Business at&t to buy directv in $49 billion deal, creating pay tv

Business
AT&T to Buy DirecTV in $49 Billion Deal, Creating Pay-TV
Giant
AT&T's and DirecTV's Boards Approve Acquisition Agreement
by
Thomas Gryta And
Shalini Ramachandran
Updated May 18, 2014 6:30 p.m. ET
AT&T agreed to buy DirecTV for $49 billion, creating a new
pay-TV giant and giving AT&T CEO Randall Stephenson more
clout with content companies as video moves to the Internet.
Shalini Ramachandran reports. Photo: Getty.
AT&T Inc. T -0.65% agreed to acquire DirecTVDTV +1.25%
for $49 billion, a deal that would make it a major player in pay
television and increase its clout with media companies at a time
when video consumption is moving online.
The agreement, which the companies' boards approved on
Sunday, comes just three months after Comcast Corp.'s CMCSA
+1.38% $45 billion agreement to buy Time Warner Cable Inc.
TWC +1.33%
The deals show how the biggest companies in television and
telecommunications are bulking up to face a changing media
landscape. Growth is slowing in some markets, like pay TV and
wireless subscriptions, and is exploding in others, like
streaming video. The companies are betting that bigger scale
will give them the resources to invest in new capabilities and
the leverage to hammer out commercial arrangements in the
media world.
The combination would create a company with 26 million pay-
TV subscribers in the U.S. That is second only to Comcast and
Time Warner Cable, which would have about 30 million
combined subscribers if regulators approve their deal and
pending divestitures are completed.
"There would not be many people who could put together

something with a nationwide mobile platform, nationwide video
platform and a 70 million household broadband build," AT&T
Chief Executive Randall Stephenson said in an interview.
AT&T said it would pay $95 per DirecTV share, about $66.50 a
share in the form of its own shares and $28.50 in cash.
The companies have considered a combination for years and the
CEOs came to the basic outline of the deal two weeks ago, Mr.
Stephenson said. DirecTV CEO Mike White gave him a tour of
the DirecTV offices in Los Angeles, and the final terms were
sealed between the two over the phone, he said.
The deal is Mr. Stephenson's biggest bet so far and is AT&T's
largest acquisition since its 2006 purchase of BellSouth for $85
billion. Mr. Stephenson became CEO in 2007 after his
predecessor, Ed Whitacre, took a regional phone company and
turned it into a national giant.
Mr. Stephenson has struggled to pull off a big-ticket
transaction. He attempted to buy T-Mobile US Inc. TMUS
+0.90% in 2011, but was shot down amid regulatory concerns.
He said on Sunday the Comcast deal didn't factor into his
decision on DirecTV, saying that the two deals aren't similar in
nature and highlighting the mobile-video aspect of the
combination.
For DirecTV, the combination ends a period of uncertainty
during which the company has struggled to chart a road map for
growth in a stagnating U.S. pay-TV industry. Unlike cable
providers, the satellite company doesn't have a piece of the
burgeoning broadband-access market.
DirecTV's smaller but faster-growing Latin American arm,
which serves 12 million subscribers, has come under pressure
due to political and economic instability in the region. Mr.
White has recently played down those threats.
AT&T agrees to buy DirecTV for $49 billion. Above, a DirecTV
employee installs a satellite. Bloomberg
The deal leaves Dish Network Corp. in an uncertain position
strategically. Many analysts have seen AT&T and DirecTV as

potential buyers of the satellite-TV provider. Verizon
Communications Inc. VZ +1.05% was also seen by some
industry experts as a potential acquirer of Dish but has signaled
it isn't interested in a deal.
A spokesman for Dish pointed to a conference call in which its
chairman outlined its strategic options, saying: "We have to be
well positioned so that no matter what happens it's all good for
us, and I think we're there."
Many Wall Street analysts have questioned whether DirecTV
has significant strategic value to AT&T, especially as U.S.
wireless competition has picked up with the resurgence of T-
Mobile and SoftBank Corp.'s acquisition of Sprint Corp. last
year.
AT&T, which has 5.7 million subscribers for its U-Verse TV
service, will become a more powerful force in pay TV by
joining with the larger DirecTV. Theoretically, as a bigger
provider, AT&T would get better rates from companies that
license TV programming.
Still, media executives said, AT&T won't automatically get
those volume discounts without thorny negotiations.
Having DirecTV in the fold could also advance AT&T's
ambitions in online video. Like many other telecom and tech
companies, it is looking for ways to capitalize on surging
consumer demand typified by the growth of streaming services
like Netflix. Last year, AT&T and DirecTV each made
unsuccessful bids for streaming service Hulu LLC, whose
owners ultimately decided not to sell.
AT&T has started approaching media companies about a
potential "over the top" Web video service that would run on
wireless broadband connections and serve up TV programming,
people familiar with the matter said. The company also recently
formed an online video venture with media mogul Peter Chernin
and said it is weighing a number of online-video options,
including launching niche services or premium products like
Netflix's.

AT&T's main rival, Verizon, has taken similar steps and is
further along, some media-industry executives said. Like
AT&T, it is interested in deploying a technology called
"multicasting," which can deliver bandwidth-intensive video
streams to many users simultaneously without tying up too
much spectrum—the frequencies used to transmit voice and
video wirelessly.
Verizon in January bought Intel Corp.'s "OnCue" media unit,
and it has approached several TV-channel owners about
launching a wireless TV service, said people familiar with the
approaches. Verizon declined to comment.
One clear benefit for AT&T from the acquisition, analysts said,
is that DirecTV's cash flow will help the company cover its
almost-$10 billion in annual dividend payments. In January,
AT&T projected 2014 free cash flow of $11 billion, making
many analysts nervous about its ability to cover the payout.
The agreement puts another major communications deal in front
of regulators, combining companies that operate in industries
where Americans already have narrowing choices and overseers
have expressed a desire to promote competition.
In part to allay concerns from regulators, AT&T stressed in its
news release that it would invest in rural broadband, commit to
abide by net-neutrality rules and spend at least $9 billion in a
coming government auction of wireless airwaves.
As part of the deal, AT&T plans to sell its long-held $6 billion
stake in Latin American phone giant America Movil SAB to
avoid regulatory conflicts.
John Bergmayer, senior staff attorney with advocacy group
Public Knowledge, warned that AT&T will need to demonstrate
that new services would offset any harm to the wireless and
video markets.
"The industry needs more competition, not more mergers," he
said. "The burden is on AT&T and DirecTV to show otherwise."
"It just doesn't make sense to me," said New Street Research
analyst Jonathan Chaplin, who asserts that AT&T would be
better off buying Dish Network because of that company's

wireless-spectrum holdings.
The acquisition raises the prospect that AT&T customers may
one day watch "Mad Men" episodes or football games over a
fast cellular broadband connection without subscribing to
traditional pay-TV service, but developing such offerings may
be difficult. Nothing is likely to change in the short term for
AT&T or DirecTV customers.
Blair Levin, former chief of staff at the Federal
Communications Commission and author of its road map for
expanding Internet access, said it's not immediately clear how
the deal would impact consumers. While the deal could be
perceived as eliminating a competitor in 25% of the country and
result in higher prices, DirecTV is a national service and
therefore prices may stay in check due to competition in other
markets. AT&T will also be able to package wireless-phone
service with home-TV subscriptions, which could result in
better deals.
Mr. Levin said AT&T's acquisition of DirecTV was likely a
response to Comcast's Time Warner deal.
"Sometimes, deals are driven by hope and opportunity and
sometimes they're driven by fear and locking down customer
bases," Mr. Levin said.
—Ryan Knutson contributed to this article.
Health Care
Chapter 22 - Health Care
Chapter twenty-Two
health careCHAPTER OVERVIEW
This chapter addresses one of the most prominent economic and
political issues of our time. Providing health care is an
economic issue, and the American public‘s concern ranges from
the problem of rising health care costs, to gaps in health
insurance coverage, to government insurance programs draining
Federal and state budgets. The debate over the desirability of
more government involvement in providing health insurance

continues.
This chapter also examines the economic aspects of our health
care problems, offers a demand and supply analysis to explain
rapid increases in health care costs, as well as potential methods
for containing costs and evaluates the Patient Protection and
Affordable Care Act (PPACA).WHAT’S NEW
This was chapter 21 in the 19e.
A fourth Quick Review has been added to the end of the
chapter.
There are three new “Consider This” discussions in the chapter.
The first is “Why do Hospitals Sometimes Charge $25 for an
Aspirin?”. The second is “Electronic Medical Records.” The
third is “PPACA Implementation Problems.”
The “Consider This” in the 19e, "Cancer Fight Goes Nuclear",
has been eliminated.
There is a new learning objective for the chapter.
All of the data and tables have been updated.INSTRUCTIONAL
OBJECTIVES
After completing this chapter, students should be able to:
1. Describe what is meant by the health care industry and
approximate its size with relevant data.
2. Identify the problem connected with rising health care
costs.
3. Give the negative effects associated with rising health care
costs.
4. Identify two consequences associated with employer
provided health insurance in the U.S.
5. Explain what is meant by the overallocation of resources
to the health care industry.
6. Describe the extent of the problem regarding a lack of
health insurance coverage.
7. Identify four special characteristics of the health care
market.
8. Give four factors that have contributed to the rise in the
demand for health care.
9. Explain the role of physicians in increasing the demand for

health care.
10. Explain the “moral hazard” problem arising from health
insurance coverage.
11. Explain how the Federal income tax structure subsidizes
health care demand.
12.
Identify three supply factors that contribute to rising health care
costs.
13. Describe how rationing health care services can reduce
costs.
14. Explain how deductibles and copayments, health savings
accounts (HSAs), managed care, Medicare and DRG, and limits
on malpractice awards can decrease incentives to overconsume
health care thereby reducing costs.
15. Present arguments for and against the PPACA.
16. Explain the major provisions of the Patient Protection
and Affordable Care Act.
17. Define and identify terms and concepts listed at the end
of the chapter.COMMENTS AND TEACHING SUGGESTIONS
1. There is a wealth of information available on health care
in the popular press. This topic provides an excellent
opportunity for student debates, papers, and presentations.
Because it is an issue that concerns so many of us, you can
easily get students to relate their personal experiences to the
economics of health care. Once you have their interest, you can
relate their concerns to many of the theoretical and structural
concepts raised in microeconomics. The material can also be
used to help students better appreciate the macroeconomic
tradeoffs, especially as they pertain to health care reform
proposals.
2. The National Issues Forum has some excellent teaching
materials that provide a focus for discussing some of the major
issues. Related to this chapter are two of their topics, “The
Health Care Cost Explosion: Why it’s so Serious, What Should
Be Done," and “Health Care for the Elderly: Moral Dilemma,
Mortal Choices.” This organization also has units that focus on

“Coping with AIDS” and “The Drug Crisis,” which may be
useful supplements in a more interdisciplinary course. For
more information about their issue books, audiocassette tapes,
and videocassettes, call 18004337834 or write to them at 100
Commons Road, Dayton, Ohio 454592777.
3. The Nebraska Council on Economic Education has an
excellent set of activities, suitable for secondary or college -
level classes, which revolve around the economics of health
care and are available for about $10. They also have a video,
“Code Blue,” of a teleconference panel highlighting some of the
major issues. For more information call 4024722333 or FAX
4024729700.
4. The health care industry can be analyzed from the
perspective of market structure, which reinforces what students
have just learned about the different market models, from
perfect competition to pure monopoly. How do the markets for
various types of health care services fit the various market
models? If the market being examined does not fit the
competitive model, or if consumers pay indirectly through
prepaid insurance plans, does it make sense to talk about market
solutions? If market solutions are possible, should reforms be
aimed at enhancing competition? The health care industry, or
particular components of it, provides excellent opportunities for
using the casestudy method to teach economic concepts.
5. Price elasticity and income elasticity of demand both play
an important role in the problems of the health care industry.
Most health care services are a necessity with few substitutes,
making the demand for them relatively priceinelastic. This fact
means that rising costs of production that decrease supply will
have more impact on the price of health care than on the
quantity purchased. Health care is a normal good, meaning that
as incomes rise the demand for health care will also increase.
Employing this chapter as a demonstration when studying the
theory of elasticity in Chapter 6 can be an effective
combination.
6.

The discussion of health care can lead easily to the discussion
of how we value human life. A fun and illuminating exercise is
to place students on “organ donation” boards, where they (in
small groups) must decide which candidate receives a vital
organ (the non-recipients die). Write profiles for four or five
prospective recipients, assume that all have the same level of
compatibility with the donor’s organ, and include information
such as age, reason for organ need (genetics, unhealthy
lifestyle, accident, etc.), annual income (or prospective annual
income for students), and family situation (single, married,
children, etc.). These are of course hypothetical, but for an
added bit of fun write profiles of what would happen to each
candidate if they received the organ (brilliant student flunks
out, welfare recipient goes on to win Nobel Prize, and so
on).STUDENT STUMBLING BLOCKS
Do not assume that your younger students know anything about
health insurance coverage, even at the personal level. Unless
they have encountered some problem, it is probably one of those
economic costs that they have ignored, since they are covered
by their parents’ insurance or university health center. The
students who have encountered some problem with coverage
will help you “open other students’ eyes.”LECTURE NOTES
I. Introduction
A. Learning objectives – After reading this chapter, students
should be able to:
1. Convey important facts about rising health care costs
in the United States.
2. Relate the economic implications of rising health care
costs.
3. Discuss the problem of limited access to health care
for those without insurance.
4. List the demand and supply factors explaining rising
health care costs.
5. Describe the cost containment strategies that rely on
altering the financial incentives facing either patients or
health service providers.

6. Summarize the goals of the Patient Protection and
Affordable Care Act and the major changes it institutes.
B. This chapter focuses on several issues.
1. The United States’ system of health care.
2. The economics of health care costs.
3. The PPACA and whether its policies will achieve its goals.
II. The Health Care Industry
A. Government’s definition of this far-reaching industry
includes many aspects.
1. Services provided in hospitals, nursing homes, labs,
physicians’ and dentists’ offices,
2. Prescription and nonprescription drugs, artificial limbs,
and eyeglasses,
3. Services of many nontraditional practitioners, but not
fitness club services, or health foods.
B. The size of the industry is immense.
1. 17 million are employed in the industry, including 850,000
physicians.
2. There are about 5,800 hospitals with almost 925,000
million beds.
3. Health care accounts for 17.3 percent of GDP.
III. U.S. Emphasis on Private Health Insurance
A. Private health insurance is uniquely American and began in
World War II to attract workers in light of price ceilings that
government had placed on wages.
B. Other countries like Canada, have a national health care
system.
1. They use tax revenue to provide each person with free or low
cost health care.
2. Very few individuals have to buy private health care.
C. In the U.S. Federal tax law makes it cheaper for employers to
provide health insurance rather than the individual buying it.
D. Consequences of employer provided benefits:
1. Creates an incentive to overuse health care.
2. Leads to a focus on regulating a familiar health care system

rather than creating a new one.
IV. Twin Problems: Cost and Access
A. Health care costs include the “price” of health care as well
as the “quantity” of health care services provided.
B. Health care costs have been rising rapidly because of
higher prices and an increase in the quantity of services
provided. The price of medical care has been increasing far
faster than the overall price level.
C. Efforts to reform health care have focused on controlling
costs and increasing accessibility. A dual system of health care
(one for those who can afford to pay and the other for those who
cannot) may be evolving.
V. High and Rising Health Care Costs.
A. Health care spending in the U.S. is rising in absolute
terms, as a percentage of domestic output and on a per capita
basis.
B. Figure 22.1 shows major types of spending and major
sources of funds for these expenditures.
1. 32 cents of each health care dollar is spent on
hospitals; 20 cents goes to physicians; 21 cents goes to dental
and vision care, and 26 cents pays for other health care services,
including prescription drugs, home care, and program
administration.
2. About 81 percent of expenditures are paid for by
public and private insurance; the remaining amount is paid by
the health-care consumer.
C. Health care absorbed 5.2 percent of GDP in 1960, and
17.9% in 2011. (Figure 22.2)
D. Global Perspective 22.1 shows that spending on health care
as a percentage of GDP is higher in the U.S. than in any other
major industrialized nation.
E. Quality of care: Are we healthier?
1. Medical care in the U.S. is probably the best in the world,
but not our health.
2. As a result of medical research, the incidence of certain

diseases has been declining and the quality of treatment has
been improving in the U.S. But the U.S. has a lower life
expectancy, higher maternal mortality and infant mortality
rates, an AIDS epidemic that has claimed over 616,400 lives;
and an increase in tuberculosis.
3. The U.S. Office of Technology Assessment has concluded
that the U.S. ranks low internationally on may health indicators.
F. There are economic implications of rising costs.
1. The increase in health care costs is the main reason
for rising health care spending.
2. Increased health care costs have other effects as well.
a. Fewer uninsured can afford health care; fewer employers
can offer health insurance to workers.
b. Adverse effects on labor markets exist.
i. Wages grow more slowly because health care benefits
are taking a larger share of the “compensation” package.
ii. Employers use more parttime and temporary workers
to avoid the high cost of health insurance coverage for workers.
Employer may contract-out the work of low-paid workers to
avoid paying health care costs.
iii. Employers have shifted work to domestic or
international suppliers (outsourcing and offshoring), reducing
costs because these outside suppliers provide less medical
benefits to their employees.
c. Large medical bills not covered by insurance may lead to
personal bankruptcies as the patient or his or her family lacks
the means to pay.
d. Government budgets at all levels have to deal with
spiraling health care expenditures.
i. Medicare and Medicaid has been the fastest growing
segment of the Federal budget.
ii. Higher taxes or reductions in other budget
components (national defense, education, and environmental
programs) must be used to cover the increases.
iii. States are finding it difficult to cover their share of
Medicaid costs and must reduce other expenditures

(infrastructure, education, and welfare).
iv. Local governments face similar strains.
G. Are we spending too much?
1. Most industries are happy to have increased spending.
Why are we alarmed about more spending on health care?
According to economist William Nordhaus, the economic value
of increased longevity is roughly equal to the increased GDP
over the last 100 years.
2. University of Chicago economists Kevin Murphy and
Robert Topel has found that reduced mortality from heart
disease benefits the U.S. economy $1.5 trillion each year.
3. Despite the successes, economists see health care
expenditures as inefficiently large, a product of the unique
features of the health care market.
4. Experts are concerned that at the margin, the
consumption of health care is worth less than the alternative
goods and services that could otherwise have been produced
with those resources. In other words, there is an overallocation
of resources to health care, which imposes a real economic cost
on society.
VI. Limited Access: Many are uninsured.
A. In 2011 about 49 million Americans (16 percent of
population) had no health insurance for the entire year. This
number grows as health care costs rise.
B. Which groups have no insurance?
1. Fifty percent of the uninsured are families where the head
works full time, the family income is too high to qualify for
Medicaid, but the earned income is not enough to afford health
insurance. Demographically, many are single-parent families,
African American, or Hispanic.
2. Young people with excellent health choose not to buy
health insurance.
3. The chronically ill find it impossible or too costly to
obtain insurance because of the likelihood they will incur
substantial costs in the future.

4. The unemployed lack insurance because most policies
accompany employment.
5. Workers for small firms are unlikely to have insurance
because high administrative costs make it costly for small
business employers to offer this benefit.
6. Part-time and low-wage workers are also less likely to be
insured.
C. The uninsured will sometimes pay directly, but often wait
until their illness is so critical that the hospital emergency room
is the only alternative, and this adds to hospitals’
uncompensated health care burdens, estimated at $36 billion per
year. Hospitals are forced to shift these costs to other health-
care customers.
VII. Why the rapid rise in costs?
A. Health care market is unique.
1. Ethical and equity considerations are intertwined. Society
regards much of health care as a right and is reluctant to ration
it solely on the basis of who can afford it.
2. Information is asymmetric: Physicians and other
caregivers possess more information about the product than the
consumer. Often the provider orders the service for the
consumer or patient.
3. External benefits exist. Healthy individuals make the
entire society more productive and contribute to general
prosperity and well-being.
4. Third-party payment or payment by the insurance company
means that the consumer has little or no direct out-of-pocket
expenditure for health care services. Therefore, the consumer
does not seek out the lowest cost alternative.
B. Demand for health care has been increasing.
1. Health care is a “normal” good, so when incomes rise, the
demand for health care rises proportionately. Elasticity with
respect to income is estimated about 1 and may be as high as
1.5 in the U.S.
2. Demand for most health care is believed to be price

“inelastic;” the quantity demanded does not decline
significantly with rising prices.
a. Most health care is a necessity.
b. There are few substitutes for most health care services.
c. Consumers do not “shop around” for doctors in most cases.
d. Patients with insurance do not care much about the price of
each service received since they prepay for the total package.
3. The population is aging. By 2000 the proportion of those
over the age of 65 had risen to 12.4 percent from 9 percent
thirty years earlier. Those over 65 consume 3 1/2 times more
health care services as those between 19 and 64. Those over 84
consume nearly two and one-half times as much as those in the
65-69 age group. By 2030, 76 million members of the baby
boomer generation will turn 65.
4. Unhealthy lifestyles, particularly substance abuse, are
common. Although smoking is declining, obesity-related
medical costs are about $147 billion per year, with taxpayers
paying more than half the bill through Medicare and Medicaid.
5. The role of physicians may increase the demand for health
care.
a. Supplier-induced demand. Asymmetric information exists,
meaning that doctors possess more information about health
care needs than do their patients (consumers) and doctors order
the services for them. Also doctors are paid on a “fee-for-
service” basis, which encourages them to order more services,
and patients seldom have advance information on the cost or
necessity of these services.
b. Defensive medicine is common in that doctors err on the
side of being overly cautious to avoid any charges of
malpractice. They often order many procedures that may not be
necessary.
c. Medical ethics cause doctors to use the “best practice” to
serve their patients and to try to sustain human life regardless
of cost.
6. Insurance pays about 79 percent of health care costs.
While this is positive in providing security against devastating

losses, it creates a “moral hazard” problem.
a. Insured may seek more health care and engage in more
damaging behavior than the uninsured.
b. Overconsumption occurs because people regard health care
as “free,” since they have prepaid for their services.
c. Price provides a direct incentive to restrict use of a
product, but insurance coverage, removes the consumer’s
budget constraint when he or she decides to consume health
care.
7.Consider This ... Why do Hospitals Sometimes Charge $25 for
an Aspirin?
a. To save taxpayers money, Medicare and Medicaid set
their payment rates for medical services above marginal cost,
but below average total cost.
b. These programs do not pick up their share of fixed
costs. Thus, patients with private insurance must cover this
shortfall.
8. Employer-financed health insurance constitutes a “tax
subsidy” because the health benefits are exempt from both
federal income tax and payroll (social security) taxation.
9. Figure 22.3a gives graphic portrayal of a competitive
health care market (on the demand side) that might exist if all
consumers were uninsured. Allocative efficiency occurs only
when we pay in full for a product. In Figure 22.3b we see the
effect of health insurance paying half the price of health care,
so the consumer’s bill for the service is the same as half price.
Therefore, the quantity consumed will be Qi rather than Qu and
there is more health care consumed than would be justified by
the total cost of this amount of care to society. Figure 22.3b
illustrates this “welfare loss” as the area abc.
10. The “equity-efficiency” tradeoff is illustrated here. The
dilemma is that if we provide social insurance that is believed
equitable, then overconsumption will occur, which is
inefficient. Efficiency may be achieved when less insurance is

provided, but this may be inequitable.
C. Rationing to Control Costs
1. Countries with national health insurance use
mechanisms to restrict the quantity supplied of health care,
decreasing money spent on health care.
2. Waiting helps to ration health care where patients
might have to wait weeks, or months for specific medical
appointments or procedures.
3. In the U.S. insurance is private so government
regulators are focused on the benefits of insurance instead of
the costs because the money is not the government’s money.
a. Over the years regulators have increased the
conditions to be covered under insurance.
b. As a result, insurance companies increased
premiums.
4. Other countries focus on denying coverage
and decreasing costs while the U.S. expands health insurance
coverage.
D. Supply factors also cause rising costs.
1. Some believe that the supply of physicians has been
restricted artificially, but the evidence for this argument is not
strong, since the number of physicians per 100,000 people has
increased over the years. But the increase in the suppl y of
physicians has not kept up with the increase in demand for
services provided.
2. Physicians’ incomes are high in part because of the high
costs incurred during their education. Although doctors have
high rates of return on their educational expenses, these returns
are below those for lawyers and business school graduates.
3. Productivity growth has been slow in health care because it
is labor intensive and there is no strong incentive to raise
productivity in a fee-for-service system.
4. Changes in medical technology have often caused rising
costs, because private and public insurance pays for new
technology regardless of costs. Some studies estimate that this
accounts for as much as one-half of the growth of health care

expenditures.
5. Consider This .. Electronic Medical Records
E. Relative importance.
1. Health care costs have escalated because of both demand
and supply side factors as enumerated above; however some
factors are more important than others.
2. Most experts attribute the relative rise in health care
spending to the following:
a. Advances in medical technology.
b. The medical ethic of providing the best treatment
available.
c. Private and public health insurance (the presence of third
partypayers).
d. Fee-for-service physician payments.
VIII. Cost Containment: Altering Incentives
A. Deductibles and Copayments
1. Creates opportunity costs for consumers and a direct cost for
health care.
2. Decreases the overuse of health care.
3. Decreases the administrative costs for health insurance
companies.
B. Health Savings Accounts (HSAs)
1. For those who qualify, individuals can make tax-deductible
contributions to their HSAs
2. They can then use the money in their HSAs to pay for
qualified medical expenses and whatever is not used in the
current year is still available for future use.
3. By using their own money, consumers will be more careful in
evaluating their MC and MB of health services and compare
prices.
4. They can use the money for non-medical reasons giving them
greater reason to be frugal, but they will have to pay income tax
on it.
C. Managed Care

1. There are two main types of managed care systems.
a. Preferred Provider Organizations (PPOs)
i. If the individual goes to a provider on the list of PPOs, the
insurance will cover 80 – 100% of costs.
ii. If they go outside of the PPO, insurance only covers 60 –
70% of the costs.
iii. The dollar amount covered by health insurance for most
services is less than the prices charged, decreasing premiums
and expenditures.
b. Health Maintenance Organizations (HMOs)
i. Provides services for enrollees who pay an annual fee.
ii. With a fixed annual revenue, there is an incentive to avoid
too much care and therefore reduce costs.
iii. There is also an incentive for more preventative care to
keep costs low.
2. Physicians and hospitals are closely monitored, so physicians
are more reluctant to perform unnecessary tests with a fixed
budget and inspection of their behaviors.
3. The prices are lower than with traditional insurance.
4.
Patients are restricted to physicians within the managed health
care system and it has been argued that perhaps there is too
much incentive to reduce costs.
D. Medicare and DRG
1. Federal government used to automatically pay all costs of a
patient’s medical expenses.
2. In 1983 Federal government started making payments based
on diagnosis-related-group (DRG) system.
a. Now, the hospital receives a fixed payment for a patient’s
care based on detailed diagnostic categories that best
characterize a patient’s conditions and needs.
b. DRG gives hospitals an incentive to lower their costs.
c. DRG has decreased the length of hospital stays.
d. It has been criticized that these changes are actually
reflective of diminished quality of medical care.
E. Limits on Malpractice Awards

1. Supporters: capping malpractice awards reduces malpractice
premiums, lowering health care costs.
2. Opponents: Large malpractice awards are the best tool for
preventing medical malpractice and medical malpractice awards
are a very small part of total health care costs.
IX. The Patient Protection and Affordable Care Act (PPACA)
A. PPACA was meant to extend and expand the existing health
care system rather than creating a new national health care
system. Its purpose is to have health insurance for nearly all
Americans.
B. Many who did not have private insurance had costly medical
conditions, so significant revenue sources had to be found
through the personal mandate to buy insurance and a variety of
new taxes.
C. Preexisting Conditions, Caps, and Drops
1. It is illegal to deny insurance for pre-existing medical
conditions.
2. PPACA prevents insurance companies from imposing annual
or lifetime caps.
3. Both of these changes result in a significant increase in costs
for insurance companies.
D. Employer Mandate
1. Every firm with 50 or more full-time employees must buy
health insurance for employees, or pay a $2,000 fine per
employee.
2. Extends insurance to as many workers as possible without
increasing the costs to government.
E.
Personal Mandate
1. Individuals must buy insurance for themselves and their
dependents if they are not already covered by insurance, or pay
a fine of $695 per uninsured family member or 2.5% of income.
2. Health subsidies are in place to prevent financial devastation
of the poor.
3. In essence, the wealthier, healthy individuals pay for health

insurance to make insurance less costly for lower income
groups.
F. Covering the Poor
1. The employer mandate means that larger employers must
provide insurance for all employees which include the poor.
2. Medicaid system was expanded to cover anyone with income
that is less than 133% of poverty level.
3. PPACA subsidizes the purchase price of health insurance for
those who have to buy it on their own and these subsidies reach
far into the middle class.
G. Insurance Exchanges
1. Individuals buying their own insurance will buy it in a
government-regulated market called insurance exchange.
2. Regulators don’t set the prices, but they can withdraw
approval of an insurer if the price increase is deemed by
regulators to be too high relative to costs.
3. The hope is that the insurance exchange will create a
competitive environment among health insurance companies.
H. Other Provisions
1. The act mandates that adult children can remain covered on
their parents’ employer-provided insurance until they are 26.
2. PPACA makes it illegal for insurance companies to charge
copayments or deductibles for annual check-ups or preventative
care.
3. It requires insurers to spend at least 80% of the money
received from health premiums on health care or improving
health care.
I. Taxes
1. .9% increase in Medicare payroll taxes for individuals
earning more than $200,000/year and more than $250,000/year
for married couples.
2. 3.8% increase in capital gains tax for individuals earning
more than $200,000/year and more than $250,000/year for
married couples.
3. A 40% tax is paid by employers for any employer-provided
insurance with a premium greater than $10,200/year for an

individual or $27,500/year for a family.
4. 2.9% excise tax for all goods sold by medical device
manufacturers.
5. 10% tax on indoor tanning.
J.
Objections and Alternatives
1. Objections
a. Not a single Republican in either chamber of Congress voted
for PPACA.
b. There will be greater inefficiencies with government
controlling pricing and the content of insurance policies.
c. Might be the first step towards a national health care system
with nonprice rationing required to keep costs down.
d. Revenue sources are insufficient to meet the costs of PPACA.
e. Large subsidies that many families qualify for will result in
significant increases in health care spending.
2. Alternatives
a. In Singapore and Indiana, wasteful spending was reduced by
increasing the out-of-pocket expenditures of the consumers and
forcing them to really evaluate their marginal benefits/costs and
the opportunity costs.
K.Consider This ... PPACA Implementation Problems
X. Last Word: Singapore’s Efficient and …
Government's Role and Government Failure
Chapter 05 - Government's Role and Government Failure
CHAPTER FIVE
GOVERNMENT'S ROLE AND GOVERNMENT
FAILURECHAPTER OVERVIEW
The chapter begins by reviewing the topic of market failure and
the important role that the government can play in (potentially)
improving economic efficiency. The chapter then discusses the
difficulties that democratic governments face when making
specific laws and regulations that govern economic activity in
an attempt to correct for this market failure. It is then argued
that as a result of these difficulties, a government can

sometimes pursue policies for which the marginal cost exceeds
the marginal benefit. These inefficient outcomes, defined as
government failure, are just as important as market failure in
understanding economic activity. In effect, the lesson from this
chapter is that society should be just as vigilant in looking for
instances of government failure as in looking for instances of
market failure.
The appendix to this chapter discusses public choice theory.
The theoretical discussion includes an examination of the
inefficiency of voting outcomes, interest group influence,
political logrolling, and the paradox of voting outcomes. The
median-voter model is also considered. WHAT’S NEW
The “Consider This … Unintended Consequences!” has been
replaced with a new “Consider This … Government, Scofflaw”.
This should make the discussion more relevant for today’s
students and highlight potential issues related to government
owned companies.
The “Last Word: Government Failure in the News” has been
updated replacing some old examples with new examples.
There are also minor changes in wording in the chapter and the
data has been updated.
The appendix to the chapter discusses the median-voter theorem
and a potential voting paradox.INSTRUCTIONAL
OBJECTIVES
1. Describe how government's power to coerce can be
economically beneficial.
2. Explain some of the difficulties associated with managing
and directing the government.
3. Explain Government failure and explain why it happens.
4. Explain why representative democracy suffers from the
principal-agent problem.
5. Discuss the idea of clear benefits and hidden costs.
6. Define unfunded liabilities and provide some examples.
7. Define and identify the terms and concepts listed at end of

the chapter.
8. (Appendix) Explain the difficulties of conveying economic
preferences through majority voting.
9. (Appendix) Explain the problems created with majority
voting and the median-voter outcome.LECTURE NOTES
Learning Objectives – After reading the chapter, students
should be able to:
Describe how government's power to coerce can be
economically beneficial and list some of the difficulties
associated with managing and directing the government.
Discuss "government failure" and explain why it happens.
(Appendix) Explain the difficulties of conveying economic
preferences through majority voting.
Government's Economic Role
0. Although the U.S. economy is primarily a market system
where markets and prices coordinate and direct economic
activity, there is still a prominent role for government in
determining how the economy functions.
Government's Right to Coerce: One key difference between the
economic activities of government and those of private firms
and individuals is that government possesses the legal right to
force people to do things. In many cases this can improve
economic efficiency.
Force and Economic Efficiency: The government can correct for
market failure by providing public goods and by providing the
appropriate incentives to firms (or households) in the presence
of externalities. This will most likely increase economic
efficiency. The government can also reduce private-sector
economic risks by enforcing property rights and enforcing
contracts. This will also most likely increase economic
efficiency.
The Problem of Directing and Managing Government
The government can substantially improve allocative and
productive efficiency if it directs its coercive powers toward
rectifying market failures and providing a low-risk economic
environment for the private sector. However, governments face

the daunting challenge of organizing millions of employees to
carry out thousands of tasks. An understanding of these
challenges and complexities will give you a better sense of how
well most governments manage to do despite all of the problems
associated with government failure.
No Invisible Hand: Government economic policies are not self-
correcting. If a government program is inefficient there is no
pressure forcing this program to become more efficient or
forcing it "out-of-business".
Massive size and scope: The size and scope of government
makes it difficult to identify and fix economic inefficiencies.
The need for bureaucracy: Given the size of government,
elected officials must rely upon many layers of supervisors to
run and manage government programs.
The need for paperwork and inflexibility: To make sure that
laws are uniformly enforced, the bureaucracy is regulated by
detailed rules and regulations governing nearly every possible
action that any individual bureaucrat might be called upon to
make.
The information aggregation problem: Because of their massive
size and scope, bureaucracies have difficulty with effectively
aggregating and conveying information from their bottom layers
to their top layers. As a result, top officials will tend to make
inefficient choices.
Lack of accountability: Democratic elections do take place, but
because the government undertakes so many activities, it is
difficult for the electorate to know the details of even a small
fraction of what the government is up to at any particular time.
As a result, many programs are run poorly without affecting the
reelection chances of the incumbent politicians.
Consider This … Does Big Government Equal Bad Government?
The actual size of the government is not necessarily "good" or
"bad". It is whether or not the marginal benefit of a government
program exceeds the marginal cost of the program. Thus, the
debate over "large" or "small" government is misplaced. It is
really a debate about the marginal benefit and marginal cost of

government programs.
Government Failure
0. Government can fail despite knowing the preferences of
voters (as discussed in the appendix) because government puts
their own interests ahead of the voters’ interests and/or
government chooses policies that create large benefits for a
small group while creating small losses for the majority.
Representative Democracy and the Principal-Agent Problem
The principal-agent problem occurs because conflicts arise
when tasks are delegated by one group of people (principal) to
another group of people (agents).
In a democracy, elected officials (agents) have goals like
reelection which conflict with the interests of the voters.
Special interests may promote the interests of a small group at
the expense of society at large.
The special-interest effect refers to the situation where a small
number of people will receive large gains at the expense of a
much larger number of people who individually suffer small
losses. The small group will be well informed and highly vocal
on the issue and press politicians for approval. The large
numbers who will each suffer small losses will not have the
incentive to be informed or feel strongly. The result is that the
politician will support the specialinterest program, whose
supporters will notice the vote in their favor, and ignore the
majority who don’t feel strongly.
Pork-barrel politics is an example of the special-interest effect.
In this case, the benefit goes to a single political district and to
the politician from that political district. The cost of the project
is spread out to many individuals who will never receive the
benefits. Pork-barrel politics is often combined with logrolling.
Rent-seeking behavior occurs when a transfer of wealth at
someone else’s or society’s expense occurs through government
action. Here the term “rent” means any payment to a resource
supplier, business, or other organization above that which
would accrue under competitive market conditions. Examples
include tax loopholes that benefit only certain groups; public

works projects that cost more than the benefits they yield; and
occupational licensing that requires more than is necessary to
protect consumers.
Clear benefits, hidden costs (or the reverse, immediate costs and
future more vague benefits) are another dilemma for politicians
trying to decide on public programs. Where the benefits are
recognizable and popular, the politician may vote for the
program even if the costs exceed these benefits if the costs are
diffuse or hidden.
Unfunded Liabilities: The political tendency to favor priorities
that have immediate payouts but deferred costs also leads to
many government programs having unfunded liabilities. An
unfunded liability occurs when the government commits to
future expenditures without simultaneously committing to
collect enough tax revenues to pay for those expenditures
(unfunded liability = present value of projected expenditures on
the program - present value of projected tax revenue for the
program).
Social Security is one of the largest programs with an unfunded
liability.
Medicare also has a large unfunded liability component.
Chronic Budget Deficits: A budget deficit occurs whenever tax
revenues are less than spending in a particular year.
Deficits might result in economic inefficiency by allowing the
government to control and direct a large fraction of the
economy's resources.
A Debt Crisis might occur because the government has
accumulated so much debt that creditors are no longer willing to
lend to the government. This can result in a major "shock" to
the economy as the government raises taxes and cuts spending
at unprecedented levels. It is better to gradually raise taxes and
phase out programs (spending) rather than to implement a
drastic adjustment to an economy.
Misdirection of Stabilization Policy: Stabilization policy
attempts to use fiscal and monetary policy to "smooth-out"
business cycle fluctuations.

Fiscal policy attempts to stimulate spending by changing tax
rates and spending levels.
Monetary policy attempts to stimulate spending by changing
interest rates.
The problem is that the politicization of fiscal and monetary
policy might result in abuse and inefficiency by government
officials. For example, the government might direct
expenditures to specific companies in their district. Or might
attempt to change interest rates before an election (an
independent Federal Reserve reduces this possibility).
Limited and bundled choice is another problem with publi c
goods. The voter must choose between a few candidates who
will have the power to select the public goods and services to be
financed by the voter’s tax money. The choices are “bundled” in
that the limited set of candidates will govern over a variety of
issues, and the voter’s preferences may not perfectly align with
any candidate. In the private sector, the consumer has a
multitude of choices available, and can generally separate out
those goods and services not desired.
Consider This … Government, Scofflaw
An interesting example of government failure occurs when
public companies operated by the government violate the law at
higher rates than private companies.
A 2015 study found that public companies were substantially
more likely than private companies to violate health and safety
laws.
One explanation is that public companies may have a difficult
time getting the tax revenue, or funding, that would be needed
to comply with the law.
Another explanation is that the law appears to be applied much
more leniently against public companies.
Bureaucracy and inefficiency can be another problem in the
public sector because the profit motive or competitive pressure
to perform efficiently is not present. Ironically, a potential
response of government to a program’s failure is to increase its
budget and staff.

Government employees, together with the special-interest
groups they serve, often have the political clout to block
attempts to pare down or eliminate their agencies.
There is a tendency for government bureaucracy to justify
continued employment by looking for and eventually finding
new problems to solve.
Inefficient Regulation and Intervention: Governments regulate
many aspects of the economy with the hope that these
regulations improve economic outcomes. Examples include the
environmental laws and banking supervision.
Regulatory Capture occurs when the government agency that is
supposed to supervise a particular industry becomes heavily
influenced by the industry that it is supposed to be regulating.
Some argue that regulatory capture has occurred in the FDA
with respect to the pharmaceutical industry.
Deregulation as an alternative to regulation will reduce (or
eliminate) regulatory capture, but this might result in other
inefficiencies, such as monopolies, false claims and unsafe
drugs, and potential negative externalities from pollution.
Government's poor investment track record
Loan guarantees reduce downside risk and result in potentially
inefficient investments.
Loan guarantees also socialize losses and privatize gains. If the
project fails then the taxpayer picks up the tab. If project
succeeds then the private investors reap the reward.
Corruption often occurs in government when officials abuse
their power.
A government official is bribed to do what he should already be
doing.
A government official accepts a bribe to do something he does
not have the legal authority to do.
An interesting debate is whether or not campaign contributions
constitute a bribe.
Imperfect institutions exist in both the public and private
sectors, which often makes it difficult to decide which
institutions would perform best in the production of certain

goods and services.
LAST WORD: “Government Failure” in the News
0. Despite Disney making a profit of over $2 billion per year
running nine of the world's 10 largest amusement parks, two
Disney contractors received $1.4 million of federal loan
guarantees in 2014.
The $878 billion American Recovery and Reinvestment Act of
2009 had many questionable spending projects. For example,
$10 million was set aside to renovate a train station in
Elizabethtown, PA that hadn't been used in 30 years.
Between 2009 and 2014, the U.S. Department of Agriculture
spent $34 million on a program to encourage Afghanis to
cultivate and consume soybeans—despite soybeans growing
poorly in Afghanistan.
The government paid out funds on over 900,000 false claims for
disaster relief from Hurricane Katrina.
APPENDIX TO CHAPTER 5: PUBLIC CHOICE THEORY AND
VOTING PARADOXES
1. Public Choice Theory
0. Economic analysis of government decision making, politics,
and elections.
Understanding government failures highlights how changes in
government processes can lead to greater efficiency.
Revealing Preferences through Majority Voting
0. Majority voting can lead to inefficient outcomes; that is, the
majority can defeat a proposal that would have provided greater
benefits than costs and adopt one that costs more than the
benefits it provides (Figure 1).
Illustration of an inefficient “no” vote result: Suppose there are
3 voters who each will have to pay $300 in tax if a proposal is
adopted. It is worth $700 to one, $250 to the second and $200 to
the third. The second and third voters will vote “no” and defeat
the proposal despite the fact that the total benefits ($1150)
exceed the $900 cost.
Illustration of an inefficient “yes” vote result: Take the same
three voters as above and the same level of taxation. Now the

proposal is worth $100 to the first voter and $350 to each of the
others. The vote will be 2 to 1 in favor of the proposal even
though the total benefit of $800 is less than the $900 cost.
Conclusion: The problem is that the oneperson onevote rule
does not measure intensity of preferences, so the result may not
be economically efficient. Too much or too little of the good is
produced.
Interest groups may improve the economic efficiency of results
by registering intense feelings with elected representatives or
by organizing major efforts to get the vote to go their way.
Logrolling or vote trading may also secure favorable decisions
for those who feel strongly about certain issues, but it may also
negate an efficient outcome in favor of a special interest group
where the value of the benefits received does not justify the
cost. The efficiency of the outcome will depend on the
circumstances.
The paradox of voting is that society may not be able to rank its
preferences consistently through majority voting.
Table 1 demonstrates a situation in which three voters have
expressed their rankings of three public projects; each has a
different ranking. If voting is done on pairs of projects, it can
be shown that national defense will win over roads, and roads
will win over weather warning systems. But the logical
conclusion that the community prefers national defense to
weather warning systems is not the case—they would each get
the same number of points (if points were awarded for a 1st,
2nd, and 3rd choice). In other words, if one choice must receive
a majority of the votes, there will not be a consistent outcome
in this case unless somehow the strengths of the rankings can be
measured.
Government might find it difficult to provide the “correct”
public goods by acting in accordance with majority voting.
Consider This … Voter Failure
The median-voter model suggests that under majority rule the
median voter will in a sense determine the outcomes of

elections. The median voter is the person holding the middle
position on an issue.
The textbook example has three voters deciding among three
types of weather warning systems. The first is willing to spend
$400; the second, $800; the third, $300. The median-voter
model suggests that the $400 proposal will win. In a choice
between the $400 and $800 proposal, the first and third will
vote for the $400 type. In a choice between the $400 and $300,
the first and second will vote for the $400 type. In other words,
both extreme voters prefer the median choice rather than the
other extreme, so the median voter will tend to predominate.
Real-world examples occur in political positions where
candidates seem to aim their appeal at the median voters within
each party to get the nomination and later at the middle of the
population in an effort to win the election.
Implications of the median-voter model:
Many people will be dissatisfied by the extent of government
involvement in the economy.
Some people may “vote with their feet” by moving into political
jurisdictions where the median voter’s preferences are closer to
their own.
Median preferences can change over time.
QUIZ
1. Which of the following are potential problems with directing
and managing government?
The government's massive size and scope
Politicians aren't as intelligent as the rest of society
It is difficult for the government to effectively aggregate
information from bottom to top
Answer A and C are correct
Answer: D
What is the correct criterion in evaluating government
programs?

1. The size of government: A larger government provides more
goods.
The size of government: A smaller government has lower taxes.
By comparing the marginal benefit to the marginal cost of the
government program. If the marginal benefit exceeds the
marginal cost this is an efficient program.
By comparing the marginal benefit to the marginal cost of the
government program. If the marginal cost exceeds the marginal
benefit this is an efficient program.
Answer: C
An unfunded liability for a government program implies that:
1. projected government expenditure exceeds projected
government revenue for the program.
the government program is self-sustaining.
projected government revenue exceeds projected government
expenditure for the program.
the government has yet to establish the program.
Answer: A
A special-interest issue is one whose passage yields:
1. large private benefits compared to external benefits.
large external benefits compared to private benefits.
small economic losses to a small number of people and large
economic losses to a large number of people.
large economic gains to a small number of people and small
economic losses to a large number of people.
Answer: D
Politicization of fiscal and monetary policy:
1. Refers to the use of fiscal and monetary policy to help
foreign governments.
Is the primary reason for public sector efficiency.
Refers to the use of fiscal and monetary policy to help
politicians before an election.
Creates the opportunity for the fallacy of limited decisions.

Answer: C
Which of the following is the most likely cause of unfunded
liabilities?
1. The cost of the program is immediate while the benefit is in
the distant future.
The benefit of the program is immediate while the cost is in the
distant future.
Politicians are helping as many people as they can.
Voters prefer taxes now rather than in the future.
Answer: B
It is often argued that government laws and regulations have
unintended consequences. Which of the following is an
unintended consequence of the 2010 healthcare reform law?
1. Everyone will now have insurance.
Companies are now willing to employ more full-time workers.
Companies are reducing full-time employees to part-time
employees.
Insurance markets are now more efficient.
Answer: C
The concept of limited choices, as used in public choice theory,
refers to the fact that:
1. Politicians may not be objective in evaluating economic
policy programs.
Because of the importance of television and other modern
communication techniques, the best and brightest candidates
may not be selected by voters.
Voters must select a candidate who represents a "bundle" of
various public policy programs and who can't register support or
opposition for specific programs.
The most economically efficient public policy programs may
not be selected because political leaders do not know enough
about economics.
Answer: C

Public choice theory focuses on the economics of:
1. fiscal and monetary policy.
the behavior of business firms.
antitrust and regulatory policy.
government decision making, politics, and elections.
Answer: D
Regulatory capture is problematic for which of the following
reasons?
1. The government collects less tax revenue.
The regulations governing an industry are set by the industry
itself.
Monetary policy is likely to influence the election outcome.
There is excess spending on politician salaries.
Answer: B
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No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
CHAPTER FOUR
MARKET FAILURES: PUBLIC GOODS AND
EXTERNALITIESCHAPTER OVERVIEW
Chapter 3 touched on how properly functioning, competitive
markets achieve economic efficiency, but this chapter extends
and deepens the analysis by including consumer and producer
surplus along with efficiency losses (deadweight losses). The

chapter examines demand-side and supply-side market failures
and their impacts on resource allocation. Students will learn
that under some circumstances goods are overproduced while in
other situations goods are underproduced.
Then the chapter analyzes government’s role in producing
public goods and how this impacts resource allocation. Marginal
analysis is used to evaluate public goods and externalities.
Various approaches for limiting negative externalities are also
presented.
The end of the chapter addresses potential government
inefficiencies that may arise, mitigating the benefits from
government’s policies.
The appendix discusses how asymmetric information results in a
third type of market failure. Since individuals may possess
different information at a given time, markets may fail to
develop or operate in a limited capacity. WHAT’S NEW
There are minor changes in wording in the chapter and the data
has been updated.
The term “Pigovian tax” replaces the term “specific tax”. This
makes the text consistent with the language of optimal
taxation.INSTRUCTIONAL OBJECTIVES
1. Distinguish between demand-side and supply-side market
failures and the kinds of externalities that are created by each.
1. Define, measure, and graphically identify consumer surplus.
1. Define, measure, and graphically identify producer surplus.
1. Identify and explain efficiency (or deadweight loss) using
consumer and producer surplus.
1. Explain how equilibrium achieves both productive and
allocative efficiency.
1. Identify the characteristics of public goods and explain how
they differ from private goods.
1. Describe graphically the collective demand curve for a
particular public good and explain this curve.
1. Explain why the supply curve for public goods is upward

sloping and explain how the optimal quantity of a public good is
determined.
1. Identify the purpose of cost-benefit analysis and explain the
major difficulty in applying this analysis.
1. Explain what is meant by externalities.
1. Describe graphically and verbally how an overallocation of
resources results when negative externalities costs are present
and how this can be corrected by government action.
1. Describe graphically and verbally how an underallocation of
resources occurs when positive externalities are present and
how this can be corrected by government action.
1. Describe government policies that would reduce negative
externalities.
1. Analyze government’s role in the economy and government’s
inefficiencies.
1. Define and identify terms and concepts listed at the end of
the chapter.
1. (Appendix) Discuss the role information asymmetries play in
market development.
1. (Appendix) Discuss how government may intervene to deal
with this potential market failure.LECTURE NOTES
Introduction
0. Learning objectives – After reading this chapter, students
should be able to:
0. Differentiate between demand-side market failures and
supply-side market failures.
0. Explain the origin of both consumer surplus and producer
surplus, and explain how properly functioning markets
maximize their sum, total surplus, while optimally allocating
resources.
0. Describe free riding and public goods, and illustrate why
private firms cannot normally produce public goods.
0. Explain how positive and negative externalities cause under -
and overallocations of resources.
0. Show why we normally won’t want to pay what it would cost
to eliminate every last bit of a negative externality such as air

pollution.
0. (Appendix) Describe how information failures may justify
government intervention in some markets.
0. Everyone uses goods and services that are provided by
government.
0. The questions to be answered are: why doesn’t the private
sector provide these goods and services efficiently, and what is
the role of government in bringing about a better allocation of
resources?
Market Failures in Competitive Markets
0. Market failures can occur in competitive markets.
Demand-side market failures:
3. Occur because at times it’s impossible to charge people what
they’re willing to pay.
3. Fireworks are an example.
3. There’s no way to prevent people who didn’t pay to see
fireworks from watching them.
3. Private firms therefore are not willing to produce the
fireworks.
Supply-side market failures:
3. Occur because the producer fails to pay the full cost of
production.
3. Pollution is an example.
3. The firm pays for all of the resources it uses, but it doesn’t
pay for the pollution it creates.
3. The firm therefore produces more electricity and pollution
than the firm would produce if they paid for the pollution they
emit.
Efficiently Functioning Markets
0. To be efficient:
4. Demand must fully reflect consumers’ willingness to pay.
4. Supply must fully reflect all costs of production.
0. Consumer Surplus
5. Definition – the difference between the maximum price a
consumer is (or consumers are) willing to pay for a product and
the actual price.

5. The surplus, measurable in dollar terms, reflects the extra
utility gained from paying a lower price than what is required to
obtain the good.
5. Maximum price a consumer is willing to pay depends on the
opportunity cost of goods and services he must forego.
5. Consumer surplus can be measured by calculating the
difference between the maximum willingness to pay and the
actual price for each consumer, and then summing those
differences.
5. Consumer surplus is measured and represented graphically by
the area under the demand curve and above the equilibrium
price. (Figure 4.1)
5. Consumer surplus and price are inversely related – all else
equal, a higher price reduces consumer surplus.
0. Producer Surplus
6. Definition – the difference between the actual price a
producer receives (or producers receive) and the minimum
acceptable price.
6. Producer surplus can be measured by calculating the
difference between the minimum acceptable price and the actual
price for each unit sold, and then summing those differences.
6. A producer’s minimum acceptable price is based on his
marginal cost and the opportunity cost of using resources to
produce other goods.
6. Producer surplus is measured and represented graphically by
the area above the supply curve and below the equilibrium
price. (Figure 4.2)
6. Producer surplus and price are directly related – all else
equal, a higher price increases producer surplus.
Efficiency Revisited and Efficiency Losses
0. Efficiency is attained at equilibrium, where the combined
consumer and producer surplus is maximized. (Figure 4.3)
7. Consumers receive utility up to their maximum willingness to
pay, but only have to pay the equilibrium price.
7. Producers receive the equilibrium price for each unit, but it
only costs the minimum acceptable price to produce.

7. Allocative efficiency occurs at quantity levels where three
conditions exist:
2. MB = MC (as represented by demand and supply).
2. Maximum willingness to pay = minimum acceptable price.
2. Combined consumer and producer surplus is at a maximum.
0. Efficiency (Deadweight) Losses
8. Underproduction reduces both consumer and producer
surplus, and efficiency is lost because both buyers and sellers
would be willing to exchange a higher quantity. (Figure 4.4a)
8. Overproduction causes inefficiency because past the
equilibrium quantity, it costs society more to produce the good
than it is worth to the consumer in terms of willingness to pay.
(Figure 4.4b)
Public Goods
0. Private goods are produced and sold in competitive markets,
and have two characteristics:
9. Rivalry in consumption – when one person buys and
consumes a good, it is not available to others.
9. Excludability – Sellers can restrict the benefits to those who
pay for the good.
0. Market demand for private goods is found by horizontally
summing the individual demand schedules.
0. Private markets allocate goods and resources efficiently –
those willing to pay to obtain goods get them. Sellers produce
goods to satisfy consumer wants, and consumer buying behavior
tells them whether to produce more or less of any particular
good.
0. Unlike private goods, public goods are those goods that are
nonrival and nonexcludable.
0. Public goods suffer from the free-rider problem, where a
consumer can enjoy the benefit of the good without having to
pay for it.
13. As a result of free-riders government must provide the good.
13. Government doesn’t prevent free-riders, but government can
finance production of the good through taxes.
13. Sometimes public goods can be subsidized through private

related goods and therefore provided by private firms.
0. Consider This … Street Entertainers
14. Street entertainers regularly appear in popular tourist areas
in major cities. Even though some people pay when the “hat is
passed,” many benefit from the shows without contributing to
the cost (free-riding).
14. Because local businesses benefit from the customers
attracted by these performers, the businesses or local
government will sometimes pay these entertainers.
14. Even when government is not contributing to the cost of
street entertainers, a public good is still being provided.
0. The demand for public goods differs from the market demand
for private goods.
15. It is a “phantom” demand since the consumers will not be
making individual purchases.
15. To find the collective demand schedule for a public good,
we add the prices people collectively are willing to pay for the
last unit of the public good at each quantity demanded (Table
4.3).
15. Figure 4.5 is a graphical illustration of this table. A
collective demand curve is the vertical sum of the individual
demand curves for the public who want that good.
15. Recall that the market demand for a private good was a
horizontal summation of the individual demand curves.
0. The supply curve for any good is its marginal cost curve. As
with private goods, the law of diminishing returns applies to the
supply of public goods.
0. The optimal quantity of a public good can be determined by
comparing the collective demand curve with the supply
(marginal cost) curve to determine their point of intersection or
by looking at the demand and supply (marginal cost) schedules
to see at what price and quantity marginal benefit equals
marginal cost (Figure 4.5c).
0. Cost-benefit analysis is a technique for decision making in
the public sector.
18. The concept involves comparing the benefit of providing

incremental units of public goods with the costs of providing
these additional units. Note that the comparison is a marginal
one, i.e., the comparison is made between the costs and benefits
of additional amounts of a public good or service.
18. Table 4.4 illustrates this concept in determining the scope of
a national highway construction project. Four possible phases of
projects are considered, with costs and benefits compared. By
comparing the marginal costs and benefits as one moves from
the least expensive phase to the mostexpensive phase, we see
Plan C is the optimal choice.
18. The rule for this decisionmaking technique is to use the
marginal benefit = marginal cost rule; if the marginal cost
exceeds the marginal benefit, that part of the project should not
be included.
18. The problem with this technique is the difficulty in
measuring costs and benefits. Benefits are particularly difficult
to estimate, because there are many related aspects that are not
easily calculated. Nevertheless, the method is widely used.
0. Quasipublic goods are those that have large positive
externalities, so government will sponsor their provision.
Otherwise, they would be underproduced. Medical care,
education, and public housing are examples.
0. Resources are reallocated from private to public use by
levying taxes on households and businesses, thus reducing their
purchasing power and using the proceeds to purchase public and
quasipublic goods. This can bring about a significant change in
the composition of the economy’s total output.
0. Consider This … Responding to Digital Free-riding
21. The music industry struggles with digital piracy. In this
example four friends start a rock band and eventually get signed
by a major record label. However, since people can download
their music for free they have a difficult time making a living.
21. To overcome this problem the band provides the free music
downloads to increase their popularity (they do not fight the
public goods nature of their music). However, they now charge
a higher price to attend their concerts, which is still a private

good.
Externalities
0. Externalities occur when costs or benefits accrue to an
individual who is external to the market transaction.
0. Figures 4.6a and 4.6b, respectively, illustrate that an
overallocation of resources occurs when negative externalities
are present and an underallocation of resources occurs when
positive externalities are present.
23. Negative externalities occur when producers are able to
shift some of their costs onto the community.
23. Positive externalities occur when the benefits of a good are
received by others in the community although they did not pay
for them. These benefits are not reflected in the individual
demand curve.
0. Consider This…The Fable of the Bees
24. The Coase theorem, named after Nobel prizewinning
economist Ronald Coase, suggests that government is not
always needed to remedy external costs and benefits.
24. With the right conditions, externalities can be solved with a
market approach to individual bargaining.
24. Bees provide many positive externalities to farmers by
pollinating their crops.
2. Farmers and beekeepers used individual bargaining to
determine payment, avoiding government intervention.
2. All farmers in an area hire beekeepers simultaneously,
avoiding free-riders.
2. Farmers willingly pay the beekeepers to maintain their
services because without the bees the farmers’ crops would be
devastated.
24. Government’s role should be to encourage bargaining
wherever possible, rather than to get involved in direct
restrictions or subsidies.
0. Direct government controls or taxes may be needed to reduce
negative externalities, or provide subsidies or government
provision where positive externalities exist.
25. Direct controls place limits on the amount of the offensive

activity that can occur. Clean air and water legislation are
examples. The effect is to force the offenders to incur costs
associated with pollution control. This should shift the product
supply curve leftward and reduce the equilibrium quantity.
Therefore, it should reduce the resource allocation in a socially
optimal way. (See Figure 4.7a)
25. Pigovian taxes can be levied on polluters. The tax payment
will increase costs to the producer, shifting the product supply
curve leftward, and reducing resource allocation to this type of
production as desired and increasing the equilibrium price. (See
Figure 4.7b)
25. Subsidies and government provision suggest three options.
2. Buyers may be subsidized. For example, new parents may be
given coupons to receive inoculations at reduced prices for their
children. This would increase the number of vaccinations and
eliminate the underallocation of resources. (See Figures 4.8a
and 4.8b)
2. Producers could be subsidized so that producers’ costs are
reduced, thus shifting the supply curve rightward, increasing
equilibrium output, and eliminating the underallocation. (See
Figure 4.8c)
2. The government could provide the product as a public good
where spillover benefits are extremely large. An example would
be administering free vaccines to all children in India to end
smallpox.
0. Table 4.5 reviews the methods for correcting externalities.
Society's Optimal Amount of Externality Reduction
0. Society’s optimal amount of externality reduction is not
necessarily total elimination.
27. To determine the correct amount of negative externalities
like pollution, it’s necessary to find the point where the MC of
cleaning it up equals the MB of cleaner air.
27. The cost of reducing spillover costs increases with each
additional unit of reduction. The benefit received from each
additional unit of reduction decreases due to diminishing
marginal utility.

27. When MC=MB, society has found its optimal amount of
pollution abatement (Figure 4.9).
27. In reality it is difficult to measure benefits as well as costs,
but this analysis demonstrates that some degree of pollution
may be socially efficient.
0. Government's Role in the Economy:
28. Identifying and correcting for market failures can be
difficult, time consuming, and costly.
28. Introducing politics into the equation complicates the
situation even more and can lead to undesirable economic
outcomes.
28. In the political environment, there can be over- and
underregulation.
28. Public and quasi-public goods may be produced because of
powerful politicians, not because the benefits of the good
exceed its costs.
28. Without a profit incentive, government is often inefficient.
Last Word…Carbon Dioxide Emissions, Cap-and-Trade, and
Carbon Taxes
0. An owner of a landfill has full property rights and charges
people to dump their garbage.
0. The payment that the landowner receives fails to account for
the negative externalities from pollution.
0. It is possible to use cap-and-trade systems where government
sets a limit on the total amount of a particular pollutant allowed
then issues permits to firms, enabling them to emit a certain
amount of the pollutant.
0. Firms can then trade permits with each other.
32. Smokestack Toys might have a permit for 100 tons of
carbon dioxide that can be used to produce toys that will
generate a profit of $100,000.
32. A power plant could use the 100 tons of carbon dioxide to
produce energy and generate $1 million in profit.
32. Smokestack Toys can sell its permit for more than $100,000
to the power plant who will willingly buy it for up to $1 million

(its expected profit).
32. Society benefits because when the energy company emits
the carbon dioxide, society gets greater net benefits from it than
it would from the production of toy cars as implied by the much
greater profits without any change in the total amount of
pollution.
0. Cap-and-trade systems are ineffective when it’s difficult for
regulators to verify that firms are following the standards like
the problems with the European Union’s cap-and-trade system
for carbon dioxide.
0. Cap-and-Trade has been very effective in the U.S. for sulfur
dioxide emissions because there are very few firms emitting this
pollutant so regulators can easily verify that firms are not
exceeding their limit.
0. To control carbon dioxide, economists recommend a carbon
tax.
Appendix to Chapter 4
This appendix discusses another potential market failure. Since
different individuals have different information about products,
health etc… markets may fail to develop or operate on a limited
basis. For example, the buyer of a used car knows less about the
quality of the used car than the seller. Thus, the two may not be
able to agree on a price.
1. Information failures are another form of market failure.
0. Information is often asymmetric – buyers and sellers don’t
have the same information about the good, service, or resource
being sold, and the cost of obtaining better information is often
prohibitive.
0. Inadequate information about sellers—two examples:
37. Assume that the gasoline market exists in an absurd
situation in which there is no system of weights and measures
established by law. In such a world, the station could advertise
highoctane gas that was actually lowoctane gas; pumps could
register more gallons than were actually being pumped. Without
government regulation, one could imagine some incentive for
some stations to cheat in such ways. Government intervenes in

such markets to prevent such cases of market failure. This
provides reliable information to buyers and also helps sellers
through enforcement of fair sales practices.
37. Licensing of surgeons is another example in which the
consumer would find it difficult to gather information about a
physician’s expertise without government licensing standards.
Such rules set minimum standards for competence. There will
still be physicians of varying abilities, but the consumer can be
confident that basic standards were met.
0. Inadequate information about buyers may lead to potential
problems for sellers.
38. The moral hazard problem occurs when there is a tendency
of one party to a contract to alter his/her behavior in ways that
are costly to the other party. Examples include the driver who
behaves more recklessly after obtaining insurance; guaranteed
contracts for athletes, which may reduce their performance;
unemployment compensation insurance, which may discourage
incentives to work.
38. The adverse selection problem arises when information
known by the first party to a contract is unknown to the second
and, as a result, the second party incurs major costs. Examples
include those in poor health who take out health insurance, the
person planning an arson attempt who takes out fire insurance
and the person whose marriage is failing who takes out the
book’s hypothetical “divorce” insurance. In areas where
insurance is traditionally underprovided, the government has
provided insurance or subsidized insurance.
38. Qualification: There are private methods of overcoming lack
of information problems.
2. Product warranties overcome lack of information about the
seller or product.
2. Franchising helps set uniform standards, so that most
McDonalds or Holiday Inns have similar quality.
2. Firms have specialized in providing information to buyers
and sellers; consumer reports, travel guides, and credit-checking
agencies are some examples.

QUIZ
Consumer surplus arises in a market because:
At the market price, quantity supplied is greater than quantity
demanded
At the current market price, quantity demanded is greater than
quantity supplied
Some consumers are willing to pay more than the equilibrium
price but do not need to do so
Some consumers are willing to pay less than the equilibrium
price but do not need to do so
Answer: C
Negative externalities arise:
1. when firms pay more than the opportunity cost of resources.
when the demand curve for a product is located too far to the
left.
when firms "use" resources without being compelled to pay for
their full costs.
only in capitalistic societies.
Answer: C
Rivalry and excludability are the main characteristics of:
1. capital goods.
private goods.
public goods.
consumption goods.
Answer: B
The market system does not produce public goods because:
1. there is no need or demand for such goods.
private firms cannot stop consumers who are unwilling to pay
for such goods from benefiting from them.
public enterprises can produce such goods at lower cost than
can private enterprises.

their production seriously distorts the distribution of income.
Answer: B
A demand curve for a public good is determined by:
1. summing vertically the individual demand curves for the
public good.
summing horizontally the individual demand curves for the
public good.
combining the amounts of the public good that the individual
members of society demand at each price.
multiplying the per-unit cost of the public good by the quantity
made available.
Answer: A
Cost-benefit analysis attempts to:
1. compare the real worth, rather than the market values, of
various goods and services.
compare the relative desirability of alternative distributions of
income.
determine whether it is better to cut government expenditures or
reduce taxes.
compare the benefits and costs associated with any economic
project or activity.
Answer: D
At the optimal quantity of a public good:
1. marginal benefit exceeds marginal cost by the greatest
amount.
total benefit equals total cost.
marginal benefit equals marginal cost.
marginal benefit is zero.
Answer: C
An important problem in evaluating public projects through the
use of cost-benefit analysis is that:

1. real costs cannot be stated in monetary terms.
one must decide whether to compare total costs and total
benefits or marginal costs and marginal benefits.
positive and negative externalities associated with such projects
may be difficult to measure.
the funding of such projects is inherently inflationary.
Answer: C
From the economist's perspective, "market failures" basically
arise when:
1. The quantity demanded for a good or service is greater than
the quantity supplied of the good or service
The quantity supplied of a good or service is greater than the
quantity demanded for a good or service
Demand and supply do not accurately reflect all the benefi ts and
all the costs of production
The market system is unable to adapt to or to accommodate
change
Answer: C
When the production of a product creates external costs greater
than external benefits, a market economy will:
1. Not produce the product without government intervention
Produce a socially optimal allocation of resources
Allocate too few resources to production of the product
Allocate too many resources to production of the product
Answer: D

Financial Uncertainty due to change in consumer trends
Lack of brand awareness
Poor Customer
Satisfaction
Reduced Cash Flow
Majority of current stock "last season"
Inability to sell stock
Border closures
No change of mind refunds
Shippit takes percentage of profits
Unable to keep staff during current climate
Customers servicing their old gear unaware of stock
No travelling customers
$1 million worth of stock sitting on shelves in 2022
Uncertainty in economic and consumer trends
Border closures
Inability to sell stock
No travelling customers
Unsatisfied customers
due to refund policy
Unable to keep staff during current climate
$1 million worth of stock sitting on shelves in 2022
Reduced Cash flow
Lack of goods and
services awareness
Lack of awareness of
multi-purpose products
Customer disinterest
Cancellation of domestic ski holidays
Majority of current

stock "last season"
Dependence on
distributors
Further reliance on online sales
Distributors take percentage of profit
Less customer engagement with sales channels
Less impromptu purchases when servicing gear
2

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