Transcript Slide 1

REGULATION, PUBLIC GOODS,
& BENEFIT-COST ANALYSIS
Government Regulation is intended
to remedy several kinds of Market Failure:
1. Monopoly
2. Externalities, and
3. Imperfect Information
Recall the message of Chapter 7:
Perfectly Competitive Markets
do not require regulation.
Competitive Markets Provide the “Right”
amounts of Goods and Services
that People Want and at Least Cost.
Chapter 11
slide 1
11.2
Market Failure due to Monopoly
Price
Industry
Demand
C. S.
PM
M
M
DWL
E
PC
QM
QC
By raising price and limiting output,
monopoly generates a deadweight loss
(relative to the social optimum of
perfect competition).
Unit Cost
Output
Market Failure due to Monopoly
Antitrust measures are intended to prevent the
emergence of monopoly and restore competition
to a monopolistic industry.
1. Breaking Up Monopolies
2. Preventing Monopolies from Arising
3. Preventing Mergers that Reduce Competition
4. Preventing Price Fixing
11.3
11.4
Market Failure due to Externalities
An externality is a side effect (good or
bad) caused by one economic agent and
incurred by other agents.
For a “dirty” industry, the
full marginal cost of production
includes the cost of the externality.
$9
8
7
6
5
4
3
2
1
0
INDUSTRY DEMAND
MTC
MC
ExternalCost
of Pollution: $1
0
2
4
8
10
12
11.5
Market Failure due to Externalities
The ideal remedy is to tax a negative
externality. The tax should equal the
marginal harm due to the externality.
The tax provides the appropriate
incentive for the firm to reduce the
externality.
The optimal amount of
cleanup balances the
resulting MB versus
the MC of cleanup.
Marginal Benefit
of Clean Up
t*
Tax t* induces the optimal
amount of cleanup P*.
Marginal Cost
of Clean Up
0%
P*
Pollution Cleaned Up
100%
PUBLIC GOODS
A Pure Public Good is
non-rival and non-exclusive.
A public good’s optimal scale
is determined by weighing
MBs and MC (where MBs
are summed vertically).
11.6
$MB,
$MC
MBTotal =
MBD + MBT
MC of
Highway
expansion
The optimal length of this
highway is H* miles
(where MBTotal = MC).
Practical Issues:
1. Estimating Benefits/Costs
from reported preferences.
2. Public Financing.
3. “Politics” and Voting.
MB
(drivers)
H*
MB
(truckers)
Highway Length
(miles)
BENEFIT-COST ANALYSIS
A program should be undertaken if and only if:
Net Benefit = Total Benefit – Total Cost > 0.
Steps:
1. Indentify benefits and costs to
all affected parties.
2. Measure dollar values for
benefits and costs (using
market values or imputed
values).
3. Compute total net benefit
(possibly considering distribution
effects on gainers and losers).
11.7
11.8
BUILDING A PUBLIC BRIDGE
1. Ferry (status quo)
CS = $5 million/year
 = $5 million.
NPV@4% = $250 million.
2. Bridge (P = $0)
CS = $20 million/year
 = -$5 million, Cap Cost = $85 m.
NPV@4% = $290 million.
Price
$4
$3
PF = $2
3. Ferry (Regulated @ P = $1)
CS = $11.5 million/year
 = $0 million.
NPV@4% = $281.25 million.
Trip demand
P = 4 - .4Q
CS =
$5 million
F
F = $5 million
AC = $1
0
Trips (millions)
5
7.5
B
10