The Mixed Economy
Is there a pure market economy?
No. No economy is either 100 percent command or market-based. Most economies
maintain a mixed or blended system.
One way to measure an economy's mix or blend of market and command elements is to
examine its government spending or expenditure relative to the economy (GDP).
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Study how government activities operate within the circle flow model of the economy and
examine the global distribution and trend of government expenditures.
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And where is the US?
The US government's final consumption of goods and services is about 14% of its GDP,
below the global average.
If we include the government’s indirect spending or transfers—not direct
“consumption”—the US government's total spending amounts to 36% of GDP.
Since the 1970s, US income transfers have increased significantly. Any thoughts on why?
(An increase in mandatory spending drives this trend.) See the CBO report.
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That said, the US is still lagging behind its peers in public spending on education assistance,
maternity leave, education, etc.
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In economics, there is no free lunch. More government interventions usually lead to slower
growth (NY Times)
Perhaps this is why Elon Musk wants to cut government spending as part of the DOGE
effort. (What are your thoughts?)
So why do governments intervene?
Why do governments intervene? Adam Smith suggested the use of the Invisible Hand
because the “market” process can sometimes fail, leading to “market failures.”
Market failure occurs when “the market mechanism produces a mix of output that is different
from the one society needs or desires, "leading to the misallocation of resources.
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Market (Supply and Demand) Process…
P Butter
X market outcome
Pm
X desired outcome
D
Qm Qs G Guns
Market failure reminds us of (what I call) Themistocles dilemma. With the discovery of
surplus silver, what should Athenians do?
Could the newly found resource be used to produce more “butter” or build up “guns” in case
of Persian aggression? Check out the story.
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Market failure is a market outcome inconsistent with a desired social outcome. In this case,
the government is justified in getting involved.
How? Transfer resources from “X market outcome” to “X desired outcome.” Note that in
this trade-off case, there is no loss of inefficiency.
What generates failures?
There are five well-defined sources of market failure. They are:
Public Goods
Externalities
Market Power
Income Distribution
Instability
Public Goods
Fundamentally, two types of economic goods can be produced with limited resources.
Public Goods – Goods or services whose consumption by one person does not
exclude consumption by others. E.G., National Defense, Fireworks, Lighthouse, Air
Traffic System
Private Goods – Goods or services whose consumption by one person excludes
consumption by others.
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The “exclusion” principle is used to identify public vs. private goods (e.g., Can you exclude
others?). In a market, public goods tend to be underproduced relative to what society may
desire, resulting in market failures.
Why? We tend to have a “free-rider” problem with public goods. The existence of free
riders requires governments to intervene (e.g., transfer resources) so that public goods are
produced and help to fix market failures.
Do you see free riders in the photo below?
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How would you address the free-rider problem? Governments tax-free riders to pay for their
share of the consumption of fireworks, free parks, and lighthouses. (Can you think of other
cases?)
Externalities
When economic activities (such as consumption and production) produce spillover costs or
benefits to a third party, this creates an economic problem associated with externalities.
The existence of externalities tends to generate either under or over-production of goods or
services. Examine the “costs” associated with mining aluminum for Ford-150 production.
(Bloomberg)
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The new all-electric model of America’s best-selling pickup truck, the Ford F-150, relies on
aluminum to keep it light and give it speed. With no delay from a piston-firing combustion
engine, it can bolt like a high-performance sports car from zero to 60 in 4 seconds. It emits
no exhaust and makes no sound.
Yet its impact can be heard a world away—in the Amazon rainforest in Brazil. That’s where
the Ford F-150’s troubled aluminum trail begins.
So what is going on here? Due to the negative externality in this example, the “private” costs
of pollution production are actually less than their “social costs.”
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Overproduction (or underproduction) leads to market failure. Ford will overproduce what it
makes in the pollution case above (e.g., negative externality) since it does not fully pay for
the pollution or social costs. And the consumers will overconsume.
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There is a long waiting list for Ford-150 purchase.
To address the market failure, the government can declare a market failure and intervene to
address spillover costs (and benefits)
Under Production Over Production
(Positive Externality) (Negative Externality)
Government Financing Taxes
Subsidies Fees
Regulation (Patent Law) Regulation
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Market Power
Market power is the ability to alter the market price of a good or service. In other words, the
existence of market power implies that one or a few firms in the market can set their own
market price to maximize their profit at the expense of consumer interest.
Too much market power can lead to market failure by limiting the supply of goods sold,
driving up market prices, and limiting choices. This hurts the consumers who may have no
alternatives.
Should we be concerned about Google’s market share/power? Why?
For this reason, governments intervene when necessary to protect consumer interests by
imposing and enforcing antitrust regulations. (For more, see Market Regulation notes.)
Inequality
This is a normative issue since it deals with what is fair in the community. That said, Credit
Suisse Research shows that “the top 1% of wealth holders now own half of all household
wealth.”
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Should we do something? Since this is a normative question, I have nothing more to say.
However, governments intervene to redistribute income based on what they consider fair.
The U.S. has a progressive tax system. The U.S. Tax Schedule shows higher tax rates are
assessed when individuals or businesses earn higher income or profit.
Instability
Business cycles bring about instability in our economic performance. Therefore,
governments intervene to ease the pain associated with recession through public spending
and income transfer.
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Since the market requires time to adjust and self-regulate, government interventions can
help to stabilize the market and economy in the short run.
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In this light, the policy goal of the U.S. government is to achieve and maintain full
employment and stable prices. (More on these topics in our next lecture.)
Can the Government Fail?
The situation can worsen when the government intervenes in the market process (to
address market failures). This worse outcome is known as a government failure. There are
two sources of government failure.
First, controlling prices and wages can lead to inefficient resource use (e.g., minimum wage
and rent control).
Second, when cost-benefit analysis is applied to governmental decisions, the process can
become “normative” and even corrupt. Check out the infamous “bridge to nowhere.”
Governor Praises Passage of Transportation Bill; Bill Includes Approximately
$223 Million for Ketchikan's Bridge—Alaska Governor Frank H. Murkowski
today praised the passage of a landmark transportation bill and thanked the
Alaska Congressional Delegation for their hard work on the measure.
Get the full text here.
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For In-Person Classes Only…
Group Questions
5.1 Provide two real-world examples of market failures. Explain how the government can
help fix the market failures.
5.2 Define the term “externality” and distinguish between a positive and a negative
externality.
5.3 Explain why private firms may under provide public goods.
5.4 Describe the “tragedy of the commons” and give an example.
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