Competition in Markets

After reading chapters 5 and 6 and Special Topic 5, write a 2-page paper describing the importance of competition in markets. How does a lack of competition affect prices and output? Describe what the role of government is in markets vis-a-vis firms in the market.

Economics of Political Action

GWARTNEY – STROUP – SOBEL – MACPHERSON

To Accompany: “Economics: Private and Public Choice, 15th ed.”
James Gwartney, Richard Stroup, Russell Sobel, & David Macpherson
Slides authored and animated by: James Gwartney & Charles Skipton
Full Length Text —
Micro Only Text —
Part: 2
Part: 2
Chapter: 6
Chapter: 6
Macro Only Text —
Part: 2
Chapter: 6

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The Size and Growth
of the U.S. Government

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Government Spending as a Share
of the U.S. Economy: 1930 – 2012
The following slide shows total government spending (federal, state, and local) as a share of the US economy.
Total government spending accounted for only 9.4% of GDP
in 1930; only one third of this spending was at the federal level.
Government spending, particularly at the federal level, soared from 1930 to 1980. Total government spending rose from 9.4%
of GDP in 1930 to 32.8% in 1980 (more than 3 times its 1930 level).
After remaining fairly constant between 1980 and 2000, the size of the US government has increased dramatically since (increasing to 38% of the U.S. economy in 2012).

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The Size of the US Government:
1930-2012

Federal

State & local
Government Expenditures as a Share (%) of GDP
1930
1940
1950
1970
1980
1990
2000
3.0
6.5
9.4
8.4
15.7
7.3
1960
24.1
16.5
7.6
30.2
19.4
10.9
32.8
21.0
11.8
34.2
21.6
12.6
31.9
19.0
12.9
21.1
14.7
6.3
2010
39.7
25.4
14.3
2012
38.0
24.0
14.0

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How the Federal
Government Spends, 2011
Source: Economic Report of the President, 2013.
Defense 19.6%
Net
Interest 6.4%
Transportation
2.6%
Other
10.8%
Social
Security 20.3%
Income
Security 16.6%
Medicare and health 23.8%
Federal Spending (2011) = $3,603 Billion

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ss in sec medicare other trans net int def 20.5 18 23.8 9.2000000000000011 2.7 5.7 20.100000000000001
How State and Local
Governments Spend, 2010
Education
29.1%
Insurance trusts 8.2%
Public welfare
& Health 17.7%
Police & Fire
Protection 4.5%
Transportation 5.4%
Administration
& other 24.7%
Interest on debt 3.4%
Utilities &
liquor stores 7.0%
Source: US Census Bureau, State and Local Finances, 2010.
State and Local Spending (2010) = $3,115 Billion

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27.6 15.8 3.4 6.8 6 6.8 22.1 11.6
The Growth of Government
Transfer Payments
Transfer payments tax income from some and transfer it to others.
As is illustrated here, government transfer payments have grown rapidly since 1930.
Source: Bureau of Economic Analysis, http://www.bea.gov.
Transfer Payments as a % of National Income
1960
5.9%
1970
8.3%
1980
11.6%
1990
11.7%
2000
12.0%
2010
18.0%
1930
1.1%
1940
2.6%
1950
6.4%
17.4%
2012

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Similarities and Differences Between Political and Market Allocation

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Differences and Similarities Between
Government and Markets
Competitive behavior is present in both the market and public sectors.
Public sector organization can break the individual consumption-payment link.
Scarcity imposes the aggregate consumption-payment link in both sectors.
Private sector action is based on mutual agreement; public sector (when democratic) is based on majority rule.

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When collective decisions are made legislatively, voters must choose among candidates who represent a bundle
of positions on issues.
Income and influence are distributed differently in the two sectors.
Differences and Similarities Between
Government and Markets

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Political Decision Making:
An Overview

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Public Choice Analysis
Public Choice analysis
– applies the tools of economics to the political process in order to provide insight concerning how the process works.
Self-interested behavior is present in both market and political sectors.
The political process can be viewed as a complex interaction among three groups:
voter-taxpayers
politicians
bureaucrats

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The Voter-Consumer:
Voters will tend to support those candidates who they believe will provide them with the most government services and transfer benefits, net of personal costs.
Rational Ignorance Effect:
Recognizing their vote is unlikely to be decisive, most voters have little incentive to obtain information on issues and alternative candidates.
Because of the rational ignorance effect, voters will be uninformed on many issues; such issues will not enter into their decision-making process.
The Voter-Consumer

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The Politician-Supplier:
Political officials are interested in winning elections.
Just as profits are the lifeblood of the market entrepreneur, votes are the lifeblood of the politician.
Rationally uninformed voters often must be convinced to “want” a candidate.
Legislative bodies, like a Board of Directors:
establishes the general direction of policy,
appoints and supervises bureaucrats who carryout the day-to-day operations of government, and,
sets the budgets of agencies and bureaus.
The Politician-Supplier

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Civil servants (government bureaucrats) as political participants:
Bureaucrats (persons that handle day-to-day operations of government) seek promotions, job security, power, etc.
The interests of bureaucrats are often complementary with those of the interest groups they serve.
Larger budgets and program expansion generally serve the interests of both bureaucrats and their constituent groups.
Government Bureaucrats

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When the Political Process
Works Well

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Distribution of Benefits and Costs
Among Voters
Consider how the 4 possible distributions of benefits and costs among voters affect the operation of representative government.
When benefits or costs are either both widespread or concentrated (type 1 or type 3), representative government tends to undertake projects
that are productive and reject those that are unproductive.
Type
1
Type
4
Widespread
Concentrated
Widespread
Concentrated
Distribution of costs
among voters
Distribution of benefits
among voters
Type
2
Type
3

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When benefits are concentrated and costs widespread (type 2), representative government is biased towards the adoption of counterproductive (inefficient) activity.
Last, when benefits are widespread but the costs are concentrated (type 4), the political process often rejects productive projects.
Type
1
Type
4
Widespread
Concentrated
Widespread
Concentrated
Distribution of costs
among voters
Distribution of benefits
among voters
Type
2
Type
3
Distribution of Benefits and Costs
Among Voters

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When Voting Works Well
Other things constant, legislators will have a strong incentive to support political actions that provide voters with large total benefits relative to costs.
If a government project is productive, it will be possible to allocate the project’s cost so that all voters will gain.
When voters pay in proportion to benefits received, all voters will gain if the government action is productive (and all will lose if it is unproductive). Under these circumstances, there is a harmony between good politics and economic efficiency.

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Benefits Derived by Voters from
Hypothetical Road Project
Consider this government program. The total benefits ($40) exceed the tax cost ($25). It is, therefore, an efficient program.
Under plan A, the tax cost ($5)imposed on each voter is the same. If decided by majority vote, the project would be rejected by
a 3 to 2 margin.
Under plan B each voter pays in proportion to benefits received.
In this case, all voters gain and the program would pass unanimously.
This example shows that harmony between politics and economic efficiency exist when costs are allocated in proportion to benefits.
Voter
Adams
Chan
Green
Lee
Diaz
Total
Tax payment
Benefits
received
$ 20
12
4
2
2
$40
Plan A
$ 5
5
5
5
5
$25
Plan B
$ 12.50
7.50
2.50
1.25
1.25
$25.00

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Questions for Thought:
“The average person is more likely to make an informed
choice when he or she purchases a laptop computer
than when he/she votes for a congressional
candidate.”
— Evaluate this statement.
Does the motivation for political action differ from market action? Are people more greedy when they make market choices than when they make political choices?

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Questions for Thought:
3. “Government action is based on majority rule, whereas
market action is based on mutual consent.”
Is this statement true or false? Is this point important? Why or why not?
4. Will efficient projects necessarily be favored by a majority of voters? Why or why not?
5. When the cost of a project is allocated among voters in direct proportion to the benefits derived, will democratic political decision making tend to accept projects that are efficient? Will it tend to reject projects that are inefficient? Discuss.

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Questions for Thought:
6. (True or false) Market allocation and political process differ in that:
(a) Competition is present in markets, but not in the
political sector.
(b) Scarcity is a constraint in markets but not in the
political sector.
(c) There is a one-to-one link between payment for and
receipt of a good in markets, but this is not always true
in the political sector.
(d) Voter-consumers are generally well informed, but
market decision makers are not.
(e) Money influences market outcomes, but not political
outcomes.

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When the Political
Process Works Poorly

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Special Interest Effect
A special interest issue generates large personal benefit for a small number of constituents while imposing a small
individual cost on a large number of others.
Interest group members feel strongly about issues that provide them with substantial personal benefits. Such issues will dominate their political choices.
In contrast, voters bearing the cost of such legislation often are uninformed on the issue because it exerts only a small impact on their personal welfare and because of the rational ignorance effect.

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Special Interest Effect
Politicians have a strong incentive to favor the views
of special interests even if the action is inefficient.
Logrolling and pork-barrel legislation strengthen the special interest effect.

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Trading Votes and
Passing Counterproductive Legislation
Consider a bill in Congress that would put a post office in district A, dredge a harbor in B, & build a military base in district C.
Benefits to A, B, & C voters vary by project.
With this bill, there are no benefits to voters in D and E; further, the sum of benefits & costs for all voters together is negative.

+
$4
+
$4
+
$4
–
$9
–
$9
–
$6
Total
–
$03
–
$03
+
$10
–
$03
–
$03
in C
–
$02
Dredging
harbor
in B
–
$03
+
$10
–
$03
–
$03
–
$03
–
$02
New
Post
Office
in A

+
$10
–
$03
–
$03
–
$03
–
$03
–
$02
Voters of
district
*
A
B
C
D
E
Total
*
Assume the districts are of equal size.
–– Net Benefits (+) or Costs (-) to Voters in Respective District ––
New
military
base
In total, voters in A, B, and C districts come out ahead despite the costs of paying taxes for activities in other districts – if they agree to vote together.
With majority rule, representatives from districts A, B, and C, can, and often will, pass counterproductive legislation.

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When Voting Conflicts
with Economic Efficiency
Shortsightedness Effect:
Issues that yield clearly defined current benefits at the expense of future costs that are difficult to identify.
The political process is biased toward the adoption
of such proposals even when they are inefficient.
The shortsightedness effect explains why politicians will find debt financing and unfunded promises attractive — they make it possible for politicians to provide current benefits to voters without levying an equivalent amount of taxes (to pay for them).

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When Voting Conflicts
with Economic Efficiency
Rent Seeking:
Actions by individuals and interest groups designed to restructure public policy in a manner that will either directly or indirectly redistribute more income to themselves.
Widespread use of the taxing, spending, and regulatory powers of government that favor some at the expense of others will encourage rent seeking.
Rent seeking diverts resources away from productive activities. The output of economies with substantial amounts of rent seeking will fall below their potential.

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Income Transfers and Rent Seeking
Income transfers are a large and growing part of the
U.S. economy.
There are three major reasons why large-scale redistribution will reduce the size of the economic pie:
When taxes take larger shares of one’s income, reward derived from work is reduced.
As public policy redistributes a larger share of income, more resources flow into rent-seeking.
Higher taxes to finance income transfers induce tax payers to focus less on income-generating activities and more on actions to protect their own income.

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Economic Inefficiency
and Government Operated Firms
The structure of incentives and the efficiency of government operated firms and agencies
In the public sector, the absence of the profit motive reduces the incentive of producers to keep costs low. Neither is there a bankruptcy process capable of weeding out inefficient producers.
Public-sector managers are seldom in a position to gain personally from measures that reduce costs.
Because public officials and bureau managers spend other people’s money, they have less incentive to be cost-conscious.

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Political Favoritism, Crony Capitalism, and Government Failure

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Political Favoritism, Crony Capitalism,
and Government Failure
As government spending, subsidies, income transfers, financial bailouts, and regulatory favors grow, businesses and other well-organized groups will expend more resources seeking to obtain government favors.
As a result, crony capitalism grows relative to market allocation.
Crony capitalism is the situation where the allocation of resources is determined by political favors rather than by consumer preferences translated through the market profit and loss system.

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Political Favoritism, Crony Capitalism,
and Government Failure
Under crony capitalism, rather than providing equal treatment of individuals and businesses under the law, government uses spending, subsidies, and regulations to favor those most willing to provide political decision-makers with campaign contributions and other forms of political support.
Economic inefficiency is the result.

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“Bootleggers and Baptists”
Crony Capitalism is often driven by the bootlegger–Baptist strategy: greedy action packaged as moral behavior.
Opportunistic rent-seekers often frame their programs in a manner designed to attract support from naïve idealists.
They argue their programs will enhance child safety, promote energy independence, save family farms, or some other widely supported goal.
But when one looks below the surface, one discovers that these programs are about government favoritism providing handsome profits to the well organized special interest groups.

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“Bootleggers and Baptists”
Bootlegger—Baptist examples include:
Mattel incorporating costly testing procedures into the Consumer Product Safety Improvement Act of 2008.
The action increased the costs of rivals and drove used toy sellers like Goodwill out of the market.
General Electric partners with environmentalists to advocate subsidies and tax breaks for alternative energy sources.
This government favoritism increased demand for GE turbine engines, solar panels, and wind farms.
Result: GE earned $15 billion in 2010 and paid zero corporate income taxes.

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Market Entrepreneurs
versus Crony Capitalists
Market entrepreneurs get ahead by providing consumers
with products that are more highly valued than the resources required for their production.
Crony capitalists get ahead by providing political players
with campaign contributions and other political resources
in exchange for government contracts, subsidies, tax benefits, and other forms of political favoritism.
Projects of crony capitalists will often be counterproductive
Crony capitalism reflects govt. failure and undermines
the legitimacy of the democratic political process.

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The Economic Way of Thinking About Markets and Government

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The Economic Way of Thinking
About Markets and Government
Two key points about government:
Protective function of government:
When government protects private property, enforces contracts evenhandedly, maintains monetary stability, and refrains from regulations that restrict entry into markets, it provides the foundation for the smooth operation of markets.
Government failure:
Both political and market organization have shortcomings.

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The Economic Way of Thinking
About Markets and Government
Public choice analysis shows that there is sometimes a conflict between winning elections and following sound policies.
For some types of activities, there is reason to believe that the political action that will help one get elected will, at the same time, encourage counter-productive activities that reduce income levels.

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The Economic Way of Thinking
About Markets and Government
Understanding the strengths and weaknesses of both sectors is important if we are going to improve our current economic institutions.
The following factors often result in market failure:
Lack of competition
Externalities
Public goods
Poor information
The following factors often result in government failure:
The special-interest effect
The shortsightedness effect
Rent-seeking
Weak incentives for operational efficiency

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Questions for Thought:
“Political officials will be led as if by an invisible hand to
support legislation that provides concentrated benefits
to interest groups at the expense of disorganized
groups such as taxpayers and consumers.”
– Is this statement true or false? Why?
What is the shortsightedness effect? How does the shortsightedness effect influence the efficiency of public sector action?

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Questions for Thought:
3. Why does representative democracy often tax some people in order to provide benefits to others? When governments become heavily involved in tax-transfer activities, how will this involvement affect the size of the economic pie? Explain.
4. What is rent seeking? What types of government activities encourage rent seeking?

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Questions for Thought:
5. “Since government-operated firms do not have to make
a profit, they can usually produce at a lower cost and
charge a lower price than privately owned enterprises.”
– Evaluate this view.
6. The US imposes highly restrictive sugar import quotas that result in a domestic price of sugar often two or three times the world price. The quotas benefit sugar growers at the expense of consumers. Given there are far more sugar consumers than growers, why are the quotas not abolished? Do the sugar quotas improve American living standards? Why/why not?

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End of
Chapter 6

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The Crisis of 2008:
Causes & Lessons For the Future

GWARTNEY – STROUP – SOBEL – MACPHERSON

To Accompany: “Economics: Private and Public Choice, 15th ed.”
James Gwartney, Richard Stroup, Russell Sobel, & David Macpherson
Slides authored and animated by: James Gwartney & Charles Skipton
Full Length Text —
Micro Only Text —
Part: 6
Part: 5
Special Topic: 5
Special Topic: 5
Macro Only Text —
Part: 5
Special Topic: 5

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page

The Crisis of 2008

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The Crisis of 2008
The headlines of 2008 were about falling housing prices, rising default and foreclosure rates, failure of large investment banks, and huge bailouts arranged by both the Fed and the Treasury
The crisis reduced the wealth of most Americans and generated widespread concern about the future of the economy
This crisis and the response to it may be the most important macroeconomic event of our lives

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Key Events
Leading up to the Crisis

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Sobel-Macpherson

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Boom and bust in housing prices
Rising default and foreclosure rates
Sharp downturn in the stock market
Soaring prices of crude oil and other energy sources
Key Events Leading Up to the Crisis

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but
began to rise toward the end of the decade.
Between Jan. 2002 and mid-year 2006, housing prices increased by a whopping 87%
Housing prices were relatively stable during the 1990s …
Change in Housing Prices, 1987-2008
Housing Prices
(annual percent change)

– 10
0
10
20

15
5
– 5
– 15
– 20
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2008
2006
2004
2002
2000
1998
1996
1994
1992
1990
1988

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Sobel-Macpherson

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In late ‘06, the boom turned to a bust and housing prices declined throughout 2007-’08.
By year-end 2008, housing prices were approximately 30% below their 2006 peak
Change in Housing Prices, 1987-2008
Housing Prices
(annual percent change)

– 10
0
10
20

15
5
– 5
– 15
– 20
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2008
2006
2004
2002
2000
1998
1996
1994
1992
1990
1988

15th
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Sobel-Macpherson

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Mortgage Default Rate, 1979-2008
Prior to 2006, the default rate fluctuated within a narrow range (around 2%).
It increased only slightly during the recessions of 1982, 1990, and 2001.
The rate began increasing sharply during the 2nd half
of 2006
It reached 5.2% during the 3rd quarter of 2008.

Mortgage Default Rate
1979
1985
1988
2000
1994
0
1%
2%
5%
6%
2003

1982
1991
1997
2006
2008
3%
4%

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Sobel-Macpherson

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Housing Foreclosure Rate, 1979-2008
The foreclosure rate followed a similar path as the default rate
Prior to mid-2006,
the foreclosure rate fluctuated between
0.15% and 0.50%
But in 2007-2008, it increased sharply and moved to the highest
level in decades

Housing Foreclosure Rate
1979
1985
1988
2000
1994
0
0.2
0.4
1.0
1.2
2003

1982
1991
1997
2006
2008
0.6
0.8

Percent
(%)

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Changes In Stock Prices, 1996-2009
The S&P 500 fell by more than 55% between October 2007 & March 2009
This collapse eroded the wealth and endangered the retirement savings of many Americans

S&P 500 Index
1996
1998
2000
2004
2002
0
1200
1600
2005

1997
2001

2008
2009
400
800

2003

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What Caused
the Crisis of 2008?

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Four major causes of the Crisis of 2008:
Regulations that lowered mortgage lending standards
A prolonged low interest rate policy of the Fed during 2002-2004
Increased debt-to-capital ratio of investment banks
and other lending institutions
High and growing debt-to-income ratio of American households
Four Major Causes of the Crisis of 2008

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The role of Fannie Mae and Freddie Mac:
These two government sponsored enterprises (GSEs) were set up as “for profit” firms by the federal government
Because of their GSE status and the perceived government backing of their bonds, they could borrow funds at 50 to 75 basis points cheaper than other lenders
The GSE structure meant they were asked to serve two masters: (1) their stockholders and (2) Congress and federal regulators
Factor 1:
Change In Mortgage Lending Standards

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The GSEs were highly political:
their top management provided key congressional leaders with large contributions and often hired away congressional staffers into high paying jobs lobbying former bosses
Fannie and Freddie did not originate mortgages, instead they operated in the secondary market where they purchased the mortgages originated by banks and other lenders
They dominated the secondary mortgage market
As a result, their lending practices exerted a huge impact on the standards accepted by mortgage originators
The Role of Fannie Mae & Freddie Mac

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Mortgages of the GSEs, 1990-2008
The share of all mortgages held by Fannie and Freddie rose from 25% in
1990 to 45% in 2001
Since 2001, their share has fluctuated between 40% and 45%

Share of Total Mortgages Outstanding
Held by Fannie Mae and Freddie Mac
1990
1994
1996
2002
1998
20
25
30
45
2004

1992
2000
2006
2008
35
40

Percent
(%)

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Regulations imposed by the Department of Housing
and Urban Development (HUD) in the mid-1990s,
forced Fannie and Freddie to extend more loans to
low and moderate income households
The HUD mandates required Fannie and Freddie to extend 40% of their new loans to borrowers with incomes below the median in 1996.
This mandated share was increased to 50% in 2000
and 56% in 2008
Regulations and Lending Standards

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In 1999, HUD guidelines required Fannie and Freddie
to accept smaller down payments and extend larger loans relative to income
In order to meet HUD mandates, the GSEs accepted more subprime loans.
Mortgage originators were willing to make subprime and other high risk loans because they could be passed on to
the GSEs.
This resulted in the deterioration of lending standards
Regulations and Lending Standards

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Beginning in 1995, modified regulations imposed by the Community Reinvestment Act (CRA) also lowered mortgage lending standards
The CRA pushed banks to extend more loans to high risk borrowers.
Mortgage loans to subprime borrowers soared as a result
of these regulations.
This is important because the foreclosure rate on subprime loans is 7 to 10 times higher than for prime loans
The intent was to promote affordable housing, but the regulations eroded lending standards, fueled the housing price boom & bust, and the defaults and foreclosures that followed.
Regulations and Lending Standards

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Subprime and Alt-A Mortgages
Alt-A loans were
extended with incomplete documentation
and verification
Both subprime and
Alt-A loans are risky.
These loans rose from 10% of the total in
2001-2003 to 33%
in 2005-2006

Share of Total Mortgages Outstanding
Held by Fannie Mae and Freddie Mac
1994
1998
2002
2000
10
15
20
30
2004

1996
2006

25
35

Percent
(%)

0
5

Subprime + Alt-A
Subprime

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Low-Down Payment Loans by Fannie Mae and
Freddie Mac
Loans to borrowers with 5% or less down payment extended by Fannie Mae and Freddie Mac jumped from less than 100,000 in 1998 to more
than 600,000 by 2007.
These low-down payment loans increased from 4% in 1998 to 12%
in 2003, and more than 23% in 2007.
Predictably, many of these
low-down payment loans extended to borrowers would end up in default & foreclosure.
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007

1998
1999
2000
2001
2002
2003
2004
2005
2006
2007

Share of Fannie Mae & Freddie Mac
loans with less than 5% down
Number of loans extended by
Fannie Mae & Freddie Mac
5%
10%
15%
20%
25%
100k
200k
300k
400k
500k
600k

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Questions for Thought:
1. Why did regulators and the politicians who directed them want to make it easier for low- and middle-income households to borrow more money and obtain a mortgage with little or no down payment?
2. What is the predictable impact of the increase and subprime and Alt-A loans on the default and foreclosure rates? Explain.
3. What impact will an increase in the share of low-down payment loans extended to borrowers have on the future default and foreclosure rates?

15th
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During 2002-04 the Fed supplied additional reserves to the banking system & kept short-term interest rates low.
This policy supplied additional bank credit, increased the attractiveness of adjustable rate mortgages (ARMs), and fueled the housing price boom
But, as inflation increased during 2005-2006, the Fed increased interest rates and this helped turn the housing
boom to a bust
Factor 2: Low-Interest Rate Policy
of the Fed During 2002-2004

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Fed Policy and
Short-term Interest Rates, 1995-2009
Fed policy kept short-term interest rates at 2% or less throughout 2002-2004
As inflation rose in 2005-2006, the Fed pushed interest rates upward.
Interest rates on adjustable rate mortgages rose and the default rate began to increase rapidly.

Federal Funds Rate and 1-Year T-Bill Rate
1995
1999
2003
2001
2
3
4
6
2005

1997
2007

5
7

Percent
(%)

0
1

2009

1-Year T-bill
Federal Funds

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ARM Loans Outstanding, 1990-2008
Measured as a share
of total mortgages outstanding, ARMs increased from 10%
in 2000 to 21% in 2005.

ARM Loans as a Share of
Total Outstanding Mortgages
1990
1994
1996
2002
1998
0
5
10
20
2004

1992
2000
2006
2008
15
Percent
(%)

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Foreclosures on Subprime Loans,
1998-2008
The foreclosure rate
for subprime loans
is shown here
Note, how the foreclosure rate rose for ARM loans during 2006, but this was not true for fixed rate mortgages

Foreclosure Rate on Fixed & Adjustable
Subprime Mortgages
1998
2000
2003
2002
2
3
4
6
2005

1999
2007
5
7

Percent
(%)

0
1

Fixed
Adjustable
2001
2004
2006

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Foreclosures on Prime Loans,
1998-2008
For prime loans, the foreclosure rate for ARMs also rose in 2006 while it was relatively constant for fixed rate loans. Thus, the pattern was the same for both subprime and prime
Note, the foreclosure rate was 7 to 10 times higher for subprime than prime loans.

Foreclosure Rate on Fixed & Adjustable
Prime Mortgages
1998
2000
2003
2002
0.4
0.6
1.0
2005

1999
2007
0.8
Percent
(%)

0
0.2

Fixed
Adjustable
2001
2004
2006

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Both the regulations that eroded mortgage lending standards and the Fed’s interest rate manipulations contributed to the housing price boom and bust
They also resulted in malinvestment
– investments that should never have been made.
It will take time to correct for these malinvestments
Housing Price Boom and Bust

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A regulation adopted by the SEC in April 2004, permitted investment banks to leverage their capital by a larger amount and thereby extend more loans
Banks were required to maintain 8% capital against commercial loans, but only 4% against residential housing loans, and only 1.6% against low-risk (AAA rated) securities
Factor 3: Increased Debt-to-Capital
Ratio of Investment Banks

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Thus, if mortgage-backed securities had a AAA rating they could be leveraged up to 60 to 1 against bank capital
Major investment banks and many commercial banks bundled mortgages together and received AAA ratings for the securities backing the mortgages
These highly leveraged securities generated large profits for investment and commercial banks and the GSEs (Fannie and Freddie) during the housing boom
Factor 3: Increased Debt-to-Capital
Ratio of Investment Banks

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Based on prior history of default rates, lending institutions thought the mortgage-backed securities were quite safe.
But they failed to recognize that the erosion of the lending standards would lead to higher default and foreclosure rates.
As housing prices leveled off in the latter half of 2006,
default rates increased and the value of the highly leveraged mortgage-backed securities plummeted.
This led to the collapse of investment banks like
Bear Stearns and Lehman Brothers, and serious problems for other financial institutions.
Factor 3: Increased Debt-to-Capital
Ratio of Investment Banks

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The debt-to-income ratio of households has risen sharply since the early 1980s
Because mortgage and home equity loans are tax deductible, but other forms of debt are not, household debt is concentrated against housing assets
As a result, housing is hit hard when economic conditions weaken.
Factor 4: High Debt to Income
Ratio of Households

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Household Debt as a Share of Income,
1953-2008
Between 1953-1980, household debt as a share of disposable (after-tax) income ranged from 40% to 65%.
Since the early 1980s,
the debt-to-income ratio of households
has risen at an
alarming rate.
It reached 135%
in 2007, more than
twice the level of
the mid-1980s.

Ratio of Household Debt
to Disposable Personal Income
1953
1963
1973
1993
1983
20
40
80
120
140
2008

1958

1968

1978

1988

1998

2003

60
100

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Housing, Mortgage Defaults,
and the Crisis of 2008

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Housing, Mortgage Defaults,
and the Crisis of 2008
Regulations that eroded lending standards, the Fed’s interest rate policy, imprudent leverage lending by banks with the help of security rating firms, and the growth of household debt combined to create the 2008 financial crisis.
Mortgage-backed securities were marketed throughout the world, and as default rates rose, the value of the securities plummeted and the crisis spread around the world.
Default and foreclosure rates rose well before the recession started in December 2007, indicating that it was the housing crisis that caused the recession, not the other way around.

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Continuing Impact
of the 2008 Crisis

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Continuing Impact of the 2008 Crisis
With the Treasury takeover of Fannie Mae and Freddie Mac, the mortgage lending market has, essentially, been nationalized. 90% of the new mortgages for housing are currently financed by the Federal Government.
The 2008 crisis reflects what happens when policies confront people with perverse incentives. Institutional reforms that restore sound lending practices, strengthen the property rights of shareholders, and provide corporate managers with a stronger incentive to pursue long-term success would help prevent future crises.
Regulation, however, is a two-edged sword
– it can generate adverse as well as positive results.

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Questions for Thought:
Many politicians have responded to the financial crisis by calling for more regulations and closer oversight of banks. Do you think more regulation will prevent the occurrence of another financial crisis? Why or why not?
Was the 2008 crisis a failure of markets or government? Why?
The Federal Reserve and Treasury provided bailouts to Fannie and Freddie, Wall Street investment banks, and large commercial banks. Many of these firms were insolvent. Why didn’t they go into bankruptcy and have their assets liquidated?

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Questions for Thought:
4. Did political action save us from the disastrous consequences of the 2008 crisis? Did the politicians inadvertently cause the crisis and then attempt to shift the blame elsewhere?

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End of
Special Topic 5

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Difficult Cases for the Market and the Role of Government

GWARTNEY – STROUP – SOBEL – MACPHERSON

To Accompany: “Economics: Private and Public Choice, 15th ed.”
James Gwartney, Richard Stroup, Russell Sobel, & David Macpherson
Slides authored and animated by: James Gwartney & Charles Skipton
Full Length Text —
Micro Only Text —
Part: 2
Part: 2
Chapter: 5
Chapter: 5
Macro Only Text —
Part: 2
Chapter: 5

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A Closer Look at
Economic Efficiency

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What is Economic Efficiency?
Economists use the concept of efficiency to judge actions because efficient use of resources implies the maximum value of output from the resource base.
2 conditions necessary for ideal efficiency:
All activities that provide individuals with more benefits than costs must be undertaken.
No activities that provide benefits less than costs should be undertaken.
In order for economic efficiency to be achieved, both conditions must be present.

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Economic Efficiency
As more resources are used to expand the level of an activity, the marginal benefits (MB) of the activity generally decline and marginal costs (MC) rise.
From the viewpoint of efficiency, the activity should be expanded as long
as the MB > MC.
Q1 is inefficient as there are some units for which the MB exceeds the MC which are not undertaken.
Q3 is inefficient as there are units produced where the MC exceeds
the MB.
Q2 is the economically efficient level of output. At Q2 the MB stemming from the consumption of that unit just equals the MC of producing it.
Marginal
Cost &
Marginal
Benefit

Quantity
All quantities other than Q2
are inefficient
Marginal
Benefit
Q1
Marginal
Cost
Q3
Inefficient
Q2

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If It’s Worth Doing,
It’s Worth Doing Imperfectly

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There is an old saying, “If it’s worth doing, it’s worth doing to the best of your ability.” – Is this really true?
Economics indicates that at some point the gains from doing something better will not be worth the cost.
It makes sense to stop short of perfection.
Economics is about trade-offs:
Even worthy activities can be pursued beyond the level consistent with economic efficiency.
If It’s Worth Doing,
It’s Worth Doing Imperfectly

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If It’s Worth Doing,
It’s Worth Doing Imperfectly
When making personal decisions, people seem to be more aware that perfection is almost never worth the cost.
The principle also applies to government.
Regardless of the sector, achievement of perfection is generally not worth the cost.

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Thinking About the
Economic Role of Government

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Two Major Functions of Government
There is substantial agreement among scholars that at least two functions of government are legitimate:
Protective function:
protection of individuals and their property against invasions by others.
Productive function:
the production of goods and services that cannot easily be provided through private markets.

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Protective Function of Government
The most fundamental function of government is the protection of individuals and their property against acts
of aggression.
Involves the maintenance of a legal structure (rules)
for the enforcement of contracts and a mechanism for
the settlement of disputes.

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Productive Function of Government
Involves the provision of a limited set of goods difficult
to supply through the market.
A stable monetary and financial environment is vital.

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Questions for Thought:
Which of the following make sense:
Make the highest possible grade in your economics class.
Eliminate all air and water pollution.
Make airplanes fully secure against terrorist attacks.
Make cars so safe there will never be another traffic fatality.
2. What is the distinction between the “protective” and “productive” functions of government?
3. “If it’s worth doing, it’s worth doing to the best of your ability.” What is the economic explanation for why this statement is often said but rarely done?

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Potential Shortcomings
of the Market

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edition
Gwartney-Stroup
Sobel-Macpherson

Four Reasons
the Invisible Hand May Fail
Lack of Competition
Externalities
Public Goods
Poor Information

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Gwartney-Stroup
Sobel-Macpherson

Why the Invisible Hand May Fail:
(1) Lack of Competition
Sellers may gain by restricting output and raising price.
Too few units will be produced.

15th
edition
Gwartney-Stroup
Sobel-Macpherson

Lack of Competition
Sellers may gain by restricting output and raising price.
In this market, under competitive conditions, supply and demand result in an output of Q1 & price P1.
But, if producers in the market are able to restrict supply and/or limit entry into the market …
then the restricted supply S2 will result, with an output of Q2 < Q1 and price of P2 > P1.
Lack of competition results in too few units produced and a price above the competitive market level.

Price
Quantity/time
P2
P1
Q1
D
S1 (competitive supply)
Q2

S2 (restricted supply)

15th
edition
Gwartney-Stroup
Sobel-Macpherson

Why the Invisible Hand May Fail:
(2) Externalities
Externalities exist when the market fails to register fully costs and benefits.
External costs:
Present when the actions of an individual or group harm the property of others without their consent.
The problem arises because property rights are imperfectly defined and/or enforced.
External benefits:
Present when the actions of an individual or group generate benefits for nonparticipating parties.

15th
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Gwartney-Stroup
Sobel-Macpherson

Problems that Arise when
External Costs are Present
Because some of the costs of production are not fully registered when external costs are present, the supply curve understates the true cost of production.
Units may be produced that are valued less than their true cost.
From the viewpoint of efficiency, too many units are produced.

15th
edition
Gwartney-Stroup
Sobel-Macpherson

External Costs
Failure to fully register external costs
In this market, under initial supply and demand conditions, output Q1 and price P1 exist.
If all economic costs were measured and included …
the supply curve S2 would result in output Q2 < Q1 and price P2 > P1.
With external costs (a negative externality) too many units are produced and price is below that which would prevail if all costs were identified and factored into the market process.
Price
Quantity/time
P2
P1
Q1
D
S1
Q2

S2 (including external costs)

Ideal price and output

Actual price and output

15th
edition
Gwartney-Stroup
Sobel-Macpherson

Problems that Arise when
External Benefits are Present
When external benefits are present, the demand curve understates the total value of the output.
Units that are more highly valued than their costs may
not be produced.
From the viewpoint of efficiency, too few units may
be produced.

15th
edition
Gwartney-Stroup
Sobel-Macpherson

External Benefits
Failure to fully register external benefits
In this market, under present supply and demand conditions, output Q1 and price P1 exist.
If all benefits were measured and included …
the new demand curve D2 would result in output Q2 > Q1 and price P2 > P1.
With external benefits (a positive externality) too few units are produced and price is below that which would prevail if all the benefits were identified and reflected in the market process.
Price
Quantity/time

P2
P1
Q1
D1
S1
Q2

Ideal price and output
D2
(including
external
benefits)

Actual price and output

15th
edition
Gwartney-Stroup
Sobel-Macpherson

Why the Invisible Hand May Fail:
(3) Public Goods
Public goods are:
jointly consumed
– Individuals can simultaneously enjoy consumption
of the same product or service.
non-excludable
– it is not possible to restrict consumption of the good
to those who pay for it.

15th
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Sobel-Macpherson

Problems that Arise
With a Public Good
If a public good is made available to one, it is simultaneously made available to others.
Because those who do not pay can not be excluded, no one has much of an incentive to pay for such goods; each has an incentive to become a free rider.
Free rider:
– a person who receives the benefits of the good
without helping to pay for its cost.
When a lot of people become free riders, too little of the good is produced.

15th
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Gwartney-Stroup
Sobel-Macpherson

Characteristics of a Public Good
It is the good’s characteristics, not the sector in which it is produced, that distinguishes it as a public good.
Examples of public goods:
national defense
broadcast radio and television signals
clean air
Markets often develop ways of providing public goods.
like the use of advertising to support the provision of broadcast radio and television.
Nonetheless, public goods often cause a breakdown in the harmony between self-interest and the public interest.

15th
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Gwartney-Stroup
Sobel-Macpherson

Why the Invisible Hand May Fail:
(4) Poor Information
The consumer’s information problem is minimal if the item is purchased regularly.
Problems of conflicting interests and unhappy customers can arise if goods are:
difficult to evaluate on inspection and seldom repeatedly purchased from the same producer, or,
potentially capable of serious and lasting harmful side effects that cannot be predicted by a lay-person.

15th
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Gwartney-Stroup
Sobel-Macpherson

Why the Invisible Hand May Fail:
(4) Poor Information
Market responses to poor information include:
Consumer information publications
Provide expert evaluation and unbiased information
Brand names and franchises
Provide standardized quality and dependability
Warranties
Supplier promises to repair possible problems

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Sobel-Macpherson

Market and Government Failure

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Sobel-Macpherson

Market Failure
Market failure is the term used to describe the failure
of markets to achieve the ideal conditions of economic efficiency.
When markets allocate goods inefficiently, the problem can generally be traced back to absence of competition, externalities, public goods, or poor information.

15th
edition
Gwartney-Stroup
Sobel-Macpherson

Government Failure
Government failure is the term used to describe the situation when there is reason to anticipate that political decision-making will fail to achieve the ideal conditions of economic efficiency.
Government action directed by political decision-making is merely an alternative form of economic organization. It is not a corrective device that can be counted on to provide a remedy for the shortcomings of markets.
Merely because market failure is present, it does not follow that political action will necessarily lead to a more efficient allocation of resources.

15th
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Gwartney-Stroup
Sobel-Macpherson

Markets Versus Government
Economic analysis is comparative. It involves comparison of expected outcomes under market and political organization.
The following chapter will analyze the operation of the democratic political process so it can be more reasonably compared with the market process.

15th
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Gwartney-Stroup
Sobel-Macpherson

Questions for Thought:
When external costs are present, how will the equilibrium price and output in a competitive market compare with the price and output consistent with ideal economic efficiency? Is the level of output too large or too small? Explain.
When the production and sale of a product generates external benefits will competitive markets sometimes produce too little of the product? Why or why not?

15th
edition
Gwartney-Stroup
Sobel-Macpherson

Questions for Thought:
3. (a) Explain why the following are public goods:
an anti-missle system around Chicago,
a radio broadcast signal, and,
the stability of the currency provided by a central bank such as the Federal Reserve System.
(b) Explain why the following are not public goods:
a college education at a state university,
Yellowstone National Park, and,
the services of your local fire department
4. Why are public goods sometimes difficult for markets to
allocate efficiently?

15th
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Gwartney-Stroup
Sobel-Macpherson

Questions for Thought:
5. Which of the following is true of public goods?
Public goods can only be supplied by the government.
From the standpoint of economic efficiency, markets will tend to supply too large a quantity of a public good.
6. Why do golf course developers generally purchase a large tract of land, much larger than will be used for the course, prior to its construction?

15th
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Gwartney-Stroup
Sobel-Macpherson

End of
Chapter 5

What Role Does Government Play

What do we expect out of a market system?

· What do we expect out of government?

· Can markets achieve efficiency and equity at all times and for all people?

· What role does government play when and if markets move away from full efficiency and equity?

These are some of the key questions empirically we ask and attempt to answer in economics. In most situations, the more competitive markets are, the more efficient and equitable they will be.

Efficiency losses in an economy can manifest when underproduction or overproduction occurs. We can assert that economic efficiency is represented by marginal cost and marginal benefit being in equilibrium.

· At a point on the marginal benefit curve above the equilibrium point, that is where underproduction would occur since marginal benefits outweigh marginal costs.

· On the other hand, if price is above equilibrium on the marginal cost curve, overproduction occurs.

Because there are efficiency losses, collusion, and less than perfectly competitive markets, market failure occurs. Underproduction produces benefit losses, while overproduction produces too much and costs in the opposite way.

Market power of firms in which a lack of competition gives firms the ability of manipulating supply and output to achieve a desired revenue price can lead to deadweight losses and negative externalities (costs to non-consenting individuals, firms, or countries).

· While public goods, which consist of non-rival and non-excludable goods available to all in the public, can lead to inequity due to the free-rider effect of some individuals, firms, or countries exploiting the use of those goods for which they did not contribute the resources making the goods possible.

As a result of market failure, the government’s role tends to expand. Inherent to the role of government is protection of individuals in society.

That protection not only takes the form of military, police, fire, and other entities who roles are to protect society from physical harm, but protection by government is also overseeing markets to ensure market competition is highest, collusion is lowest, and equity and fairness occur through the market exchange process. Government failure can ultimately occur if actions taken by government actually lead to misallocation of scarce resources or less market efficiency and equity.

In summary, markets seek equilibrium and will achieve greater efficiency and equity when competition increases and markets are close to or at perfectly competitive. However, it is rare perfectly competitive market competition occurs.

· Market failure does transpire when firms exercise market-power pricing and output, underproduction or overproduction is carried out, negative externalities are present, and when public goods lead to free-rider effects.

Pareto inefficiency (one person is made worse off when one person is made better off) transpires thereafter, encouraging more government intervention in markets and economies. When government actions and/or policies lead to more market failure, then government failure ensues.

Market Failure

Market failure occurs when markets don’t achieve complete efficiency and equity.

What leads to a higher government failure rate?

Because the size of the federal government in particular has grown in size consistently since the Great Depression of the 1930s, the benefits sought after by individuals and firms from government has risen too.

There are differences in government systems and market systems, but there are many similarities too. Just as market power and collusive actions in markets lead to market failure, so too do those kinds of actions lead to government failure.

When we compare and contrast markets and government systems, what are some of the differences and similarities?

· Competitive behavior is present in both market and public sectors

· Scarcity imposes the aggregate consumption-payment link in both sectors

· Private-sector action is based on voluntary choice; public sector is based on majority rule

· When collective decisions are made legislatively, voters must choose among candidates who represent a bundle of positions on issues

· Income and power are distributed differently in the two sectors

· Self-interest is present in both government and market systems

As we discussed in earlier lecture points, markets can improve in efficiency and equity when competition increases and gets closer to perfectly competitive, when collusion is reduced and/or eliminated, and when markets are in equilibrium between demand and supply (aggregate demand and aggregate supply).

Similarly, government systems can improve in efficiency and equity when voters’ interests are fully considered, spending and costs are allocated prudently, and when economic and political harmony occurs.

In summary, as competition decreases in markets, market efficiency and equity fall; market failure increases.

When the size of government expands and the processes within government systems fail voters and create more marginal costs than benefits, government failure increases. Market capitalism is compromised ultimately when government failure rises due to the following:

· Special interest

· Interest groups

· Uninformed voters

· Logrolling

· Shortsightedness effect

· Rent seeking

· Widespread use of taxation, spending, and regulation

· Public officials spending other people’s money

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