Economic Policy & Analysis

Week Five – Case Study:

Seven Important Ideas

I) Public Goods

Public goods are goods or resources which are unlimited and would be difficult to exclude anyone from using. Air is probably the best example to communicate the point. Air is virtually unlimited; it is something that I can use (via breathing) and it does not limit how much you can use; it would be very difficult to exclude you from using (except through death). That is the basic definition of public goods.

Some public goods are not as easy to identify, roads for example. In some cases roads have been turned into private goods (toll roads), but most roads are public goods. They fit the definition as is demonstrated. If I drive on the road I am not eliminating anyone else from driving on it. I do prefer if other people do not drive in the same space I am occupying, but there are alternatives to the space I am using (like the next lane over). Also, it would be difficult to exclude people from driving down 9^th st (or any street). If people needed to go to my house they must drive down 9^th St, just before turning into my driveway.

II) Externalities

Externalities are the effects of actions that are not seen from the perspective of the buyer or seller in some market. These effects may be positive or negative. A negative example is the exhaust fumes of my neighbor’s lawn mower blowing into my window on a warm spring day. Neither he nor the grass that he was mowing think about the pollution that was being created in an effort to cut the grass, but the externality was seen by me while the blue cloud rolled through my house while I was allowing “fresh air” into my living quarters. A positive externality would be the benefit I might receive while walking though the park for an evening stroll and hearing the music of a concert going on in the amphitheater across the soccer field.

One externality that is often overlooked is the sound pollution near airports. Although it is something not considered, trying to enjoy some lemonade on a hot summer day while talking with friends is hard to do with 80dB of jet-wash screaming overhead every 90sec.

III) Indirect Effects of Government Policy

Most policies are enacted to cause some event or reaction but they also have much broader effects than is anticipated. One example of an indirect effect is enacting a price cap on any good, gasoline for example. Now the government is looking out for its constituents and hears the angry cries when gas prices start to climb. One strategy that was used in the 1970’s was to limit the amount that could be charged for a gallon of gas. This seemed a great solution because then we would not have to continue to pay higher and higher prices for gasoline. It is just a constant (higher) price for fuel.

The indirect result was that with this steady price for gas, came a problem that some companies who were previously supplying fuel were not able to supply it for that price. That meant that there was a shortage of fuel because fuel producers who could not afford to supply, didn’t. This shortage was in part caused by the price cap, although it was not the intent.

IV) Supply & Demand

Supply and demand have an inverse relationship in terms of price and quantity. That is to say that as the price of goods (or service) increases the supply is expected to increase. The reasoning behind this is that with higher prices more people are able to produce the good and sell it for a profit. Inversely, as price decreases the demand increases. This is because more people are willing to purchase the good (or service) when the price is low.

This concept is demonstrated well in the previous example of gas prices and the government cap placed on them. When the price was limited to a point that would be lower than the natural market would place it, suppliers were forced to remove themselves from the market. That means that the supply would decrease. When there is a shortage of a product like gas, people who need it are willing to pay more for the good.

V) Market Risk

Risk is needed for markets to be successful and efficient. The ability of people and firms to develop new improved ways of carrying out their business is what creates competition and rewards those who put resources on the line to make the improvements. When we look at risk it is the investment of resources (money, time, land, etc.) to make improvements. These risks may or may not pay off. That is the risk; you may lose all the resources invested because someone else made better improvements or has a better understanding of what the market wants. Free markets use risk (thus competition) to demand efficiency. If you as a supplier are not producing at your most profitable level a competitor may make some improvement that allows them to produce more at a lower cost. With the lower cost they would be able to steal some (if not all) of your customers. By forcing all competitors in the market to make improvements and become more efficient, consumers will also be getting more for less, thus freeing up money to enrich themselves with more (or other) products.

VI) Government's Responsibility in Market Protection

The government has the responsibility to ensure the welfare of its citizens as a whole. The government will not (or should not) step in when individuals or firms take on risk and fail. But when a market is at risk the effects can destroy entire nations (think Great Depression, partially caused by the stock market crash of 1929). When the failure is on this level the government will do what it takes to ensure as soft a landing as possible.

Risk is a huge factor in markets that keeps them efficient. But what happens when this risk that is taken on by a market is so high that not just firm failure happens but entire markets collapse? Although risk is encouraged to increase efficiency sometimes it kills markets, when too much risk is accepted. The government will inflate the value of money or place temporary limits on different goods. It may also give subsidies to encourage producers or consumers to behave in a way that it believes will most benefit the market.

VII) Impacts of Incentives

Incentives are a way in which to manipulate individuals, firms and markets to behave in desirable ways. Incentives can be any creative use of resources to encourage a desired behavior. One common incentive is for firms to make some of an employee’s compensation dependant on the profit level of the company. This incentive makes the individual as well as the owner of the company focus his attention and work on making the company to be successful.

McKenzie and Lee (2006). Microeconomics for MBA's: the economic way of thinking for managers. New York: Cambridge University Press.