PS 408 Midterm Study Guide

Question 1

What is market failure?

Answer 1

market failure is the inefficiency of the allocation of goods and services, resulting in a suboptimal outcome.

Question 2

What are the four reasons that market failure can occur?

Answer 2

1.) Externalities
2.) Public Goods
3.) Natural Monopolies
4.) Asymmetry

Question 3

What are the characteristics of public goods? And give an example

Answer 3

1.) nonrivalrous: A good is nonrivalrous in consumption when more than one person can derive consumption benefits from some level of supply at the same time.

2.) non-excludability: A good is nonexcludable if it is impractical for one person to maintain exclusive control over its use. For example, species of fish that range widely in the ocean are usually nonexcludable in use because they move freely among regions such that no individual can effectively exclude others from harvesting them.

Examples of public goods: National defense or a street lamp

Question 4

What are the characteristics of a natural monopoly?

Answer 4

Natural monopoly occurs when average cost declines over the relevant range of demand.

1.) Economies of scale: Natural monopolies can take advantage of economies of scale, which occur when the cost per unit decreases as the level of output increases.

2.) Barrier to entry: Because a natural monopoly can produce goods or services at a lower cost than any potential competitor, it can create a barrier to entry for other firms.

3.) High fixed costs: Natural monopolies often involve high fixed costs, such as large investments in infrastructure or specialized equipment.

4.) Price maker: As the sole producer in the market, a natural monopoly has the ability to act as a price maker, setting prices without fear of competition.

Examples of natural monopolies may include: water and electricity companies, and gas pipelines.

Question 5

Table of Public goods characteristics continued

Give an example of something that is excludable and non-rivalrous:

Give an example of something that is rivalrous and non-excludable:

Give an example of something that is excludable and non-rivalrous:

Give an example of something that is non-excludable and non-rivalrous:

Answer 5

Give an example of something that is excludable and non-rivalrous:
Shoes, clothing, and phones.

Give an example of something that is rivalrous and non-excludable:
A park, and the fishery. Problem, The tragedy of the commons arises when individuals or groups overuse the common-pool resource because they do not bear the full costs of their actions. A resource is overuse.

Give an example of something that is excludable and non-rivalrous:
Concert, tennis, club, and cable television.

Give an example of something that is non-excludable and non-rivalrous:

National defense, and a street lamp.

Question 6

What are problems associated with public goods?

Answer 6

Free rider problem: A person who enjoys the benefit of a good but does not pay for it.

Pure public goods: will not be provided by market because private providers cannot exclude people who do not pay for public goods.

Tragedy of the commons: Some public goods, such as clean air and water, are also common-pool resources, meaning that they are non-excludable but rivalrous. Overuse or depletion of these resources can lead to the tragedy of the commons, where individuals or groups overuse the resource because they do not bear the full costs of their actions.

Question 7

What are the characteristics of externalities?

Answer 7

• Externalities: a situation in which by-product of either production or consumption of good may benefit or harm other people.
• Negative externalities: externalities that harm others
• Air and water pollution generated by firms
• Cigarette smoke that nonsmokers must breathe in public places
• Positive externalities: externalities that benefit others
• Vaccinations
• Digital music exchange

Question 8

How do the characteristics of public goods result in a market failure?

Answer 8

• Due to non-excludability, it is difficult to charge individuals for the use
  of public good.
• Free-rider problem: When individuals get the benefit from public
  goods without paying for their use because they do not report their
  true demand for the public goods.

Question 9

What is a government failure?

Answer 9

an economic inefficiency (inefficient allocation of
resources) caused by a government intervention or problems inherent
in political system.

Question 10

What causes government failure?

Answer 10

• Direct democracy
• Representative government
• Bureaucratic supply
• Decentralized government

Question 11

Why does direct democracy cause government failure?

Answer 11

Paradox of voting:
* Voting right is the foundation of democracy.
* Mechanism for aggregating individual preferences.
* In elections, voters select candidates whose policy positions most closely match their own policy position or preferences.

the paradox of voting is still present, as the probability of an individual’s vote affecting the outcome of a policy decision is similarly low. This can lead to government failure, where the policy outcome chosen does not reflect the preferences of the majority of the population.

Bundling: a process where several policy proposals are combined into a single package, and voters are given the option to vote for or against the package as a whole, rather than each policy proposal individually.

can create a situation where voters are forced to choose between supporting policies they may not agree with to achieve a desired outcome, or voting against the entire package, which may mean rejecting policies they support.

Question 12

What is the problem of bundling?

Answer 12

Voters evaluate the bundle of positions offered by candidate.
* Different voters vote for the same candidate for different reasons.
e.g., support tax policy (tax cuts), but do not support immigration policy.
* A particular policy in bundle ≠ the will of a majority.

Question 13

Why does a representative government cause government failure?

Answer 13

Rent seeking:
* Occurs when an entity seeks to gain the
existing wealth without increasing
productivity.
* Someone who try to get a larger slice of
the cake without an effort to make the
cake bigger.
* When a rent-seeker gains benefits,
someone else must lose those benefits. such as lobbying for favorable government policies, seeking monopoly privileges, or engaging in legal or regulatory actions that create barriers to entry for competitors.

Electoral cycles:
* Representatives should select policies for which benefits > costs.
* In reality, representatives select policies with visible net benefits to
increase the odds of being reelected.
* Electoral cycles interact with the partisan preferences of incumbents,

electoral cycles can cause government failure in a representative government if politicians prioritize short-term goals that will help them get re-elected over long-term policies that are in the public interest, leading to a misallocation of resources and suboptimal policy outcomes.

Influence of interest group
Geographic constituencies
Public attention.

Question 14

What is geographic representation?

Answer 14

The problem of geographically defined districts.
* Self-interest (e.g., reelection) = districts’ interests ≠ national welfare.
* Politicians may adopt policies with “visible net benefits” to their own
districts for the short-term but large social costs in subsequent years.
* Politicians avoid political risks of raising taxes.
* Logrolling for district “pork” contributes to deficit spending.

Question 15

Why does a bureaucratic supply cause government failure?

Answer 15

This is mainly because of the principal-agent problem: arises when there is a conflict of interest
between the agent (bureaucrats) and the principal (politicians).
* Asymmetric information: Agent often has more information than the
principal.
* Agents can pursue their own interests to some extent, taking
advantages of asymmetric information.

Agency loss
Limited competition

Question 16

Why does decentralization cause government failure?

Answer 16

Bureau failure as market failure
Diffuse authority of Federalism
Fiscal externalities

Question 17

What are the ways of framing public policy problems, and relate to the market failures?

Answer 17

■ Tuition policy
→ pricing policy

■ Airplane noise
→ externality

■ Utility
→ Natural monopoly

■ Research
→ public goods

Question 18

What is the principal-agent problem?

Answer 18

Principal-agent problem: arises when there is a conflict of interest
between the agent (bureaucrats) and the principal (politicians).

Question 19

What are the differences between government corporations and government bureaus?

Answer 19

• Government cooperations operating with their own source of revenue → gives them
  independence from legislative or executive interference.
• The Tennessee Valley Authority (TVA):
• A federal owned electric utility corporation in the U.S.
• The sixth largest power supplier and largest public utility in the U.S.

A government corporation is a public sector entity that operates like a private corporation, but is owned and controlled by the government. It typically operates in a commercial or business-like manner,

Bureaus typically operate in a more bureaucratic and hierarchical environment, with decision-making authority resting with the head of the department or agency. Bureaus usually do not generate revenue or profits, but instead carry out government policy or implement regulations.

Question 20

What is the rationale for government corporations?

Answer 20

• Single market failure test
• Natural monopoly
• Other market failures (e.g., externalities, public goods)

address market failures or other issues that might prevent the private sector from providing these goods or services.

Question 21

What is natural monopoly?

Answer 21

• A situation in which one firm can produce the total output of the
  market at lower cost than several firms could.
• Example: governments frequently grant monopoly rights to public
  utilities to provide essential goods or services such as water, gas,
  electric power, or mail delivery

Question 22

What are the advantages and disadvantages of special districts?

Answer 22

Advantages
* Allow consumers to observe the
relationship btw service
provision and tax-price clearly.
* Internalize externalities that spill
across the boundaries of local
governments.

Disadvantages
* The costs that consumers face in
monitoring “mini-governments”
for different services.

Illinois is an example state which has many special districts

Question 23

Why do we need to do cost-benefit analysis?

Answer 23

• Governments need to ensure that taxpayer money is being used
  effectively given resource constraints.
• A cost-benefit analysis helps us understand its effectiveness of certain
  policy or program.

Question 24

How to conduct/steps for benefit analysis?

Answer 24

Step 1: Identifying relevant impacts of the policy
Step 2: Assign a monetary value to each item
Step 3: Estimate costs and benefits by discounting for time and risk
Step 4: Selecting among policies, comparing costs and benefits

Question 25

What is the value of 1,000 dollars in 1 year, 2 years, 3 years, and 10 years with a discount rate of 5%?

Answer 25

• 1000 × (1 + 0.05) = 1050, formula for 1 year
• 1050 × (1.05) = 1102.5, formula for 2 years
• 1000 ×(1.05)^3 = 1157.625, formula for 3 years
• 1000 ×(1 + 0.05) ^10 = 1628.9, formula for 10 years

Question 26

1. Identify a set of mutually exclusive contingencies
   * One or more major floods in the next 20 years
   * No floods in the next 20 years
2. Estimate the present value of net benefits under each contingency.
   * $25 million if one or more floods
   * - $5 million if no floods.

Assign a probability of occurrence to each contingency
1) P of major floods occurring:
* 0.02 2) P of no floods: 3) P of major floods occurring in the next 20 years: 4) P of no floods occurring in the next 20 years:

Answer 26

2) P of no floods:
* 1– 0.02 = 0.98
3) P of major floods occurring in the next 20 years:
* 1 - 0.98^20 = 0.33
4) P of no floods occurring in the next 20 years:
* 1 – 0.33 = 0.67

Question 27

What project does offer the largest net benefits? need to look at the table

Answer 27

• Project B offers the largest net benefits.

Question 28

What project does have the largest ratio of benefits to costs? need to look at the table

Answer 28

It is not B (cost-benefit ratio of 3), but A (cost-benefit ratio of 10).

Question 29

Which project should be selected? A or B? need to look at the table

Answer 29

Select project B because it offers larger net benefits.

Question 30

What is the procedure to convert the problem of floods to risk?

Estimate the present value of net benefits under each contingency

25 million dollars if one or more floods

-5 million dollars if no floods

Answer 30

Multiply the present value of net benefits for each contingency by the probability that the contingency will occur and sum to arrive at the expected value of the present net benefit.
(0.33)($25 million) + (0.67)(-$5 million) = $4.9 million

Question 31

Assume that none of the projects are mutually exclusive and total costs cannot exceed $10 million.
If project B is selected, will budget constraint be met?

Answer 31

• Costs of project B = $10 million. Net benefits = $20 million.

Question 32

If projects A, C, and D are selected, will budget constraint be met?

Answer 32

Costs of projects A, C, and D = $8 million. Net benefits = $9 + $14 = 23 million.

Question 33

Which project or projects should be chosen under the budget constraints?

Answer 33

Under the budget constraints, net benefits are maximized by choosing projects A, C, and D.

Question 34

What does voting with one’s feet mean?

Answer 34

In other words, when someone “votes with their feet,” they are making a statement about their preferences or beliefs by choosing to physically move to a different location or to participate in a particular activity.

Question 35

What are fiscal externalities?

Answer 35

It also gives people some opportunity to choose the bundles of public goods they consume through their selections of jurisdictions. The greater the variation in public goods bundles across jurisdictions, the greater is the opportunity for people to exercise choice by voting with their feet.

Fiscal externalities can be positive or negative. A positive fiscal externality occurs when a fiscal policy has a beneficial effect on parties not directly involved in the policy decision. For example, a government may invest in public infrastructure such as roads that benefit the entire community. But if a government provides tax breaks or subsidies to certain industries, it may create an unfair advantage for those industries and harm others.

Question 36

What is passive government failure?

Answer 36

The failure of government to intervene is best described as passive government failure. It can include outcomes that are attributable to the government not diagnosing market failures correctly as well as situations in which the lack of intervention derives from more concrete causes, such as the active influence of organized interest groups that successfully block efforts to correct market failure.

Passive government failure refers to a situation where the government fails to take action to address a problem or issue, even though it has the authority and the ability to do so.

Question 37

When the government does not diagnose the market failures correctly, for example?

Answer 37

The salmon fishery example since there was an overuse of the resources, more than the fish could be produced.

Question 38

How can we measure the opportunity cost?

Answer 38

It depends on the nature of the market.

Question 39

What does the opportunity cost mean?

Answer 39

Opportunity cost is a fundamental concept in economics that refers to the value of the next best alternative forgone when choosing among different options. In other words, it is the cost of what you give up in order to pursue a particular action or decision.

Question 40

Discounting for time and risk?

Answer 40

Present value: provides basis for comparing costs and benefits that accrue at different times.

Expected value: provides the approach to deal with risky situations. For example, want the 1,000 now instead of the future to buy a new laptop and inflation, instead of doing it for 10 years, not sure if alive in the future.

Question 41

What does mutually exclusive mean?

Answer 41

When two events do not influence each other, and have to be independent.