No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Thirteen: Market “Failure” and the Role of the Government 308 production should be reduced? We’ve already discussed earlier in the book that there is an optimal amount of “bads.” It is not at all clear that the correct amount of toxins in the river ought to be zero—at least from a social welfare sense. It is entirely possible that units of production (that result in some positive level of toxins in the river) would provide a higher level of utility to those consuming Stinky Steel’s product than the negative utility of those living downstream. If the gains to those upstream exceed the losses incurred by those downstream, the upstream winners could potentially compensate the losers downstream (either through private agreement or through a government taxation scheme). But this comes back to the knowledge problem: how do we compare the upstream gains to the downstream losses? The knowledge problem is not the only consideration; administration of a central planning bureaucracy requires significant resources. Much of the tax revenue ostensibly taken for flower subsidies (or steel industry regulation) will be used by the planning bureaucracy to accomplish its mission. Indeed, it often will cost more than a dollar to provide a dollar’s worth of benefit to some constituency. Further, if the central planner happily stumbled upon the socially optimal quantity of a given good (but how would he know he did?!), individual preferences constantly change; the planner would have no way of knowing whether he should adjust production at any time. While markets are likewise not omniscient, prices provide a signal to guide production changes as the market process unfolds. But the central planner has no way of dealing with a dynamic world of changing tastes and preferences. This does not mean that government action can never improve a market outcome in the presence of externalities. It simply means the difficulties noted ensure that the government cannot hit (or maintain) some socially optimal production level, and it means that government action could make the situation worse . It is always a case of comparing differing institutional arrangements in the real world. One cannot simply assume that if markets aren’t perfect, government can and must correct them—as if government action had no problems of its own. We’ll explore some of these problems in chapter 14. REMEDIES FOR EXTERNALITIES The knowledge problem that precludes government from hitting the socially optimal production level does not mean we can’t do anything. We can put many institutional improvements in place to encourage the internalization of externalities; that is, make the P ($) Q (#) Q 1 Q 2 $4 $3 S D 1 D 2 Figure 13.7, Mr. Anderson’s Flower Demand with $1 Subsidy. When the taxpayer provides a $1 subsidy to the consumer to purchase additional flowers, the demand curve will shift to the right, such that at every quantity, the new demand curve rises over the original demand curve by the amount of the subsidy. In this case, quantity will rise to Q 2 , but flowers that were previously valued at only $3 by the customer will be purchased for $4 because of the taxpayer subsidy.