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Market Failures
Use the readings and videos from this unit (see attachment), as well as your own research to support your responses to the following questions:
• What do you consider to be the biggest, or most significant, market failure in the U.S. economy of the last five years? Explain why you think this.
• How should the failure be addressed? Use proper APA format for citations and references.
Resources
• Discussion Participation Scoring Guide.
• Externalities | Transcript.
Due Date: Weekly.
Percentage of Course Grade: 30%.
Discussion Participation Grading Rubric
Criteria Non-performance Basic Proficient Distinguished
Applies relevant course
concepts, theories, or
materials correctly.
Does not explain relevant
course concepts, theories, or
materials.
Explains relevant course
concepts, theories, or materials.
Applies relevant course
concepts, theories, or
materials correctly.
Analyzes course concepts, theories,
or materials correctly, using
examples or supporting evidence.
Collaborates with fellow
learners, relating the
discussion to relevant course
concepts.
Does not collaborate with
fellow learners.
Collaborates with fellow
learners without relating
discussion to the relevant
course
concepts.
Collaborates with fellow
learners, relating the
discussion to relevant course
concepts.
Collaborates with fellow learners,
relating the discussion to relevant
course concepts and extending the
dialogue.
Applies relevant professional,
personal, or
other real-world
experiences.
Does not contribute
professional, personal, or
other real-world
experiences.
Contributes professional,
personal, or other real-world
experiences, but lacks
relevance.
Applies relevant professional,
personal, or other real-world
experiences.
Applies relevant professional,
personal, or other real-world
experiences to extend the dialogue.
Supports position with
applicable
knowledge.
Does not establish relevant
position.
Establishes relevant position. Supports position with
applicable knowledge.
Validates position with applicable
knowledge.
Participation Guidelines
Actively participate in discussions. To do this you should create a substantive post for each of the
discussion topics. Each post should demonstrate your achievement of the participation criteria. In
addition, you should also respond to the posts of at least two of your fellow learners for each discussion
question-unless the discussion instructions state otherwise. These responses to other learners should also
be substantive posts that contribute to the conversation by asking questions, respectfully debating
positions, and presenting supporting information relevant to the topic. Also, respond to any follow-up
questions the instructor directs to you in the discussion area.
To allow other learners time to respond, you are encouraged to post your initial responses in the
discussion area by midweek. Comment to other learners’ posts are due by Sunday at 11:59 p.m. (Central
time zone).
Discussion Participation Scoring Guide
Page 1 of 1Discussion Participation Scoring Guide
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EXTERNALITIES
Professor John Min
I am going to introduce to you a new TV series. It is called the… instead of the TV show that was on FOX, the…
what was it… 90210. Yeah, yeah. I am going to introduce you to a TV series called Zip Code 22015. Zip code
22015, and that is where I live. That is my neighborhood and…
Male Speaker
Econ Professor John Min lives in a neighborhood haunted by what economist call a “spillover effect” or an
“externality”, a situation in which an unintended cost or benefit of an activity that falls on people besides those
pursuing the activity.
Professor John Min
When I first moved in, I could tell right away that the most important thing in that neighborhood is, what?
Female Student
A car.
Professor John Min
No! That is what I thought, but we are beyond cars. What is it?
Female Student
Lawn.
Professor John Min
Condition of the lawn. You know that is? It is a sentiment. I live in a neighborhood where… how can I say it –
they judge the content of your character by the condition of the lawn.
Male Speaker
And John’s neighbors expect the world to judge them by the condition of all the lawns in the neighborhood.
Professor John Min
Here is my neighbor’s lawn. Is it not nice?
Male Speaker
Now, both John and his next door neighbor, Dennis, have lovely lawns. There is, however, what John calls a
lawn failure.
Professor John Min
The problem is this. We have a beautiful lawn, beautiful lawn, but we have a lawn failure. There is a property
line that goes right down the middle on this patch of the lawn. This side belongs to me and that side belongs to
Dennis.
Page 1 of 6Transcript – Externalities
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Male Speaker
And the two neighbors have never been able to cooperate on watering this patch. So it goes brown in the
summer, which not only makes John and Dennis feel bad. In economic terms, that is an emotional cost to
them, but lowers the entire neighborhood’s self-respect, a much broader social cost. To stick with the language
of lawn watering, a spillover cost from John and Dennis’s action also known in economics as a “negative
externality”.
Professor John Min
When you come to my house, when you drive into that cul-de-sac, when you park right here and you will look
up, you are going to see a patch of dirt, because no one takes care of that lawn. Now, here is the more
important question though: How can we fix this?
Male Speaker
At this point, Professor Min began suggesting possible solutions to the problem.
Professor John Min
And they can subsidize…
Male Speaker
When suddenly, another externality rang in.
Professor John Min
> What is that? Is that a phone?
Male Student
Yeah.
Professor John Min
Did you just get a phone call?
Male Student
Yes.
Professor John Min
In the classroom?
Male Student
Yeah.
Professor John Min
Well, well, well, well. All right, do me a big favor. Could you look at… count the seconds. Okay. Who is calling
you right now?
Male Student
I do not know. Hello!
Professor John Min
Is anyone there?
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Male Student
I do not think I know this person.
Professor John Min
Wrong number? That even makes it worse.
Male Speaker
A wrong number. No big, it seemed, to the guy who got the call, but should it not be?
Professor John Min
Time out, time out, time out. We just experienced what type of externality? Action of one individual had a
spillover… cost. Who felt it?
Female Student
All of us.
Professor John Min
You felt it. What happened? We were lecturing about the externality and suddenly we have to stop, because of
action of one person that it… it affected?
Female Student
All of us.
Professor John Min
All of us. So now, how should… how should we solve this problem?
Male Speaker
Mahmood’s cellphone call has a clear external cost, which we as good economist are about to graph. But first,
let us put price as usual on the Y-axis, and the on the X-axis quantity. Here, the total number of cellphone
calls, assuming, to keep the numbers simple that each call lasts one minute. Here is a very rough sketch of
Mahmood’s individual cost curve for the cellphone calls he takes in class, including the cost of the phone
service and the value of Mahmood’s own scarce time.
MMC, Mahmood’s marginal cost. That first phone call would not cost him much, but once he uses up his
monthly quota, calls start costing more and more and with each marginal call, he is using more and more of his
own time, which becomes precious, the lesser that he has. That is why the marginal cost curve slopes up.
MMB, Mahmood’s margin benefit curve. If he checks caller ID and takes only the most important calls, say
from a perspective date. Those first ones provide a high benefit. But if he loosens rule and takes more and
more, each marginal call will be less valuable. And Mahmood gets a lot of calls.
Mahmood’s marginal cost curve intersects with his marginal benefit curve about here, which reveals the
number of calls Mahmood would be willing to take during class where the marginal benefit is exactly equal the
marginal cost. But, and here is the big but. The calls he chooses to take cost his fellow students and their cost
is not on the graph.
A modest cost as it happens being in a community college, still Professor John Min and the class setout to
estimate the damage.
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Professor John Min
But you know what. The harm has been done. We need to be compensated somehow. So how should I do it?
Male Student
You can take a look at how much money… I mean, the tuition in one of them pay to be in the class.
Male Speaker
Say in-state students pay a $108 for a two-credit course like this one.
Male Student
And how much time I have been talking on the phone.
Male Speaker
As it turned out, about one minute. So 24 one-hour classes per semester equals how many total minutes in
class?
Professor John Min
Where is your pencil and paper? Where is the paper? You can use the phone, the phone calculator. And if you
are not really good with math, this is a good time to call your buddy. Lifeline, right?
Male Speaker
Twenty-four classes times 60 minutes. Fourteen hundred and forty minutes per semester and $108 in tuition
divided by those 1440 minutes gets what cost per minute?
Male Student
Seven and a half cents times 20 people in the class, and it would be a $1.50.
Male Speaker
The class has estimated the spillover or a external cost of $1.50 per minute for cellphone used during class
time, and adding the spillover cost to Mahmood’s individual margin cost gives us a new curve. A social
marginal cost curve that represents one way to reckon the cost to everyone of Mahmood’s indiscretion… not
counting the Virginia taxpayers who are subsidizing much of this class.
Moreover, if this had taken place at a private school like Dartmouth, Depaul, or Duke, you would be talking
tuition of more than $25,000 a year, which works out to something over $2 a minute per person. In an Econ
lecture of 700 then, a measly one minute interruption could have a spillover cost of more than $1400, but it is
not a factor in the call taker’s decision, because she or he does not have to pay.
So a social marginal cost curve better reflects all the cost associated with the transaction and so an economist,
all the costs are key. Any truly efficient outcome would include it. And how do we determine an efficient
outcome? It is here at the intersection of the social marginal cost curve and the marginal benefit curve,
because here, everyone’s cost are considered and for fewer calls, only those worth all the costs are taken.
[Phone Rings]
Excuse me for a second.
[Phone Conversation Starts]
Look, I cannot listen to that right now. It cost society a fortune.
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[Phone Conversation Ends]
See, if I took that call for even a minute, even at a low opportunity cost of your time, say 10 bucks an hour, I
would have used about 17 cents of your time, multiplied by say half a million of you who used McGraw-Hill
Econ textbooks $80,000 or more of your collective time wasted by this one negative externality. Unless of
course in this, it was worth something to you in instructional or amusement value, in which case, you will have
to do the math. But the point is negative externalities are everywhere from two-person transactions like
Professor John Min and his neighbor.
Professor John Min
And I said, “Hi, Dennis!” And he says, “Hi, John!”…
Male Speaker
That are in theory, at least, easy to resolve to one’s with wider impact as with our cellphone call examples to
externalities that affect indeterminate numbers of people such as airplanes that transport their passengers in
relative quiet, but deafen the rest of us, porn that can offend us, pollution that can poison us… all our market
failures in that the usual concepts of marginal cost and marginal benefit do not result in an efficient outcome,
because the decision maker’s marginal cost curve does not include everyone else’s cost.
And if society does not account for the negative externalities of something, it gets more of that something than
it would want. The market has failed to send the right signals, failed to come up with the most efficient
outcome.
Professor John Min
I am going to ask you to get up or leave…
Male Speaker
The class is trying to dialup a workable solution.
Professor John Min
So what can we do?
Male Student
We take it off, sir.
Male Speaker
Now, government intervention is one obvious way to correct the market failure of externalities and in fact, most
grade in high schools and some colleges simply ban cellphones in class and confiscate them when they ring.
But as an economist, Professor John Min has taken on the role of government to apply a more economical
solution… a tax.
Professor John Min
All right. So you owe us $1.50 and I do not kick you out. Is that a deal?
Male Student
Sure.
Professor John Min
All right, give me a $1.50.
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Male Student
I have only a dollar.
Professor John Min
Where is the 50 cents?
Male
I do not have it.
Male Speaker
Professor Min took a pen for the 50 cents.
Professor John Min
What do you think, 50 cents? All right, so… anyway. Is that okay? I take the $1.50, you get to stay? So here we
go. Here is the rule in this classroom. It is okay for you to receive phone call in my classroom as long as long
as we know that the cost, the tax that you are going to incur. How much is that? It is a $1.50 per minute.
Male Speaker
And that the tax money at the end of the semester will be shared by all in the form, in this case, of a class
pizza party.
Professor John Min
Is that a good deal? You can answer that now.
Male Speaker
But free pizza is not really the point, which we can see with one last look at our graph. The $1.50 per minute
tax shifts Mahmood’s marginal cost curve resulting in a new greatly reduced equilibrium quantity. Mahmood will
now choose to take way fewer calls, not this many, but this many and that benefits everyone in the class. We
invite pointing out that in a classroom like this, figuring out the total social cost is not that tough, nor is the
problem that tough to resolve. But when it gets to negative externalities like airplane, page porn or a pollution
involving billions of dollars and the health of the millions of people, it is a whole lot tougher.
REFERENCES McGraw-Hill Education: Externalities
L i c e n s e d u n d e r a C r e a t i v e C o m m o n s A t t r i b u t i o n 3 . 0 L i c e n s e .
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RATIONAL MAXIMIZING
Paul Solman
Economics now covers everything we do in the ordinary business of living. It analyzes what we do by
making just a couple of core assumptions about how we actually behave.
Jake
That is not bad. I mean…
Erin
Yeah?
Jake
I like it better than I thought I was going to.
Erin
Great, awesome.
Paul Solman
The first assumption is that we are all self-interested.
Jake
Oh, a thousand bucks.
Erin
[Laughs] No way. Wait a minute, no, no, no, this car is way better than a thousand.
Jake
I am just throwing out a figure. I do not…
Erin
Okay. No that is fine. That is fine. I just…
Paul Solman
The second assumption is that we are all rational.
Jake
Two thousand, I mean that…
Paul Solman
That is by weighing the costs and benefits of any action, we can figure out how to maximize our self-
interest. That is why economics calls people rational maximizers.
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Jake
This is a ’93 Accord.
Erin
Yeah, but it only has like 50,000 miles on it.
Jake
Really?
Erin
Yeah.
Paul Solman
So, for example, when economic woman here sells her car to economic man, he is trying to get the best
price he can.
Jake
I thought I was getting a deal here!
Erin
You are. You are. You are my bud, come on. It is a good car. I would not sell you a bad car.
Paul Solman
And economic woman is acting in her rational self-interest as well. There must be people who need a car
more than this guy, but they cannot meet her price.
Erin
No.
Jake
Forty-seven? Forty-eight?
Erin
I can’t.
Jake
Five thousand.
Erin
Five thousand.
Jake
Five thousand.
Erin
You just bought yourself a car.
Jake
Yes!
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Paul Solman
Now, most of us do not think there is anything wrong with selling at the highest price or buying at the
lowest price; that is just human nature, isn’t it. To get the most one can using simple reasoning. In fact,
rational maximizing turns out to have been the driving force behind market economics from the very
beginning. Adam Smith, the first name in economics. Here is how he famously put it in his book, “The
Wealth of Nations,” published the same year as the Declaration of Independence.
Adam Smith
Give me that which I want, and you shall have this, which you want. It is not from the benevolence of the
butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest.
Paul Solman
So people are self-interested.
Erin
Hey, you just bought yourself a car.
Jake
Ah, yes!
Paul Solman
And they are supposedly rational.
Neely
Can I have the number nine, please?
Paul Solman
But how true are these assumptions? Very true, say mainstream economists. To prove the point,
textbook author Stan Brue asks students in his class which line they choose at a fast food restaurant.
Stan Brue
They say, “The shortest line.” “Why?” “Well, my time is valuable, you know? I do not want to waste my time
standing in line.” “Why do not you get in the longest line?” Well, they intuitively understand that. I said,
“You have made some little kind of a cost-benefit decision in your self-interest. It was rational for you to
get into the shortest line.”
Paul Solman
So here, getting in the line with only three people would be the rational choice.
Greg
Thank you.
Paul Solman
But Professor Brue insists that you are even being a rational maximizer if getting on this line turns out to
be a whopper of mistake.
Kevin
Three cheeseburgers.
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Stan Brue
Maybe you are in the shortest line and you find out that the person in front of you is ordering fries and
hamburgers for the Greyhound bus out back.
Kevin
Four of the combos.
Stan Brue
But you did not have that information when you got into line.
Kevin
BLT with cheese, I would like 10 of them.
Stan Brue
Should you now go seek that information by going up to everybody and say, “Sir, I would like to get your
order so that I can make a rational decision”?
Morgan
Hi, can I get your order so I can make a rational decision?
Steve
What?
Stan Brue
Heck no. Because the information is costly to get, people would probably wonder what you were up to,
and it is not it worth your while. But that is another rational decision.
Paul Solman
And yet, we can all think of behavior that seems both irrational and counter to what we would usually
think of as our own self-interest.
Paul Solman
Literally it is hurting right there in my elbow just to hold it.
Paul Solman
Like trying out a shot-put for first time in one’s late-50s. Yeah, but then you have got to throw it. I decided
not to make an irrational fool of myself, but instead asked students at this track meet, if they had
encountered much irrationality in their lives lately.
Derrick
Well, being in college, I mean, I have seen a lot of irrational things. So I would probably say the most
irrational thing that I have seen is a guy getting naked at a party.
Corey
Yeah, I can top it. One of my friends, unfortunately, we were at a party together. And we went to the party
together so we were kind of keeping an eye on each other and he got out of sight and one thing led to
another and he was going to the 7-Eleven to get some cigarettes. He borrowed someone’s truck, he had
no idea whose truck it was and he ended up about 30 miles away from [inaudible] in the woods. He had
crashed, drunk driving. And that was pretty irrational, I would say.
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Shelby
Sleeping in class always happens.
Paul Solman
Sleeping in class?
Shelby
Yes. It is normal to stay up until four and then go to class and sleep.
Paul Solman
But that is not rational.
Shelby
No, it does not make sense.
Paul Solman
Well, how much are you paying for a class, I mean, for example?
Shelby
I know we pay about $115 a class.
Paul Solman
A hundred and fifteen dollars a class, and you sleep through some of them?
Shelby
Sometimes.
Paul Solman
So that would be irrational?
Shelby
Yeah. If my Dad knew, he would probably kill me.
Paul Solman
And there is getting into shape today only to overeat for the next two weeks; being scared to compete on
Friday the thirteenth; the list is endless. In economics, even tipping at a roadside restaurant can seem
irrational. Do you leave tips at roadside restaurants you are never going back to?
Jen
Yeah, I definitely do. I have waitressed before, so I always have.
Paul Solman
And you?
Karen
Absolutely. Absolutely leave tips.
Paul Solman
But why? You are never going to go back there.
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Karen
Because if she has done a good job, she should be rewarded for it.
Jamie
I work at a restaurant where we have a collection of tips that are split at the end of the night. And I know
what it feels like not to be tipped, because I would say 50 percent of people that come in there do not. So
I would definitely leave a tip.
Paul Solman
Indeed, the model of the purely self-interested homoeconomicus… economic man… is so simplistic, it is
long been the subject of satire.
Chamran Knebter
How do you do? I am a merchant banker.
Customer
How do you do, mister…?
Chamran Knebter
Um, I forget my name at the moment, but I am a merchant banker.
Paul Solman
As when an investment or merchant banker is solicited by a charity worker.
Customer
I wondered whether you would like to contribute to the orphans’ home.
Chamran Knebter
I am awfully sorry I do not understand. Can you just explain exactly what you want?
Customer
Well, I want you to give me a pound and then I go away and give it to the orphans.
Chamran Knebter
Yes?
Customer
Well, that is it.
Chamran Knebter
No, no. No, I do not follow this at all. I mean, I do not want to seem stupid, but it looks to me as though I
am a pound down on the whole deal.
Customer
Yes, you are.
Chamran Knebter
I am? Well, what is my incentive to give you the pound?
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Customer
Well, the incentive is to make the orphans happy.
Chamran Knebter
Happy? Are you quite sure you have got this right?
Customer
Yeah, lots of people give me money.
Chamran Knebter
What? Just like that?
Customer
Yes.
Chamran Knebter
They must be sick. [Laughter]
Paul Solman
But this banker from the English TV comedy series Monty Python’s Flying Circus is not it a fair example of
the rational maximizer according to some economists.
Chamran Knebter
Nice to do business with you!
Paul Solman
They argue instead that acts of apparent altruisms such as giving money to orphans, tipping, or as here at
MIT, free bike repair, really do maximize self-interest by making the person who does them feel better.
Kent Ford
Now, Mother Theresa was not selfish, no-one says she was selfish. But she pursued her self-interest. She
did the things that made her happy, and that was to help other people; and avoided the things that
brought her pain, watching them suffer. And we all do that to some extent. We leave tips at roadside
restaurants we will never see again, why? Because it will make us feel bad if we do not. And so acts of
altruism are acts in really, in self-interest. They are unselfish, but they are self-interested.
Paul Solman
But to critics of economics and more and more economists, this is too broad a definition of self-interest.
If anything you do is self-interested because it must make you feel better or you would not do it, the idea
of rational maximizing loses its power to explain. If this poor guy, say, starts drinking his oil instead of
spraying it and drops dead, we do not explain anything by saying that he must like oil and so drinking it
had to be an act of rational self-interest. In fact, the 2002 Nobel Prize for Economics went to a
psychologist and an economic experimenter for showing just how human humans can be. Bob Frank,
who came up with the oil example, is a star of behavioral economics, a new field that he says…
Bob Frank
…unites psychology and economics. I think the neo-classical economists were guilty for a long time of
ignoring human psychology. And what the behavioral economics movement has done is bring some of
the known facts about human psychology back into the picture. We are not always the rational,
automatons assumed by the neo-classical model. And I think that has been one of the interesting
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contributions of behavioral economics, is to remind economists that we are really kind of a richer more
complicated creature than some of the models suggest.
Paul Solman
Bottom line then, there is a debate within economics about how accurate the basic economic
assumptions… rationality and self-interest… really are and, thus, about the basic economic model of
human behavior. Professor Nancy Folbre is another noted critic of the neo-classical model.
Nancy Folbre
I think it is half right. I think in a lot of situations, people make very rational decisions with a lot of
foresight and a lot of information, but I think in general, economists still overstate the extent to which
you can explain everything with a rational futility maximizing model.
Paul Solman
On the other hand, says Stan Brue, that model is true enough in the end to make some pretty useful
predictions about economic behavior.
Stan Brue
I am going to predict that people will prefer a higher wage to a lower wage, other things equal. And I am
going to predict that a consumer will prefer a lower price to a higher price, other things equal, like the
quality of the product. And I am going to predict that a business is going to try to earn more profit rather
than less in terms of rational decision processes, under normal, usual circumstances. But people are not
perfect decision-makers, and just because they do not always behave in some perfect rational way, does
not mean that it is not it valuable to have an assumption that they act as if, most of the time.
Paul Solman
But the assumption economics makes, is that people act as if they were rational maximizers all of the
time. And bottom line, that is the assumption that just about every textbook and every textbook model is
based on.
Kevin
Ten diet cokes, 12 cokes.
REFERENCES McGraw-Hill Education: Rational Maximizing
L icensed under a Crea t ive Commons Att r ibut ion 3 .0 L icense .
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Market Failures
Use the readings and videos from this unit, as well as your own research to support your
responses to the following questions:
• What do you consider to be the biggest, or most significant, market failure in the
U.S. economy of the last five years? Explain why you think this.
• How should the failure be addressed?
Use proper APA format for citations and references.
Resources
• Discussion Participation Scoring Guide.
• Externalities | Transcript.
Link to videos:
Readings
Use your Macroeconomics text to complete the following:
• Read Chapter 4, “Market Failures: Public Goods and Externalities,” pages 83–105,
and pages 108–110.
• Read Chapter 5, “Government’s Role and Government Failure,” pages 112–124,
and pages 127–131.
