Market Failure and Government Intervention
MARKET FAILURE AND GOVERNMENT INTERVENTION
SECTION 2. MARKET FAILURE ............................................................................................ 2
A. Market Power ..................................................................................................................... 3
deadweight welfare loss ................................................................................................... 3
B. Externalities ........................................................................................................................ 4
social optimum ................................................................................................................. 4
The net social benefit ....................................................................................................... 4
consumption externalities ............................................................................................... 5
social marginal cost (or social supply)............................................................................ 5
production externalities .................................................................................................. 5
consumption externality .................................................................................................. 5
nationalize......................................................................................................................... 5
public enterprise .............................................................................................................. 5
C. Divisibility and Excludability ............................................................................................. 7
pure private good or service ........................................................................................... 7
a pure public good ........................................................................................................... 7
excludability ..................................................................................................................... 7
free riders ......................................................................................................................... 7
indivisible.......................................................................................................................... 7
public bad ......................................................................................................................... 7
D. Information ......................................................................................................................... 7
E. Equity .................................................................................................................................. 8
Lorenz curve .................................................................................................................... 8
quintiles ............................................................................................................................ 8
Gini Coefficient ................................................................................................................ 8
F. Dynamic Market Failure ................................................................................................... 10
Cobweb Model ................................................................................................................ 10
Replenishable Resources ................................................................................................. 11
Non-replenishable resources ............................................................................................ 12
SECTION 6. GOVERNMENT FAILURE ........................................................................... 12
Economic Impact Analysis ............................................................................................ 13
closure analysis .............................................................................................................. 13
cost effectiveness analysis .............................................................................................. 13
objective-cost study........................................................................................................ 13
regulatory impact analyses (RIAs) ............................................................................... 14
fiscal impact analysis ..................................................................................................... 14
A. Market Power .................................................................................................................... 15
patent............................................................................................................................... 16
Innovation ....................................................................................................................... 17
cross license ..................................................................................................................... 17
cross licensed................................................................................................................... 18
B. Externalities and Side Effects ........................................................................................... 18
1
Market Failure and Government Intervention
C. Economic Distortions ....................................................................................................... 18
D. Information ....................................................................................................................... 19
E. Equity ................................................................................................................................. 19
marginal rate of taxation .............................................................................................. 19
deficit financing ............................................................................................................. 20
F. Lags and Dynamic Government Failure ........................................................................... 20
recognition lag ................................................................................................................ 20
response lag .................................................................................................................... 20
implementation lag ........................................................................................................ 20
impact lag ....................................................................................................................... 20
industrial policy ............................................................................................................. 22
As executives work their way up through the hierarchy of management in a firm they are
likely to find themselves spending more and more of their time dealing with people outside of the
firm. Many members of society have a stake in a firm's decisions because their welfare is
affected by the firm. They include employees, customers, suppliers, stockholders, financial
institutions, environmentalists, civil rights groups, and even competitors. Such groups are
referred to as stakeholders1 or constituents of a firm.
Stakeholders may not have direct access to the governance of a firm. They may not even
have any standing in the eyes of the law to be a party to a lawsuit. But they do have access to
their elected officials who can change the law. A firm that chooses to ignore its stakeholders’
interests may find that governmental agencies formalize those interests in ways that are far more
constraining than informally taking account of what stakeholders might want. The government
agencies represent different stakeholder interests and it is important to learn the languages of
these agencies.
SECTION 1. THE ECONOMIC BASIS FOR GOVERNMENT
INTERVENTION
CEOs often defend their markets by arguing for or against further government
intervention. In their lobbying efforts it is helpful to argue the economic basis for government
intervention. The economic arguments for government intervention are typically justified on the
basis of market failures. Private markets have characteristics which can cause them to fail to
achieve a desired social optimum.
Market power, lack of information, externalities,
indivisibility of a product, inequities, and dynamic forces can all push a market away from such a
social optimum.
1
For an easily readable of the management concept of stakeholders see R. Edward Freeman.
Strategic Management Pitman; Boston, 1984
2
Market Failure and Government Intervention
A. Market Power
Market power causes the price to move above the social optimum price and quantity to
fall below the social optimal quantity. As a result both producers and consumers experience
welfare loss. The deadweight welfare loss can be measured in terms of the loss in consumer
and producer surplus due to the lower quantity and higher prices resulting from market power.
Figure 17-1.
DEAD WEIGHT WELFARE LOSS OF MONOPOLY
Price
Loss to Consumers (B)
+Loss to Producers (C)
=WELFARE LOSS
A:Transferred to Producer
B
B
MARGINAL
COST
C
C
DEMAND
D
Resources
That
Go to
Other
MARGINAL
Monopoly Industries Competitive REVENUE
Case
Case
(MC=MR)
(MC=P)
Output
NOTE: With monopoly the consumer loses the consumer surplus (areas, A and B). However, the
producer gains only part of this consumer surplus (area A); area B is lost. In addition the
producer loses some producer surplus, area C. The shaded region (area B and C) is the
deadweight loss.
By intervening with antitrust policy, the government hopes to lower prices and increase
quantity. However, antitrust policies may not effectively correct structural problems leading to
market power.
3
Market Failure and Government Intervention
Figure 17-1 which shows the hypothetical demand curve facing a monopolist. We can
identify the output at which the monopolist maximizes profit (marginal revenue=marginal cost)
and the competitive equilibrium (price=marginal cost). By raising its price the monopolist can
grab some consumer surplus (area “A”) which offsets its loss in producer surplus (area “C”).
However, higher prices reduce output which reduces benefits to both consumers and producers.
Much of this loss is compensated by sending the resources to offsetting uses elsewhere in the
economy (Area D in Figure 17-1). However, there is still a little triangle (Shaded areas B and C)
which is lost both to consumers and producers from the cutback in production. No one receives
the advantage of this reduction and it is therefore referred to as the deadweight welfare loss of
monopoly pricing.
B. Externalities
A social optimum should occur where net social benefits are maximized. The net social
benefit is the difference between social benefits and social costs. The concept of social benefit
in the public sector is parallel to the concept of total revenue in the private sector. Similarly the
concept of social cost is parallel to the concept of total cost in the private sector. However,
benefits or costs accruing to anyone and everyone, not just the stockholders, must be included in
the measurement of net social benefits. As we will see in section 3, such a broad accounting
requires more creativity and more measurement problems than a firm would face.
Table 17-1
Social Benefits and Costs of
Education
# of
Students
Total
Benefit
Total
Cost
Marginal
Social
Benefit
Marginal
Social
Cost
(millions
per year)
(1)
($ millions
per year)
(2)
($ millions
per year)
(3)
($ per
student)
(4)
($ per
student)
(5)
0
0
0
-
-
1
20,000
1000
20000
1000
2
35,000
6000
15000
6000
3
45,000
16000
10000
10000
4
50,000
36000
5000
20000
4
Market Failure and Government Intervention
NOTE: The marginal benefit is the difference of the total benefit from column 2 divided by the
increment in the number of people who receive the benefit from column 1. Marginal costs are
computed similarly.
The problem of finding maximum net social benefit is parallel to the problem of
maximizing profit. In fact net social benefit is often referred to as social profit. However,
society may value consumption differently than an individual consumer. Generally, if there are
parties other than the consumers of a product who are affected by the consumption of the
product, then the private and social demand curves diverge. The difference between the social
private and social demand curves are a measure of the consumption externalities from the
consumption of the good. If the externalities benefit third parties- besides the producer or
consumer- then the social demand curve will be above the private market demand curve.
However, if the consumption externalities hurt third parties, then the social demand curve will be
below.
Similarly society may value production differently than an individual producer.
Generally, if there are parties other than the producers who are affected by the supply of a good
or service, then the private and social cost curves diverge. The difference between the social
private and social marginal cost (or social supply) curves are a measure of the production
externalities from the supply of the good. If the externalities benefit third parties then the social
marginal cost curve will be below the private marginal cost curve. However, if the production
externalities hurt third parties, then the social marginal cost curve will be above.
The difference between the private and social demand curves is the positive consumption
externality . Externalities prevent the private market equilibrium from correctly delivering the
social optimum. To correct such a market failure, the government can intervene in a number of
ways:
1.
Prohibitions on production or consumption. Prohibitions are suited to goods which
produce clear public harm without compensatory public benefit. In the United States this
kind of intervention is used for many types of drugs, other harmful products, prostitution,
violence, and a wide number of antisocial behaviors.
2.
Nationalization or Public Enterprise. When a good is highly dangerous but has a clear,
offsetting, and overriding benefit, the government may nationalize a private firm or go
into business itself as a public enterprise. The government sets up public enterprises
like NASA to run the space program, the U.S. Post Office, the public education system,
and many other services.
3.
Regulation. The government can directly limit prices, output, profit, conduct, and
performance of a firm. The government closely regulates utilities, government
contractors, the banking system, and firms engaged in national security.
4.
Taxes and Subsidies. Taxes and subsidies can be tailored in such a way that they force a
firm to pay the full cost (or receive the full benefit) of an externality. For example,
government imposes specific taxes on cigarettes, alcohol, gambling and other slightly
deleterious luxuries. On the other hand, it has subsidized semiconductors, synthetic fuels,
5
Market Failure and Government Intervention
American shipping, and other industries contributing to national security.
5.
Creating new markets or adjusting existing ones. Often a market failure can be corrected
by changing market incentives. For example, states like California have created pollution
rights to streams or environments. If environmentalists wish to buy the pollution rights,
they can and pollution will be prevented. However, if firms receive the highest bid, they
can pollute according to the right that they purchase.
Generally the least intrusive or restrictive form of government intervention should be used to
correct distortions due to externalities.
6
Market Failure and Government Intervention
C. Divisibility and Excludability
A pure private good or service can be divided into infinitely small units for
consumption and can be allocated strictly to the people who buy the good. A purely private good
does not have impacts on parties other than the seller and buyer which means there are no
externalities. By contrast a pure public good cannot be divided into discrete quantities that each
customer can buy, and it actually costs something to exclude some people from enjoying the
good.
A good which does not have complete divisibility or excludability may be difficult for a
private market to deliver at the social optimum. Without excludability people have an incentive
to let someone else pay and then become free riders in the enjoyment of the good once it has
been paid for. Frequently indivisible goods or services- those which cannot be divided among
consumers- do not have complete excludability. We cannot subdivide a park, giving everyone in
the city a square inch of it. Effectively there is a choice to have the park or not to have it; after
deciding to have the park, everyone can use it and it would cost a great deal of money to try to
exclude anyone.
The means of correcting the problems of indivisibility and non-excludability are similar
to the means for correcting externalities that were examined above. One of the most potent
weapons of our legal system is the legal procedure for ascribing blame and assessing damages
from those responsible. For example, the problem of excludability becomes a problem with a
public bad like depletion of the ozone layer. There is no way to insulate anyone from the effects
and it is costly and difficult to allocate the effects to the people who cause the problem.
D. Information
For firms to contest in a market, there must be information not only on the profitability of
the market but upon the technology necessary to enter the market. A firm must be able to find
knowledgeable personnel, know what resources to use, know how to use them, and know
demand conditions in order to enter a market successfully. Information provides customers with
the ability to bargain prices downward to the costs of providing a good. Information also allows
sellers to find the best markets for their goods.
With imperfect access to information by either customers or buyers a market may not
reach a social optimum. To assure that markets work efficiently the government may intervene
to provide adequate information as it does in agriculture, utilities, the banking system, the
business census, and labor.
Access to information does not mean that managers of a firm must know everything
about a market, but only that they be able to find out what other managers in the market know or
are able to know. Great opportunities to enter a market often occur precisely when there is little
7
Market Failure and Government Intervention
or no information about the market.
E. Equity
The private market can sometimes lead to an inequitable distribution of resources. When
a society determines that a more equitable distribution is necessary, then government may
intervene to engineer such a redistribution. One measurable standard of equity is the equal
distribution of resources.
Equality in the distribution of resources or the income from those resources can be
measured with the Lorenz curve. The Lorenz curve portrays the cumulative percentage of
resources (or income) distributed to owners. The owners are grouped from the poorest to the
richest. For example Table 17-2 groups nations into quintiles (5 groups) on the basis of the per
capita incomes of their people. By cumulating each quintile's income (measured by the Gross
National Product (GNP) in column 5 of Table 17-2) and we have the Lorenz curve (Figure 17-5).
The Lorenz curve provides a quick visual summary of equality or inequality. The curve
always starts at zero and ends at 100%. If the curve is a straight line it is called the line of
equality and it marks a perfectly equal distribution of income. In other words, the lowest 20% of
the population has 20% of the income and each subsequent quintile has a percentage of total
income proportional to its percentage of total population. However, if the curve follows the xaxis up until the last person, then one person would have the entire income and no one else
would have anything; a situation of perfect inequality. The current distribution of world wide
GNP is in fact closer to this unequal case.
The degree of inequality can actually be summarized by a single number, called the Gini
Coefficient. The Gini Coefficient divides (a) the area between the line of equality and the
Lorenz curve (shaded in Figure 17-5) by (b) the total area below the line of equality. In Table
17-2 the first area has been estimated by approximating the amount of inequality existing for
each quintile (column 8) and adding them together for a numeric total of 3281. The area under
the line of equality is a triangle, the base of which is the x-axis (measuring 100%) and the height
of which is the y-axis (also measuring 100%); the triangle is half the area of the base times the
height which means it has a numerical value of 5000. The Gini Coefficient is therefore .6562.
8
Market Failure and Government Intervention
Table 17-2
Quintiles Based on Per Capita
Income
Quintile
Cumulative %
% of
World
GNP
Cumulative
% GNP
Inequality
(2)-(4)
Average InequalInaequal- ity %
ity/%
(1)
(2)
(3)
(4)
(5)
(6)
(7)
0
0
20
20
1.80
1.80
18.2
9.1
1.82
30
50
2.58
4.38
45.62
31.91
9.57
10
60
2.53
6.91
53.09
49.36
4.94
20
80
17.22
24.13
55.87
54.48
10.90
20
100
75.87
100
0
27.94
5.59
100.00
Measure of
Total
0
Inequali 32.81
ty
The difference in the cumulative percentage of population (col.2) and the cumulative GNP (col.
4) is a measure of inequality (col.5). This measure is averaged for the quintile (col.6) and
multiplied by the percentage of total population in the quintile (col.1). Summing these weighted
measures of inequality provides the measure of total income inequality (bottom of column 7).
9
Market Failure and Government Intervention
Figure 17-5
WORLD INCOME DISTRIBUTION
100
90
Cumulative
% of:
Coun- GNP
tries
80
70
60
50
0
20
50
60
80
100
40
30
20
10
0
0
20
40
60
80
0
1.8
4.4
6.9
24.1
100
100
NOTE: The cumulative percentage of GNP (column 5 in Table 17-2) is diagrammed on the yaxis against the percentage of the population in each quintile (column 2 of Table 17-2) along the
x-axis.
F. Dynamic Market Failure
Markets may be structured in such a way that they become dynamically unstable when
left to themselves. Lags in obtaining information and responding effectively to it can lead to
dynamic instability in a market. Such instability may cause a market to wander away from a
social optimum. Following are three examples of dynamic market failures from such instability:
(1) The Cobweb Model and lagged adjustment: When demand is relatively inelastic while
supply is very elastic, lagged adjustment can move a market away from equilibrium as shown in
the hypothetical chemical example pictured in Figure 17-6. A price above equilibrium one year
causes chemical firms to supply a large quantity of goods the next year; in effect the firms are
responding with a one year lag to the price signals of the previous year. However, the larger
quantity supplied results in a precipitous price reduction. Again with a one year lag firms
respond by cutting back the quantity supplied. However, the lower quantity supplied results in
skyrocketing prices. The process continues and progressively moves away from the equilibrium
quantity and supply.
10
Market Failure and Government Intervention
Figure 17-6
Price
COBWEB MODEL
80
70
60
Bo
50
Ao
40
B1
A1
A3
30
A2
20
10 B3 Such a low price provides no incentive B2
to produce any product at all.
0
0
5
10
15
20
CHEMICALS (millions of pounds/year)
NOTE: In response to high prices at Ao Chemical companies would expand capacity to produce
A1. However, with excess capacity prices fall to A2 and capacity exits to A3. The shortage in
capacity raises prices up to Bo. The cycle starts all over, but the swings are more dramatic
leading to dynamic market failure.
(2) Overuse of Replenishable Resources: Many populations of plants and animals replenish
themselves to produce a sustained yield for industry. However, if the rate of utilization reaches
past a certain critical level, the density of the resource population may be reduced to a point
where the population can no longer sustain itself. If firms do not know the critical level for a
resource population or experience a lag in being able to measure the use of a resource, they may
inadvertently reach past the critical point and send the resource into extinction. In this case lack
of information or a lag in monitoring information is the source of the problem.
Even with knowledge about sustaining the yield of a population, market incentives may
lead to the demise of the population. A prisoner's dilemma faces the firms using the population.
11
Market Failure and Government Intervention
If everyone cooperates, sustained yield can be achieved. If they don't cooperate the population
will become extinct. However, if some individuals cooperate while others do not, the resource
population will not only become extinct but the cooperating individuals will lose out to those
who do not cooperate as the resource disappears.
(3) Non-replenishable resources. Even when resources are not replenishable there may
be an optimum rate of exploitation based on the speed with which they can be replaced with
substitutes. However, invention, innovation, and diffusion must work smoothly to produce the
new substitutes. Otherwise society faces a crisis of market failure.
While market failure provides a basis for government intervention, such intervention has
its own costs. The benefits of government intervention must be weighed against the costs of that
intervention.
SECTION 2. GOVERNMENT FAILURE
Implicitly government has been assumed so far to be capable of correcting market failure.
However, government involvement may make a market failure worse rather than better.
Furthermore, the government may set up rules which lead to market failure. Finally government
itself requires resources which can place a heavy drain on an economy. In this section we'll
examine these government failures from the point of view of a former CEO of the Dupont
Corporation, named Irving Shapiro .
Government intervention is costly. There are administrative costs of government
intervention which reflect the costs of the agency personnel and other resources used by a
government agency to intervene in a market. Then there are the compliance costs which are the
direct costs experienced of complying with government regulations and interventions by the
businesses themselves. Finally there are the efficiency costs which reflect the losses from using
less efficient technologies and conducting less efficient businesses as a result of government
interventions. These three kinds of costs must be weighed against the benefits of allowing the
government to intervene.
There are a variety of different studies which are used to determine the desirability of
government intervention by weighing the costs and benefits of government intervention. Each
government agency develops its own procedures for studying its regulations or projects. The
Army Corps of Engineers was first required to weigh commercial benefits and costs of projects
in the River and Harbor Act of 1902. Cost-benefit analysis began to be widely used after the
Flood Control Act of 1936 and the experience with dam building helped define a standard
procedure to be followed in such projects. This procedure was codified by the U.S. Bureau of the
12
Market Failure and Government Intervention
Budget (the precursor to the present Office of Management and Budget) in 19522 to help settle
disputes between different interest groups.
Economic theory was methodically applied to cost-benefit analysis only in the early
fifties. Certain practices such as the use by some agencies of a zero discount rate were
criticized. Furthermore, useful approaches to the accommodation of multiple goals were
suggested including economic development, environmental quality, and quality of life.4 Costbenefit analysis was applied in a wide variety of applications including the analysis of urban
renewal projects, transportation systems, social spending, and defense. It had spread to state and
local governments as well as governments in developing nations.
3
While it had generally been applied to projects which resulted in greater development,
cost benefit analysis was redirected by the Nixon administration toward regulation. The Office
of Management Budget reviewed regulatory actions and required reports from agencies on the
objectives, alternatives, benefits, costs, and reasons for regulation.5 This procedure was
augmented in the Carter administration to consider the direct and indirect effects of regulation
and the selection of the least burdensome forms of regulation.
With new social regulation, agencies developed their own reporting formats which the
government attempted to standardize. Economic Impact Analysis was a method for analyzing
the effects of regulation on prices, output, employment, and the financial health of firms.
However, this kind of study had a biased focus on the negative impacts of regulation, not the
benefits. One variant of economic impact analysis called closure analysis showed how much
regulation could be applied without shutting any firms down. Implicitly, unprofitable markets
might pollute at will while profitable markets would be comparatively regulated.
Many agencies also used cost-effectiveness analysis. As we have seen in chapters 8 and
9, cost effectiveness analysis permits the focus to be solely on the costs of a project; the implicit
assumption is that different alternatives will each achieve the given objectives. Agencies like
EPA would often use a variant of cost effectiveness analysis called an objective-cost study
which would match different cost levels with the amount of objective that could be achieved.
For example EPA would match cleanup expenditures with the amount of a pollutant which
would be cleaned up. Of course, the burden was placed on decision makers to weigh how
2
U.S. Bureau of the Budget. Budget Circular A-47 (see Campen p. 17)
3
Eckstein 1958, Krutilla and Eckstein 1958; McKean 1958 See Campen p. 17.
4
Campen page 19. Ralph A. Luken "Weighing the Benefits of Clean-up Rules Against Their
costs" EPA Journal p. 9 (cover of journal shows people struggling against EPA)
5
EPA Journal , op. cit., p. 9
13
Market Failure and Government Intervention
valuable a given amount of pollution abatement would be. They promptly failed that test when
they used the same weight reduction standards for very different chemicals!
Within days of the beginning of the Reagan administration Executive Order 12291 was
issued which required regulatory impact analyses (RIAs) for regulations costing more than
$100 million. This order established net social benefit as the criterion for deciding whether or
not to regulate. While cost-benefit analysis was at the core of RIAs, the RIAs were required to
analyze the shortcomings of the cost-benefit analyses. The effect of RIAs was to slow down the
ability of agencies to impose new regulations without extensive analysis. Furthermore, since
such analyses were expensive- the average cost of an RIA at EPA was $685,000- the RIAs ate
heavily into agency budgets and limited agency actions.
With more state and local government agencies under severe budget limitations, fiscal
impact analysis became a widely used tool for analyzing the desirability of projects. A
government unit would undertake a project if it promised more revenues than costs. Implicitly
government revenues (in other words, costs to the public) were viewed as benefits while
government costs (in other words, benefits to the public) were undesirable. Such a misleading
objective should provide no basis for comparing projects, but only for testing if a single project
exceeds a rigid governmental budget constraint. Furthermore, if revenues exceed costs on a
project, such projects would likely be ones that the market would itself undertake, instead of the
government.
Table 17-3 summarizes the studies that have just been introduced. Without question,
new varieties of studies will evolve. While cost benefit analysis takes into account all costs and
benefits incurred by anyone, the other studies focus more narrowly on particular costs or benefits
to be analyzed, as shown in Table 17-3. For example, economic impact analysis and closure
analysis focuses on the costs of the regulated without weighing the benefits of a regulation. By
contrast, regulatory impact analysis can be even more general than cost benefit analysis by
taking into account many non quantifiable considerations that must be weighed against costs and
benefits. Cost Effectiveness Analysis is particularly useful when there are a limited number of
objectives which cannot necessarily be given a dollar value. As long as an objective can be
quantified in some way, cost effectiveness analysis can measure how much of the objective is
achieved per unit of cost and allows different methods for achieving the objectives to be
compared. Fiscal Impact Analysis is typically used by government agencies to examine the
budgetary impact of its policies on the government agency itself.
Figure 17-7
14
Market Failure and Government Intervention
GOVERNMENT STUDIES
Type of
Study
Objective of
Study
Definition and Focus
Implicit
Constraints
Cost Benefit
Analysis
Net Social
Benefit must
be positive
Multiple
social
objectives
Minimizes
costs on the
regulated
Maximize
regulatory
objective
Minimizes
ratio of net
cost to net
effectiveness
Maximize net
govt. surplus
Benefits & costs
included to whomever
occurring
Includes cost benefit
analysis and other
studies
Examines price,
output, financial, &
employment impacts
Defines degree of
regulation that will
shut firms down
Maximizes efficiency
in achieving objective
None
Regulatory
Impact
Analysis
Economic
Impact
Analysis
Closure
Analysis
Cost
Effectiveness
Analysis
Fiscal Impact
Analysis
Focuses only on
government finances
Problem
________
Requires measurement of
all benefits & costs.
Ignores unmeasurable ones
Environmental &
Goes beyond cost-benefit,
other constraints
but becomes very
subjective
arbitrary limits on Regulation discouraged.
acceptable costs of Ignores most social
compliance
benefits and costs
Implicitly, firms
Over regulates profitable,
are not to be shut
under regulates
down
unprofitable
Budget or cost
Comparisons difficult
constraint of
when objectives
organization
(“effectiveness”) differ
across programs
Govt. revenue
Ignores full costs &
must exceed cost
benefits to society
Each new type of study is likely to ignore certain costs or benefits and have its own
peculiar assumptions. Generally, by knowing what has been ignored, it is possible to guess what
biases may creep into governmental choices based on a given type of study. A manager should
be able to step back from any type of government report, read between the lines on what the
report is trying to do, and be able to criticize it effectively. Since most agencies are required to
open regulations up for public comment before imposing them, a manager who can deliver an
effective criticism may be able to forestall or improve a potentially harmful regulation.
Perhaps the most unsettling government failures are the ones which actually produce
worse results than the market failures they are designed to cure. The rest of this section focuses
on how government itself can exacerbate market failures.
A. Market Power
Ideally government should try to promote competition in markets. While antitrust is the
government's tool for fostering competition, much of antitrust effort is aimed at prosecuting price
conspiracy behavior rather than altering the structural characteristics in a market which might
lead to better competition.
Antitrust policy is not aimed so much at monopolists as at
oligopolists trying to achieve monopoly.
Government contracting and subsidy activity may actually enhance market power. There
is a cost in dealing with many small firms or individuals in grants, purchasing contracts, or even
15
Market Failure and Government Intervention
sales of government products. The cost effectiveness of forming relationships with a few large
firms can defeat the goal of promoting competition. The merging of railroads, for example, has
led to significantly less competition with questionable gains in efficiency. In the case of Union
Pacific, it merger with major rivals has actually led to significant drops in efficiency for years.
Patent policy and regulatory policies also contribute to market power. While patents give
monopolies outright, regulatory agencies often bestow market power in more subtle ways. When
the Civil Aeronautics Board regulated airlines, it would prevent any firms from entering and
would assign airline routes to ensure that no major airline firm exited the market. It therefore
eliminated the keystone to competition in the airline market.
While antitrust law is designed to prevent the undesirable effects resulting from monopoly
power, patents are government sponsored rights that create monopoly power. A patent is an
exclusive right to use and sell an invention and to prevent others from using or selling it. The
reasons for patents include: (1) encouragement of inventors to invent by helping them to reap the
benefits of their inventions, (2) providing an incentive to inventors to disclose their inventions by
preventing others from stealing the invention once it becomes public, and (3) helping inventions
reach the market place by making it worthwhile for firms to make the initial investment to develop
inventions.1
A firm applying for a patent must be aware that they are not a full proof method of
protecting an invention:
(1) The government has had a very difficult time disentangling patents and determining when they
have been infringed. Trials often take a long time and require expensive technical testimony.
(2)
Patents can be self defeating. A firm that announces its invention by filing for a patent may
find foreign imitators or illegal imitators that undercut the firm's prices. The firm then has to
undertake the litigation expenses and time to press charges against such violators; this can wear the
firm down and it may lose.
(3) When illegal product surfaces in a market at cut rate prices, distributors of the patented product
are placed in a precarious position. Any licensed distributors find themselves facing rough
alternatives; do they (a) maintain their legal relationship to the firm with the patent and face their
demise in the market place by the price cutters or (b) distribute the good illegally and face litigation
from the owner of the patent?
(4) A large firm might simply take a patent to court and try to get it invalidated. With resources
that are superior to those of the inventor, a large firm is likely to accomplish this; 60% of the cases
going to court actually do result in such invalidation.
When patents fail to protect a firm, the firm may be forced to use other techniques to protect itself.
16
Market Failure and Government Intervention
Treating an invention as a trade secret is a ready alternative to patenting. In this case, the
inventor simply tells no one how his invention is made. Trade secret laws protect inventors from
having someone else steal their idea. However, they are not protected if someone "invents" the
same product.
Nevertheless, patents are widely used and generally do provide some protection to the
inventor. In fact historically a wide number of strategies for using patents have evolved:
(1) Patents can foreclose markets. If a firm can accumulate enough patents around a particular area
of invention and specify them broadly enough to prevent inventions in the area, they may be able to
push competitors away from inventing in the area. Anyone wishing to invent in the area must
"invent around" existing patents.
When considering a patent, a major question is whether to write the patent application as a
"sword" or as a "shield". If written as a sword, the language employed for the application is broad
so that other inventors may be taken to court for producing overselling competitive products which
appear even remotely related. On the other hand, written as a shield, the patent is written very
specifically and narrowly. The shield provides protection from suits brought by those with swords.2
(2) To circumvent patents, firms may invest a great deal of money to invent around existing
patents. Such a tactic has been used in the Pharmaceutical markets.
(3) Firms can intimidate other firms by showering patent applications on the government. Because
of lags in granting patents, a large number of patent applications in an area can cause great
uncertainty to inventors and steer them away from inventing in the area. Such intimidation seems
to be occurring today in biotechnology and superconductors.
(4)
Patents may sometimes be used to prevent threatening inventions from coming to market
through innovation. Innovation is required to bring a good from an invention to a marketable
product. However, a firm may obtain a patent on an invention and may simply decide to sit on it.
At that point, the patent serves as a way of denying the invention to the market place.
(5) Patents do bestow monopolies upon firms and this means that society experiences all of the
inefficiency associated with restrained production and high prices. Such a problem is lessened by
limiting for how long patents will be granted which has traditionally been a seventeen year period.
Unfortunately these strategies do not necessarily mean that patents represent true inventive effort
and that they are used to stimulate efficiency in the marketplace.
To break such dysfunctional use of patents, firms can cross license patents. Cross licensing
allows firms to share each other's patents. For example, in the semiconductor market, the
government went one step further. It allowed the creation of organizations like Sematech that
should spur inventions which would lead to patents. These patents were shared among American
17
Market Failure and Government Intervention
producers. The problem with such government involvement is that it may remove some of the
incentives to invent, which traditionally are provided by patents. As the process of invention is
moved further from firms and as the fruits of invention are shared, it is not certain that firms will
maintain their individual inventive capabilities. Nevertheless, without such cross licensing, joint
ventures for invention, and other government aid; there might not be any American semiconductor
firms at all, not to mention firms that would maintain their inventive capability.
A problem of close coordination on invention is the inevitable spillover of coordination into
the realm of prices and output. When firms have cross licensed patents to each other, they have
occasionally used the opportunity to coordinate pricing, production and other matters as well.3
A further problem occurs when patents are used to give the firm market power over other
products. Antitrust agencies and the courts have restricted the use of patents by some firms and
have severely limited the use of patents when their effects have spilled over into other markets.4
In spite of all of the problems of the patent system, economists do not have the answer for a
better system and the patent system probably will not be replaced. Therefore, firms must carefully
weigh the strategic consequences of the use of the patent system.
B. Externalities and Side Effects
Government policies can have their own externalities and side effects which may not
always be desirable. When the Soviet Union fell apart in the early 1990s it became apparent that
the Soviet government had permitted massive pollution and destruction of its territories. The
American government itself has been a major polluter. Oversight of the government by the
government itself produces an obvious conflict of interest.
C. Economic Distortions
Government policy can also lead to inefficiencies. The government has been very slow to
realize the sophisticated workings of markets. By imposing rules, a government agency can
create surpluses or shortages. Either type of market disequilibrium results in waste.
Once again it is instructive to look at the example of the Soviet Union before it fell. As
American director of the U.S. - U.S.S.R. Trade and Economic Council, Inc., Du Pont's Shapiro
had become acquainted with a classic example of the inefficiencies of government:
It's much worse in Russia, because the only structure in their society is government. All
the VIPs are government officials. The bureaucracy, the rules, the regulations, the
paperwork- why, it's simply overwhelming. To paraphrase an old Churchill line about
democracy, "It's got a lot of defects; it just happens to be better than anything else we can
18
Market Failure and Government Intervention
come up with.'6
By attempting such complete control, the Russian government also took the complete blame for
what occurs to the economy. It is much easier to allow the private sector to handle the intricacies
of the market and for government to step in whenever there are abuses. Socialist and Communist
governments throughout Europe and the Eastern block began a retreat toward reliance more on
the private sector. Specifically, many government industries are being sold to the private sector
in a move called privatization.
D. Information
The government should attempt to make more information available to allow markets to
work competitively and efficiently. However, under government auspices firms can often
cooperate and prevent outsiders from getting information about the cooperative effort. For
example, when firms get together to lobby for a particular price control ceiling, or target price for
protectionism, they may exclude other participants in the market who would be hurt by the
policy. Under the guise of national security, the government may withhold information about
projects that it undertakes with firms; such insulation from public scrutiny prevents the forces of
competition from controlling prices and costs. Ultimately whenever the government allows one
firm in a market to gain a relative advantage in the acquisition of information, it prevents the
competitive market from working efficiently.
E. Equity
Government must often define as well as find policies to achieve equity among the
members of society. Typically the government tries to use taxes and subsidies as a means for
correcting inequities. However, such policies may result in their own inequities.
When the government attempts to make transfers itself by taxing on the one hand and
subsidizing on the other it faces substantial incentive problems. First of all, the bureaucracy
needed to administer such transfers is expensive and adds to the government deficit. Secondly,
the government finds it easier to disperse money than to collect it which means there tends to be
a bias for the government to run a deficit. Thirdly, the government's policies are likely to
decrease private market incentives. When the government taxes it inevitably penalizes earners.
Implicit in any tax policy is a marginal rate of taxation which indicates how much of every
extra dollar earned is actually received as after tax income. Instead of receiving a dollar for every
dollar earned, individuals may receive only eighty cents which means there is a marginal tax rate
of 20%. High marginal taxation lessens the incentive for people to earn money. Governments
therefore face a tradeoff between equitable transfers and efficient incentives.
6
Shook, op. cit. p. 225
19
Market Failure and Government Intervention
Of course, the government can avoid taxation by deficit financing. But deficits cause the
U.S. debt to stack up which scares business. CEO Shapiro, whom we have already quoted above,
stated:
... The heart of the problem is a political system in which the people in public office want
to promise every constituent group whatever they want- and our society can't produce
enough wealth to do everything. But this can be overcome by good management. It's no
different than running Du Pont. I can't invest more capital than I have, and I know that.
We have to tailor our investment program to our capital and our borrowing capacity. And
in government, you can't give away more than you've got without creating inflation and
other serious consequences. As soon as the American people accept that premise and
start putting heat on the politicians as, for instance, the Germans have done, then we can
lick inflation."7
The analogy between the government and firms fails to account for the government's ability to
tax. Nevertheless, the fact that so many experienced business leaders believe in this analogywhether right or wrong- means that larger government deficits trigger fears of inflation, higher
interest rates, and heavy debt burdens for future generations. These fears surface in market
reactions to government financial data and attempts by the business community to reform
government.
F. Lags and Dynamic Government Failure
As in the private market, lags can play a destabilizing role in the government's interaction
with markets. There are four basic lags between the time that a problem arises and the time that
the government does something about it:
(1) Recognition lag. Between the time a problem occurs and the time it is recognized as a
problem by a government there is a recognition lag.
(2) Response lag. Between the time a problem is recognized and the time that a decision is
made about what to do there is a response lag.
(3) Implementation lag. Between the time a problem is responded to and the time that action is
taken, there is an implementation lag.
(4) Impact lag. Between the time of implementation and the time when the final impact is felt,
there is an impact lag.
7
Shook, op. cit. pp. 225-226
20
Market Failure and Government Intervention
If the pollution problem of ozone were to progressively deteriorate the above schedule could be
far too slow to take care of the problem. The government would always be responding with too
little action, too late and there would be clear government failure.
Government involvement is no guarantee that a market failure can be corrected. In
evaluating whether or not a government should intervene in the market, the problems of
government failure must be weighed against the problems of market failure. Unless the
government can clearly and efficiently correct a market failure it should generally not interfere.
When it does have to interfere, then it should do so with the minimum restraint that is necessary.
The problem of deciding whether or not the government should intervene reduces to a
problem of weighing market failures against government failures. As shown in Table 17-5, there
are many market failures (left hand column) that might justify government intervention (middle
column). However, the government failures (right hand column) may potentially be worse than
the market failures that are to be corrected. The political process must be relied upon to weigh
government failure and market failure before the government intervenes. As part of this process,
cost benefit analysis and economic impact analysis are studies that may be undertaken to support
different sides of the argument for intervention
Table 17-5
MARKET GOVERNMENT GOVERNMENT
FAILURE INTERVENTION FAILURE
EXTERNALITY PUBLIC ENTERPRISE
-PUBLIC GOODS -NATIONALIZATION
MARKET
-PRIVATIZATION
POWER
REGULATION
INEQUITIES
- OUTPUT
DYNAMIC
- PRICE
MKT. FAIL.
- STANDARDS
INDIVISIBILITY ANTITRUST
INFORMATION
-STRUCTURE
ASYMMETRY
-CONDUCT
TAXES (SUBSIDIES)
PROVISION OF
INFORMATION
RATIONING (MONEY)
ADMINISTRATIVE
COST
COMPLIANCE
COST
EFFICIENCY COST
- NEGATIVE EXTER.
-PUBLIC BADS
- MKT POWER
- INEQUITIES
- DYNAMIC
- INDIVISIBILITY
- INFORMATION
21
Market Failure and Government Intervention
NOTE: Government failure should be less than the market failure that government intervention is
designed to correct.
To ensure that the government adopts policies which are not unnecessarily severe,
managers must work closely with government. Shapiro summarized a business view of what
needs to be done:
As American business becomes even more internationalized, I suspect that competition
will force us to move closer to the patterns of government-business cooperation which
exist in some other countries. This does not mean government passivity or compliance. I
do not think you could call the governments of West Germany or Japan anyone's weak
sisters. It does mean that government will not approach business as its sworn enemy.
Even an arm's-length relationship will allow us to shake hands now and then.8
Shapiro became CEO of Du Pont and became one of the ten valued members of the Business
Roundtable precisely because he knew how to encourage the spirit of cooperation between
government and industry.
He was voicing the great hope of industrial policy- that government and industry can
work together to make American firms more competitive. Unfortunately, government and
industry cooperation can easily be used to curb competition and may result in other government
failures. Shapiro's response depends upon the wisdom and spirit of leaders in being able to
achieve what is in the public interest:
I, for one think that there's a strong case for the idea that government, industry, and labor
unions all exist to serve the public interest- not for private purposes as such. And unless
they can demonstrate that that's what they're doing, they have no legitimacy.9
However, even with selfless intentions, there are likely to be profound disagreements about how
to strengthen American industry to compete. Like democracy in the political arena, competition
in the economic arena has a lot of defects, but it just happens to be better than anything else we
can come up with.
See Scherer, op. cit., pp. 440-441 for an analysis of the
success of patents in achieving each of these goals.
1.
T.R. Reid. The Chip Simon and Schuster, New York 1984 p. 83
2.
8
Shook, op. cit., p. 216
9
Shook, op. cit. p. 219
22
Market Failure and Government Intervention
3.
Scherer, p. 452
4.
Scherer, op. cit.
23