the benefits each taxpayer receives. Taxes may be regressive, proportional, or progressive. The major types of taxes in the United States are income taxes, sales and excise taxes, and property taxes. Economists seek to determine who bears the burden of a tax by examining its incidence. Taxes may be borne by buyers or sellers, depending on the relative elasticities of demand and supply.

Two broad perspectives are used to examine choices in the public sector. One is the public interest approach, which uses cost-benefit analysis to find the efficient solution to resource allocation problems. It assumes that the goal of the public sector is to maximize net social benefits. Cost-benefit analysis requires the estimation of benefits and costs that are not revealed in the marketplace. The second approach to the analysis of the public sector is public choice theory, which assumes utility-maximizing and rent-seeking behavior on the part of participants in the public sector and those trying to influence it. We examined two insights stemming from public choice theory: the problem of rational abstention from voting and the role of special interests.

We saw that antitrust policy has evolved from a view that big business was bad business to an attempt to assess how the behavior of firms and the structure of markets affect social welfare and the public interest. The rule of reason rather than per se illegality guides most antitrust policy today, but because there is considerable debate concerning the appropriate role of government antitrust policy and regulation, application of the rule of reason in specific cases is uneven. Prosecution and enforcement of the nation’s antitrust laws has varied over time.

The rising role of a global economy in the last half of the twentieth century reduced the degree of market power held by domestic firms. Policymakers have reconsidered antitrust policy and what types of joint ventures and cooperation among competing firms should be allowed. U.S. antitrust policy has not been abandoned, but since the early 1980s it has been applied with greater consideration of its implications for the competitiveness of U.S. businesses against Asian, European, and other firms. Whether or not antitrust laws among nations will be made more compatible with each other is an issue for the future.

We saw that there are many different schools of thought concerning regulation. One group believes that regulation serves the public interest. Another believes that much current regulation protects regulated firms from competitive market forces and that the regulators are captured by the firms they are supposed to regulate. Yet another group points out that the regulators may do little more than serve their own interests, which include increasing the bureaucratic reach of their agencies.

Finally, the chapter looked at the complex issues surrounding consumer protection regulations. Consumer protection legislation has costs, borne by consumers and taxpayers. Economists are not in agreement concerning which, if any, consumer protection regulations are warranted. They do agree, however, that market incentives ought to be used when appropriate and that the most cost-effective policies should be pursued.

Concept Problems

  1. For each of the following goods, indicate whether exclusive, transferable property rights exist and whether the good poses a problem for public policy. If it does, does the problem relate to a problem of property rights?
    1. Clean air
    2. Tomatoes
    3. Housing
    4. Blue whales

  1. The dry-cleaning industry is a major source of air pollution. What can you conclude about the price and output of dry-cleaning services?

  2. Economists often recommend that polluters such as dry-cleaning establishments be charged fees for the pollution they emit. Critics of this idea respond that the establishments would simply respond by passing these charges on to their customers, leaving the level of pollution unchanged. Comment on this objection.

  3. Government agencies often require that children be inoculated against communicable diseases such as polio and measles. From the standpoint of economic efficiency, is there any justification for such a requirement?

  4. Which of the following goods or services are public? Why or why not?

    1. Libraries
    2. Fire protection
    3. Television programs
    4. Health care
    5. Water for household consumption

  5. If a village in Botswana is granted several licenses to kill elephants, how does this give it an incentive to preserve elephants and increase the size of the herd? How does the international ban on ivory sales affect the incentive in Botswana to preserve the elephant?

  6. The number of fish caught in the ocean has fallen in recent years partly as a result of more intensive fishing efforts and the use of more sophisticated equipment. Fish in the ocean are a common property resource. How might this fact be related to declining fish catches? How do you think this drop in the catch affects the price of seafood?

  7. Identify each of the following government programs as efforts to correct market failure, to promote or discourage the consumption of merit or demerit goods, or to transfer income.

    1. Head Start, a preschool program for low-income children
    2. Sports leagues for children sponsored by local governments
    3. A program to limit air pollution generated by power plants
    4. Species preservation efforts by the government
  8. Public Broadcasting System (PBS) stations regularly solicit contributions from viewers. Yet only about 11% of these viewers, who on average have much higher incomes than the rest of the population, ever contribute. Why?
  9. Do you expect to benefit from the research efforts sponsored by the American Cancer Society? Do you contribute? If you answered “Yes,” then “No,” does this make you a free rider?
  10. Suppose the population of the United States increases. What will happen to the demand for national defense? What will happen to the efficient quantity of defense?
  11. How could a program that redistributes income from rich to poor be considered a public good?
  12. We noted that local governments typically supply tennis courts but not bowling alleys. Can you give a public choice explanation for this phenomenon? How about a public interest explanation?
  13. Find out the turnout at the most recent election for student body president at your school. Does the turnout indicate student apathy?
  14. Some welfare programs reduce benefits by $1 for every $1 that recipients earn; in effect, this is a tax of 100% on recipient earnings. Who pays the tax?
  15. Suppose the quality of elementary education is a public good. How might we infer the demand for elementary school quality from residential property values?
  16. V.I. Lenin, founder of the former Soviet Union, wrote that “the State is a machine for the oppression of one class by another.” Explain whether Lenin’s view typifies the public interest or the public choice school of public sector choice.
  17. Sugar prices in the United States are several times higher than the world price of sugar. This disparity results from a federal government program that keeps enough foreign-produced sugar out of the United States to hold U.S. sugar prices at a high level. The program raises the price of all sweetened foods produced in the United States; it boosts food costs for the average household by more than a hundred dollars per year. Who benefits from the program? Why do you suppose it exists?
  18. The table on federal income tax rates facing various income groups suggests that the marginal tax rate in the United States has fallen since the 1993–1996 period used in the study of marginal tax rates and labor supply discussed in the Case in Point essay. What would your prediction be as to how this reduction in the marginal tax rate would affect the quantity of labor supplied in the United States?
  19. Given that we cannot have a perfectly accurate count of the votes in any election, is there any point in having elections at all?
  20. Apex Manufacturing charges Zenith Manufacturing with predatory pricing (that is, selling below cost). What do you think the antitrust authorities will want to consider before they determine whether to prosecute Zenith for unfair practices in restraint of trade?
  21. Some states require firms to close on Sunday. What types of firms support these laws? Why? What types of firms do not support these laws? Why?
  22. Individual taxis in New York, Chicago, and many other cities must have permits, but there are only a fixed number of permits. The permits are typically sold in the marketplace. Who benefits from such a regulation?
  23. What do you predict is the impact on workers’ wages of safety regulations in the workplace if the labor market is competitive?
  24. Many states require barbers and beauticians to be licensed. Using the public interest theory of regulation as a base, what, if any, arguments could you make to support such a regulation? Do you think consumers gain from such regulations? Why not just allow anyone to open up a barber shop or beauty salon?
  25. Suppose a landowner is required to refrain from developing his or her land in order to preserve the habitat of an endangered species. The restriction reduces the value of the land by 50%, to $1 million. Under present law, the landowner does not have to be compensated. Several proposals considered by Congress would require that this landowner be compensated. How does this affect the cost of the regulation?
  26. A study by the Federal Trade Commission compared the prices of legal services in cities that allowed advertising by lawyers to prices of those same services in cities that did not. It found that the prices of simple wills with trust provisions were 11% higher in cities that did not allow advertising than they were in cities that did (Cox, C., and Susan Foster, 1990). This, presumably, suggests the cost of such regulation. What might be the benefits? Do you think that such advertising should be restricted?
  27. Economist W. Kip Viscusi, whose work was cited in the Case in Point, and Gerald Cavallo studied the effects of federal regulations requiring cigarette lighter safety mechanisms (Viscusi, W. K., 1984). Explain how this technological improvement might improve safety and how it might reduce safety.
  28. Explain how licensing requirements for providers of particular services result in higher prices for such services. Are such requirements justified? Why or why not?
  29. What is so bad about price-fixing? Why does the government prohibit it?
  30. In a 1956 antitrust case against DuPont, the Justice Department argued that the firm held a near monopoly in the cellophane market. DuPont argued that the definition of the market should be changed to include all wrapping paper. Why is this issue of market definition important? (DuPont’s position prevailed.)
  31. The Case in Point on the efficacy of antitrust enforcement painted a rather negative view of antitrust enforcement. Do you agree with this assessment? Why or why not?
  32. The Case in Point on Boeing and the European Union discussed a situation in which a foreign government, the European Union, attempted to exert authority over a relationship between two U.S. firms. How is this possible?

Numerical Problems

  1. The local gasoline market in a particular city has demand and supply curves given by the following data. (All quantities are in millions of gallons per month.)
Price per Gallon $1.00 $1.50 $2.00 $2.50 $3.00 $3.50 $4.00
Qd 6 5 4 3 2 1 0
Qs 0 1 2 3 4 5 6
  1. Plot the demand and supply curves, and determine the equilibrium price and quantity.
  2. Show the areas of consumer and producer surplus.
  3. Now suppose that the community determines that each gallon of gasoline consumed imposes $0.50 in pollution costs. Accordingly, a $0.50-per-gallon tax is imposed. The tax is imposed on sellers of gasoline, and it has the effect of increasing by $0.50 the price required to induce the quantities supplied in the table. For example, a price of $2.00 is now required for a quantity of 1 million gallons to be supplied each month. Plot the new supply curve.
  4. Approximate the new equilibrium price and output.
  5. Does the price increase by the full amount of the tax? If not, explain why.
  6. Would your answer be different if the demand for gasoline were perfectly inelastic
  1. The flu vaccination market has the demand and supply curves given by the following data. (All quantities are in thousands.)
Price per Vaccination $10 $15 $20 $25 $30
Qd 90 80 70 60 50
Qs 50 60 70 80 90
  1. Plot the demand and supply curves, and determine the equilibrium price and quantity.
  2. Show the areas of consumer and producer surplus.
  3. Now suppose that each vaccination given generates an external benefit, as those who do not get vaccinated are less likely to get the flu when others do get vaccinated. As a result, suppliers receive a $10 subsidy from the government for each vaccine. For example, if consumers pay $10 per vaccination, suppliers receive $20, so only $10 from consumers is required to induce suppliers to offer 70,000 vaccinations per month. Plot the new supply curve.
  4. Determine the new equilibrium price and quantity.
  5. Does the price fall by the full amount of the subsidy? If not, explain why.
  6. What is the total amount that consumers now pay for the new equilibrium quantity of vaccinations?
  7. What is the total subsidy that suppliers receive from the government at the new equilibrium quantity of vaccinations?
  1. In an effort to beautify their neighborhood, four households are considering leasing a small section of vacant land for a park. For a monthly leasing fee, the owner of the vacant land is willing to arrange for some of the maintenance and to make the park available only to the four households. The demand curves for the four households (A, B, C, and D) wanting parkland are as follows (all demand curves are linear):
Acres of Parkland Demanded per Month
A B C D
$100 0 0 0 0
$75 1 0 0 0
$50 2 1⅓ 0 0
$25 3 2⅔ 2 0
$0 4 4 4 1

Draw the demand curves for the four neighbors, and show the neighborhood demand curve for parkland.

  1. Suppose the owner of the vacant land will provide for and maintain a neighborhood park at a fee of $25 per acre; the neighbors may lease up to 5 acres of land per month. Add this information to the graph you drew in Problem 36, and show the efficient solution. Are the neighbors likely to achieve this solution? Explain the problems involved in achieving it.

  2. The perfectly competitive blank compact disc industry is in long-run equilibrium, selling blank discs for $5 apiece. Now the government imposes an excise tax of $2 per disc produced.

    1. Show what happens to the price and output of discs in the short run.
    2. Now show the impact in the long run.
    3. Who pays the tax? (Note: Show quantities as Q1, Q2, etc.)

  3. A monopoly firm has just taken over the blank compact-disc industry. There have been technological advances that have lowered production cost, but the monopoly firm charges a price greater than average total cost, even in the long run. As it turns out, the firm is still selling compact discs for $5. The government imposes an excise tax of $2 per disc produced.

    1. What happens to price?
    2. What happens to output?
    3. Compare your results to your answer in Problem 38 and explain.

  4. The following hypothetical data give annual spending on various goods and services for households at different income levels. Assume that an excise tax on any of these would, in the long run, be shifted fully to consumers.

    Income range Average income Food Clothing Entertainment
    $0–$25,000 $20,000 $5,000 $1,000 $500
    $25,000–$50,000 $40,000 $8,000 $2,000 $2,000
    $50,000–$75,000 $65,000 $9,750 $3,250 $5,200
    $75,000–$100,000 $80,000 $10,000 $4,000 $8,000
    > $100,000 $200,000 $16,000 $10,000 $30,000

    Determine whether a tax on any of the following goods would be progressive, proportional, or regressive.

    1. Food.
    2. Clothing.
    3. Entertainment.

  5. In 1986, Pepsi announced its intention to buy 7-Up, and Coca-Cola proposed buying Dr Pepper. The table below shows the market shares held by the soft-drink firms in 1986. Assume that the remaining 15% of the market is composed of 15 firms, each with a market share of 1%.

    Company Market share (percent)
    Coca-Cola 39
    PepsiCo 28
    Dr Pepper 7
    7-Up 6
    1. Calculate the Herfindahl–Hirschman Index (HHI) for the industry as it was structured in 1986.
    2. Calculate the postmerger HHI if only PepsiCo had bought 7-Up.
    3. Calculate the postmerger HHI if only Coca-Cola had bought Dr Pepper.
    4. How would you expect the Justice Department to respond to each merger considered separately? To both?

    (By the way, the proposed mergers were challenged, and neither was completed.)

References

Cox, C., and Susan Foster, “The Costs and Benefits of Occupational Regulation,” Federal Trade Commission, October 1990, p. 31.

Viscusi, W. K., “The Lulling Effect: The Impact of Protective Bottlecaps on Aspirin and Analgesic Poisonings,” American Economic Review 74(2) (1984): 324–27.

License

Icon for the Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License

Microeconomics for Managers Copyright © 2020 by Margo Bergman is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License, except where otherwise noted.

Share This Book