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Principle #9: When Markets Don’t Achieve Efficiency, Government Intervention Can Improve Society’s Welfare

Let’s recall from the Introduction the nature of the market failure caused by traffic congestion—a commuter driving to work has no incentive to take into account the cost that his or her action inflicts on other drivers in the form of increased traffic congestion.

There are several possible remedies to this situation; examples include charging road tolls, subsidizing the cost of public transportation, and taxing sales of gasoline to individual drivers. All these remedies work by changing the incentives of would-be drivers, motivating them to drive less and use alternative transportation. But they also share another feature: each relies on government intervention in the market. This brings us to our ninth principle:

When markets don’t achieve efficiency, government intervention can improve society’s welfare.

That is, when markets go wrong, an appropriately designed government policy can sometimes move society closer to an efficient outcome by changing how society’s resources are used.

An important branch of economics is devoted to studying why markets fail and what policies should be adopted to improve social welfare. We will study these problems and their remedies in depth in later chapters, but, briefly, there are three principal ways in which they fail:

An important part of your education in economics is learning to identify not just when markets work but also when they don’t work, and to judge what government policies are appropriate in each situation.

!worldview! ECONOMICS in Action: Restoring Equilibrium on the Freeways

Restoring Equilibrium on the Freeways

When a powerful earthquake struck the Los Angeles area back in 1994, it caused several freeway bridges to collapse and thereby disrupted the normal commuting routes of hundreds of thousands of drivers. The events that followed offer a particularly clear example of interdependent decision making—in this case, the decisions of commuters about how to get to work.

Witness equilibrium in action on a Los Angeles freeway.
Glowimages/Getty Images

In the immediate aftermath of the earthquake, there was great concern about the impact on traffic, since motorists would now have to crowd onto alternative routes or detour around the blockages by using city streets. Public officials and news programs warned commuters to expect massive delays and urged them to avoid unnecessary travel, reschedule their work to commute before or after the rush, or use mass transit.

These warnings were unexpectedly effective. In fact, so many people heeded them that in the first few days following the quake, those who maintained their regular commuting routine actually found the drive to and from work faster than before.

Of course, this situation could not last. As word spread that traffic was relatively light, people abandoned their less convenient new commuting methods and reverted to their cars—and traffic got steadily worse. Within a few weeks after the quake, serious traffic jams had appeared. After a few more weeks, however, the situation stabilized: the reality of worse-than-usual congestion discouraged enough drivers to prevent the nightmare of citywide gridlock from materializing. Los Angeles traffic, in short, had settled into a new equilibrium, in which each commuter was making the best choice he or she could, given what everyone else was doing.

This was not, by the way, the end of the story: fears that traffic would strangle the city led local authorities to repair the roads with record speed. Within only 18 months after the quake, all the freeways were back to normal, ready for the next one.

Quick Review

  • Most economic situations involve the interaction of choices, sometimes with unintended results. In a market economy, interaction occurs via trade between individuals.

  • Individuals trade because there are gains from trade, which arise from specialization. Markets usually move toward equilibrium because people exploit gains from trade.

  • To achieve society’s goals, the use of resources should be efficient. But equity, as well as efficiency, may be desirable in an economy. There is often a trade-off between equity and efficiency.

  • Except for certain well-defined exceptions, markets are normally efficient. When markets fail to achieve efficiency, government intervention can improve society’s welfare.

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  1. Question 1.3

    Explain how each of the following situations illustrates one of the five principles of interaction.

    1. Using eBay any student who wants to sell a used textbook for at least $30 is able to sell it to someone who is willing to pay $30.

      This illustrates the concept that markets usually lead to efficiency. Any seller who wants to sell a book for at least $30 does indeed sell to someone who is willing to buy a book for $30. As a result, there is no way to change how used textbooks are distributed among buyers and sellers in a way that would make one person better off without making someone else worse off.

    2. At a college tutoring co-op, students can arrange to provide tutoring in subjects they are good in (like economics) in return for receiving tutoring in subjects they are poor in (like philosophy).

      This illustrates the concept that there are gains from trade. Students trade tutoring services based on their different abilities in academic subjects.

    3. The local municipality imposes a law that requires bars and nightclubs near residential areas to keep their noise levels below a certain threshold.

      This illustrates the concept that when markets don’t achieve efficiency, government intervention can improve society’s welfare. In this case the market, left alone, will permit bars and nightclubs to impose costs on their neighbors in the form of loud music, costs that the bars and nightclubs have no incentive to take into account. This is an inefficient outcome because society as a whole can be made better off if bars and nightclubs are induced to reduce their noise.

    4. To provide better care for low-income patients, the local municipality has decided to close some underutilized neighborhood clinics and shift funds to the main hospital.

      This illustrates the concept that resources should be used as efficiently as possible to achieve society’s goals. By closing neighborhood clinics and shifting funds to the main hospital, better health care can be provided at a lower cost.

    5. On eBay books of a given title with approximately the same level of wear and tear sell for about the same price.

      This illustrates the concept that markets move toward equilibrium. Here, because books with the same amount of wear and tear sell for about the same price, no buyer or seller can be made better off by engaging in a different trade than he or she undertook. This means that the market for used textbooks has moved to an equilibrium.

  2. Question 1.4

    Which of the following describes an equilibrium situation? Which does not? Explain your answer.

    1. The restaurants across the street from the university dining hall serve better-tasting and cheaper meals than those served at the university dining hall. The vast majority of students continue to eat at the dining hall.

      This does not describe an equilibrium situation. Many students should want to change their behavior and switch to eating at the restaurants. Therefore, the situation described is not an equilibrium. An equilibrium will be established when students are equally as well off eating at the restaurants as eating at the dining hall— which would happen if, say, prices at the dining hall were higher than at the restaurants.

    2. You currently take the subway to work. Although taking the bus is cheaper, the ride takes longer. So you are willing to pay the higher subway fare in order to save time.

      This does describe an equilibrium situation. By changing your behavior and riding the bus, you would not be made better off. Therefore, you have no incentive to change your behavior.

Solutions appear at back of book.