“The health effects of secondhand smoke exposure are more pervasive than we previously thought,” Carmona said. “The scientific evidence is now indisputable: Secondhand smoke is not a mere annoyance. It is a serious health hazard that can lead to disease and premature death in children and nonsmok- ing adults.”
According to the report, the government’s most detailed statement ever on secondhand smoke, exposure to smoke at home or work increases the nonsmokers’ risk of developing heart disease by 25 to 30 percent and lung cancer by 20 to
Analysis: The health risks imposed on nonsmokers via “passive smoke” represent external costs. The market price of cigarettes doesn’t reflect these costs borne by third parties.
30 percent. It is especially dangerous for children living with smokers and is known to cause sudden infant death syndrome, respiratory problems, ear infections and asthma attacks in infants and children. . . .
The report does not present new scientific data but is an analysis of the best research on secondhand smoke. It said, for instance, that the Centers for Disease Control and Prevention estimated last year that exposure to secondhand smoke kills more than 3,000 nonsmokers from lung cancer, approximately 46,000 from coronary heart disease, and as many as 430 new- borns from sudden infant death syndrome.
—Marc Kaufman Source: Washington Post, June 28, 2006 p. 1. © 2006, The Washington Post, excerpted with permission.
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C H A P T E R 4 : T H E P U B L I C S E C T O R 71
The term externalities refers to all costs or benefits of a market activity borne by a third party, that is, by someone other than the immediate producer or consumer. Whenever exter- nalities are present, market prices aren’t a valid measure of a good’s value to society. As a consequence, the market will fail to produce the right mix of output. Specifically, the market will underproduce goods that yield external benefits and overproduce those that generate external costs.
External Costs. Figure 4.3 shows how external costs cause the market to overproduce cigarettes. The market demand curve includes only the wishes of smokers, that is, people who are willing and able to purchase cigarettes. The forces of market demand and supply result in an equilibrium at E M in which q M cigarettes are produced and consumed. The market price P M reflects the value of those cigarettes to smokers.
The well-being of non smokers isn’t reflected in the market equilibrium. To take the non- smoker’s interests into account, we must subtract the external costs imposed on them from the value that smokers put on cigarettes. In general,
Social demand market demand externalities
In this case, the externality is a cost, so we must subtract the external cost from market demand to get a full accounting of social demand. The “social demand” curve in Figure 4.3 reflects this computation. To find this curve, we subtract the amount of external cost from every price on the market demand curve. What the social demand curve tells us is how much society would be willing and able to pay for cigarettes if the preferences of both smokers and nonsmokers were taken into account.
The social demand curve in Figure 4.3 creates a social equilibrium at E O . At this juncture, we see that the socially optimal quantity of cigarettes is q O , not the larger market-generated level at q M . In this sense, the market produces too many cigarettes.
Externalities also exist in production. A power plant that burns high-sulfur coal damages the surrounding environment. Yet the damage inflicted on neighboring people, vegetation, and buildings is external to the cost calculations of the firm. Because the cost of such pol- lution is not reflected in the price of electricity, the firm will tend to produce more electric- ity (and pollution) than is socially desirable. To reduce this imbalance, the government has to step in and change market outcomes.
externalities: Costs (or bene- fits) of a market activity borne by a third party; the difference between the social and private costs (benefits) of a market activity.
externalities: Costs (or bene- fits) of a market activity borne by a third party; the difference between the social and private costs (benefits) of a market activity.
QUANTITY OF CIGARETTES (packs per year)
PRICE (per pack)
EO PM
qO
EM
qM
Market supply
Market output Optimal
output
External cost per pack
Market demand
Social demand
FIGURE 4.3 Externalities
The market responds to consumer demands, not externalities. Smokers demand qM cigarettes. But external costs on nonsmokers imply that the social demand for cigarettes is less than (below) market demand. The socially optimal level of output is qO, less than the market output qM.
Check out the pollution problems in your neighborhood at www.epa.gov/
epahome/commsearch.htm
webnote
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72 T H E E C O N O M I C C H A L L E N G E
External Benefits. Externalities can also be beneficial. A product may generate external benefits rather than external costs. Your college is an example. The students who attend your school benefit directly from the education they receive. That’s why they (and you) are willing to pay for tuition, books, and other services. The students in attendance aren’t the only beneficiaries of this educational service, however. The research that a university con- ducts may yield benefits for a much broader community. The values and knowledge stu- dents acquire may also be shared with family, friends, and co-workers. These benefits would all be external to the market transaction between a paying student and the school.
Positive externalities also arise from immunizations against infectious diseases.
If a product yields external benefits, the social demand is greater than the market demand. In this case, the social value of the good exceeds the market price (by the amount of external benefit). Accordingly, society wants more of the product than the market mechanism alone will produce at any given price. To get that additional output, the government may have to intervene with subsidies or other policies. We conclude then that the market fails by
• Overproducing goods that have external costs.
• Underproducing goods that have external benefits.
If externalities are present, the market won’t produce the optimal mix of output. To get that optimal mix, we need government intervention.
In the case of both public goods and externalities, the market fails to achieve the optimal mix of output because the price signal is flawed. The price consumers are willing and able to pay for a specific good doesn’t reflect all the benefits or cost of producing that good.
The market may fail, however, even when the price signals are accurate. The response to price signals, rather than the signals themselves, may be flawed.
Restricted Supply. Market power is often the cause of a flawed response. Suppose there were only one airline company in the world. This single seller of airline travel would be a monopoly —that is, the only producer in that industry. As a monopolist, the airline could charge extremely high prices without worrying that travelers would flock to a competing airline. At the same time, the high prices paid by consumers would express the importance of that service to society. Ideally, such prices would act as a signal to producers to build and fly more planes—to change the mix of output. But a monopolist doesn’t have to cater to every consumer’s whim. It can limit airline travel and obstruct our efforts to achieve an optimal mix of output.
Monopoly is the most severe form of market power. More generally, market power refers to any situation in which a single producer or consumer has the ability to alter the market price of a specific product. If the publisher (McGraw-Hill) charges a high price for this book, you’ll have to pay the tab. McGraw-Hill has market power because there are relatively few economics textbooks and your professor has required you to use this one. You don’t have power in the textbook market because your decision to buy or not won’t alter the market price of this text. You’re only one of the million students who are taking an introductory economics course this year.
The market power McGraw-Hill possesses is derived from the copyright on this text. No matter how profitable textbook sales might be, no one else is permitted to produce or sell this particular book. Patents are another common source of market power because they also preclude others from making or selling a specific product. Market power may also result from control of resources, restrictive production agreements, or efficiencies of large-scale production.
Whatever the source of market power, the direct consequence is that one or more pro- ducers attain discretionary power over the market’s response to price signals. They may use that discretion to enrich themselves rather than to move the economy toward the opti- mal mix of output. In this case, the market will again fail to deliver the most desired goods and services.
Market Power Market Power
monopoly: A firm that pro- duces the entire market supply of a particular good or service.
monopoly: A firm that pro- duces the entire market supply of a particular good or service.
market power: The ability to alter the market price of a good or a service.
market power: The ability to alter the market price of a good or a service.
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C H A P T E R 4 : T H E P U B L I C S E C T O R 73
The mandate for government intervention in this case is to prevent or dismantle con- centrations of market power. That’s the basic purpose of antitrust policy. Another option is to regulate market behavior. This was one of the goals of the antitrust case against Micro- soft. The government was less interested in breaking Microsoft’s near monopoly on operat- ing systems than in changing the way Microsoft behaved.
In some cases, it may be economically efficient to have one large firm supply an entire market. Such a situation arises in natural monopoly, where a single firm can achieve economies of scale over the entire range of market output. Utility companies, local tele- phone service, subway systems, and cable all exhibit such scale (size) efficiencies. In these cases, a monopoly structure may be economically desirable. The government may have to regulate the behavior of a natural monopoly, however, to ensure that consumers get the benefits of that greater efficiency.
Public goods, externalities, and market power all cause resource misallocations. Where these phenomena exist, the market mechanism will fail to produce the optimal mix of out- put in the best-possible way.
Beyond the questions of WHAT and HOW to produce, we’re also concerned about FOR WHOM output is produced. The market answers this question by distributing a larger share of total output to those with the most income. Although this result may be efficient, it’s not necessarily equitable. As we saw in Chapter 2, the market mechanism may enrich some people while leaving others to seek shelter in abandoned cars. If such outcomes violate our vision of equity, we may want the government to change the market-generated distribution of income.
Taxes and Transfers. The tax-and-transfer system is the principal mechanism for redis- tributing incomes. The idea here is to take some of the income away from those who have
“too much” and give it to those whom the market has left with “too little.” Taxes are levied to take back some of the income received from the market. Those tax revenues are then redistributed via transfer payments to those deemed needy, such as the poor, the aged, the unemployed. Transfer payments are income payments for which no goods or services are exchanged. They’re used to bolster the incomes of those for whom the market itself pro- vides too little.
Merit Goods. Often, our vision of what is “too little” is defined in terms of specific goods and services. There is a widespread consensus in the United States that everyone is entitled to some minimum levels of shelter, food, and health care. These are regarded as merit goods, in the same sense that everyone merits at least some minimum provision of such goods.
When the market does not distribute that minimum provision, the government is called on to fill in the gaps. In this case, the income transfers take the form of in-kind transfers (e.g., food stamps, housing vouchers, Medicaid) rather than cash transfers (e.g., welfare checks, Social Security benefits).
Some people argue that we don’t need the government to help the poor—that private charity alone will suffice. Unfortunately, private charity alone has never been adequate.
One reason private charity doesn’t suffice is the “free-rider” problem. If I contribute heav- ily to the poor, you benefit from safer streets (fewer muggers), a better environment (fewer slums and homeless people), and a clearer conscience (knowing fewer people are starving).
In this sense, the relief of misery is a public good. Were I the only taxpayer to benefit sub- stantially from the reduction of poverty, then charity would be a private affair. As long as income support substantially benefits the public at large, then income redistribution is a public good, for which public funding is appropriate. This is the economic rationale for public income-redistribution activities. To this rationale one can add such moral arguments as seem appropriate.
The micro failures of the marketplace imply that we’re at the wrong point on the produc- tion possibilities curve or inequitably distributing the output produced. There’s another basic question we’ve swept under the rug, however. How do we get to the production
antitrust: Government inter- vention to alter market struc- ture or prevent abuse of market power.
antitrust: Government inter- vention to alter market struc- ture or prevent abuse of market power.
natural monopoly: An industry in which one firm can achieve economies of scale over the entire range of market supply.
natural monopoly: An industry in which one firm can achieve economies of scale over the entire range of market supply.
Inequity Inequity
transfer payments: Payments to individuals for which no current goods or services are exchanged, like Social Security, welfare, and unemployment benefits.
transfer payments: Payments to individuals for which no current goods or services are exchanged, like Social Security, welfare, and unemployment benefits.
merit good: A food or service society deems everyone is enti- tled to some minimal quantity of.
merit good: A food or service society deems everyone is enti- tled to some minimal quantity of.
Macro Instability Macro Instability
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74 T H E E C O N O M I C C H A L L E N G E
possibilities curve in the first place? To reach the curve, we must utilize all available resources and technology. Can we be confident that the invisible hand of the marketplace will use all available resources? Or will some people face unemployment —that is, be will- ing to work but unable to find a job?
And what about prices? Price signals are a critical feature of the market mechanism. But the validity of those signals depends on some stable measure of value. What good is a dou- bling of salary when the price of everything you buy doubles as well? Generally, rising prices will enrich people who own property and impoverish people who rent. That’s why we strive to avoid inflation —a situation in which the average price level is increasing.
Historically, the marketplace has been wracked with bouts of both unemployment and inflation. These experiences have prompted calls for government intervention at the macro level. The goal of macro intervention is to foster economic growth—to get us on the production possibilities curve (full employment), maintain a stable price level (price stability), and increase our capacity to produce (growth).