McConnell - Microeconomics Chapter 4 & 5 (Market Challenges & The Role of Government)

What is moral hazard?

Another asymmetric information problem is moral hazard. Moral hazard occurs when the behavior of one changes after the contract is made.

What is adverse selection?

Asymmetric information, when there is an imbalance of information among parties, can also create a market failure. Adverse selection can arise when information is known to one party in a transaction that is not known to the other, at the time the contract is made

What is unfunded liability?

Unfunded liability - a future government spending commitment (liability) for which the government has not legislated an offsetting revenue source.

Explain the assumptions outlined in the Coase Theorem.

When conflicting property rights occur, bargaining between the parties involved will lead to an efficient outcome regardless of which party is ultimately awarded the property rights, as long as the transaction costs associated with bargaining are negligible. Specifically, the Coase Theorem states that "if trade in an externality is possible and there are no transaction costs, bargaining will lead to an efficient outcome regardless of the initial allocation of property rights."

What are the government (3) options to combat underallocation of resources?

Where spillover benefits are large and diffuse, as in our earlier example of inoculations, government has three options for correcting the underallocation of resources: 1) Subsidies to buyers 2) Subsidies to producers 3) Government provision

What is coase theorem?

Coase theorem - the idea, first stated by economist Ronald Coase, that some externalities can be resolved through private negotiations among the affected parties. EX: Consider the positive externalities that bees provide by pollinating farmers' crops. Should we assume that beekeeping will be underprovided unless the government intervenes with, for instance, subsidies to encourage more hives and hence more pollination?

What is consumer surplus?

Consumer surplus - the difference between the maximum price a consumer is (or consumers are) willing to pay for an additional unit of a product and its market price; the triangular area below the demand curve and above the market price.

What is cost-benefit analysis?

Cost-benefit analysis - a comparison of the marginal costs of a project or program with the marginal benefits to decide whether or not to employ resources in that project or program and to what extent.

What is debt crisis?

Debt crisis - an economic crisis in which government debt has risen so high that the government is unable to borrow any more money due to people losing faith in the government's ability to repay. Leads to either massive spending cuts or large tax increases, either of which will likely plunge the economy into a recession.

What is deregulation?

Deregulation - the removal of most or even all of the government regulation and laws designed to supervise an industry. Sometimes undertaken to combat regulatory capture.

What is economic inefficiency?

Economic inefficiency - deficits may allow the government to control and direct an inefficiently large fraction of the economy's resources. To the extent that deficit spending facilitates an underallocation of resources to the private sector and an overallocation of resources to the government sector, there will be a tendency to underproduce private goods and overproduce public goods. If that occurs, the economy will experience a decrease in both allocative and productive efficiency.

What is efficiency losses?

Efficiency loss - reductions in combined consumer and producer surplus caused by an underallocation or overallocation of resources to the production of a good or service. Also called deadweight loss.

What is excludability?

Excludability - the characteristic of a private good, for which sellers can keep people who do not pay for a product from obtaining its benefits. (the seller can keep nonbuyers from obtaining the good) EX: Only people who are willing and able to pay the market price for bottles of water can obtain these drinks and the benefits they confer.

What are two stabilization policies?

Governments often attempt to smooth out these so-called business cycles by using two types of macroeconomic stabilization policy: Fiscal policy For example, if the economy is going into a recessionary period with falling output and rising unemployment, the government may attempt to stimulate the economy by lowering tax rates or increasing government spending. ] Monetary policy In particular, the government can use its control over the money supply to lower interest rates during a recession.

What is externality?

Externality - a cost or benefit from production or consumption that accrues to to someone other than the immediate buyers and sellers of the product being produced or consumed (see negative externality and positive externality). - This failure to account for all production costs causes firms' supply curves to shift to the right of (or below) where they would be if firms properly accounted for all costs.

What is fiscal policy?

Fiscal policy - changes in government spending and tax collections designed to achieve full employment, price stability, and economic growth; also called discretionary fiscal policy.

What is free-rider problem?

Free-rider problem - the inability of potential providers of an economically desirable good or service to obtain payment from those who benefit, because of nonexcludability.

What is government failure?

Government failure - inefficiencies in resource allocation caused by problems in the operation of the public sector (government). Specific examples include the principal-agent problem, the special-interest effect, the collective-action problem, rent seeking, and political corruption.

What are loan guarantees?

Loan guarantees - a type of investment subsidy in which the government agrees to guarantee (pay off) the money borrowed by a private company to fund investment projects if the private company itself fails to repay the loan.

Name two types of market failures?

Market failures in competitive markets fall into just two categories: 1) Demand-side market failures happen when demand curves do not reflect consumers' full willingness to pay for a good or service. 2) Supply-side market failures occur when supply curves do not reflect the full cost of producing a good or service.

What is monetary policy?

Monetary policy - a central bank's changing of the money supply to influence interest rates and assist the economy in achieving price-level stability, full employment, and economic growth.

What are negative externalities?

Negative externalities cause supply-side market failures. These failures happen because producers do not take into account the costs that their negative externalities impose on others. - This failure to account for all production costs causes firms' supply curves to shift to the right of (or below) where they would be if firms properly accounted for all costs.

What is nonexcludability?

Nonexcludability - the inability to keep nonpayers (free riders) from obtaining benefits from a certain good; a characteristic of a public good. (means there is no effective way of excluding individuals from the benefit of the good once it comes into existence.) EX: Once in place, you cannot exclude someone from benefiting from national defense, street lighting, a global positioning system, or environmental protection.

What is nonrivalry?

Nonrivalry - the idea that one person's benefit from a certain good does not reduce the benefit available to others; a characteristic of a public good. EX: Everyone can simultaneously obtain the benefit from a public good such as national defense, street lighting, a global positioning system, or environmental protection.

What is the optimal reduction of an externality?

Optimal reduction of an externality - the reduction of a negative externality such as pollution to the level at which the marginal benefit and marginal cost of reduction are equal.

What is pigovian tax?

Pigovian tax - a tax or charge levied on the production of a product that generates negative externalities. If set correctly, the tax will precisely offset the overallocation (overproduction) generated by the negative externality.

What are positive externalities?

Positive externalities cause demand-side market failures. These failures happen because market demand curves in such cases fail to include the willingness to pay of the third parties who receive the external benefits caused by the positive externality. - This failure to account for all benefits shifts market demand curves to the left of (or below) where they would be if they included all benefits and the willingness to pay of both the third parties as well as the primary beneficiaries.

What is principal-agent problem? (2)

Principal-agent problems - (1) At a firm, a conflict of interest that occurs when agents (workers or managers) pursue their own objectives to the detriment of the principals' (stockholders') goals. (2) In public choice theory, a conflict of interest that arises when elected officials (who are the agents of the people) pursue policies that are in their own interests rather than policies that would be in the better interests of the public (the principals).

What are private goods?

Private good - a good, or service that is individually consumed and that can be profitably provided by privately owned firms because they can exclude nonpayers from receiving the benefits.

What is producer surplus?

Producer surplus - the difference between the actual price a producer receives (or producers receive) and the minimum acceptable price; the triangular area above the supply curve and below the market price.

What is the public good?

Public good - a good or service that is characterized by nonrivalry and nonexcludability. These characteristics typically imply that no private firm can break even when attempting to provide such products. As a result, they are often provided by governments, who pay for them using general tax revenues.

What is quasi-public good?

Quasi-public good - a good or service to which excludability could apply but that has such a large positive externality that government sponsors its production to prevent an underallocation of resources. EX: include education, streets and highways, police and fire protection, libraries and museums, preventive medicine, and sewage disposal. They could all be priced and provided by private firms through the market system. But, because the benefits of these goods flow well beyond the benefit to individual buyers, these goods would be underproduced by the market system. Therefore, government often provides them to avoid the underallocation of resources that would otherwise occur.

What is regulatory capture?

Regulatory capture - the situation that occurs when a governmental regulatory agency ends up being controlled by the industry that it is supposed to be regulating.

What is rent seeking?

Rent-seeking behavior - the actions by persons, firms, or unions to gain special benefits from government at the taxpayers' or someone else's expense. Alternative exp: Those engaged in "rent seeking" are attempting to use government influence to get themselves into a situation in which they will get paid more for providing a good or service than the minimum amount you would actually have to pay them to provide that good or service.

What is rivalry?

Rivalry - (1) The characteristic of a private good, the consumption of which by one party excludes other parties from obtaining the benefit; (2) the attempt by one firm to gain strategic advantage over another firm to enhance market share or profit. EX: When Adams purchases and drinks a bottle of mineral water, it is not available for Benson to purchase and consume.

What is special-interest effect?

Special-interest effect - any political outcome in which a small group ("special interest") gains substantially at the expense of a much larger number of persons who each individually suffers a small loss.

What unfunded liability can cause?

That may be problematic because chronic deficits can pose several economic challenges, including 1) Economic inefficiency 2) Debt crises A government's accumulated debt level may rise so high that investors lose faith in the government's ability or willingness to repay its debts.

Describe how to determine the collective demand curve for a particular public good and how this differs from determining the market demand for a private good.

The (private good) schedule represents a horizontal summation of the individual demand curves; the (public good) schedule represents a vertical summation of these curves. The market demand curve for the private good will determine—in combination with market supply—an actual price-quantity outcome in the marketplace. Because potential buyers of public goods do not reveal their individual preferences in the market, the collective demand curve for the public good is hypothetical or needs to be determined through ―willingness to pay studies.