Ch 16 Market failure

Chapter 16

Market Failure?

© Pilot Publishing Company Ltd. 2005

Contents:

•

Examples of Market Failure

•

Counter Argument – the Market Works!

•

Government Intervention is Unnecessary and Inappropriate


Examples of Market Failure


Definitions:



Market failure

 is the situation in which the invisible hand (the market price) fails to allocate resources efficiently.

 Externality

 is the situation in which one’s action affects others

(in a non-pecuniary way) without compensation.


External cost

Private cost

 is the cost borne by the decision maker.

External cost

 is the uncompensated cost borne by others.

Social cost

 is the total cost borne by the whole society



= private cost + external cost.


Divergence between private and social costs

 is the situation in which the private cost is different from the social cost due to the presence of external cost

Example:

Noise from a construction site


Equilibrium & efficiency:

S

Deadweight loss

MSC

Private optimum :



Q p

(MPB = MPC)

MEC

MPC

MPB =

MSB

Social optimum :



Q s

(MSB = MSC)

0

Q s

Q p

Over-production


Q

External benefit

Private benefit

 is the benefit obtained by the decision maker.

External benefit

 is the uncompensated benefit obtained by others.

Social benefit

 is the total benefit obtained by the whole society



= private benefit + external benefit.


Divergence between private & social benefits

 private benefit

 social benefit

 due to the existence of external benefit

Example:

Fundamental education


Equilibrium & efficiency:

S


MPC =

MSC

Private optimum :



Q p

(MPB = MPC)

MEB

0

Q p

Q s

Under-production


MSB

MPB

Q

Social optimum :



Q s

(MSB = MSC)

Effects of externality

Result

(by invisible hand)

Remedy

(by visible hand)

External cost

(e.g., congestion & pollution)

Over-production

(Qp > Qs)

Impose unit tax

(to internalize the external cost)

External benefit

(e.g., public goods

& make-up)



(Qp < Qs)

Impose unit subsidy

(to internalize the external benefit)

Definitions:

Private good

 is a good of which its consumption by any individual reduces the amount available for others

 it is exclusive in consumption


(Pure) Public good

 its consumption by any individual does not reduces the amount available for others

 it is non-exclusive in consumption

Example: Pure public good :

National defense


Impure public good

 can be consumed by many but not all individuals at the same time

 not all individuals can consume it (or the whole amount of it) because usually an additional cost is involved in its consumption

Examples: Impure public good

Radio broadcast

Stage performance


Q16.3:

Explain why the above are examples of pure public goods & impure public goods.


Q16.4:

Distinguish between public goods & public services.


Q16.5:

Some economists define public good as a good of which the marginal cost of serving an additional consumer is zero. Comment.


$

Demand for a public good

MUV

1

+MUV

2

= MSB

Public good is non-exclusive in consumption. Once produced, all individuals consume & pay for the same stock of public good.

MUV

2

MUV

1

Market demand curve for a public good = vertical sum of MUV curves of all individuals in the market (=

MSB curve)

0


Q

$

The social optimum

MSB =

MUV

1

+MUV

2

MUV

2

Optimal output:

MSC

MSB (=



MUV) = MSC (=MC)

Optimal pricing scheme :

Perfect price discrimination

(i.e., P i

= MUV i then



P i

=



)

MUV i

= MSC

MUV

1

P

2

P

1

0

Q s


P

1

P

2

= MSC

Q

Private optimum

If uniform pricing is practised:

1. Cannot attain allocative efficiency



To high MUV users: MUV > P

To low MUV users: MUV < P and refuse to consume



MR collected (



P) is much smaller than MSB (



MUV)



In equating MR = MC, private optimum is much smaller than social optimum



Under-production and allocative inefficiency result

2. Cannot attain consumption efficiency



Once produced, no additional cost is incurred in consumption, but low MUV users are excluded from consumption



Under-consumption and consumption inefficiency result


If perfect price discrimination is practiced:



It is extremely costly for a producer to investigate the

MUV of every individual & charge them accordingly.



Individuals may pretend to be low MUV users to bargain for a lower price.



The revenue collected from perfect price discrimination would also be smaller than MSB.



Under-production & allocative inefficiency result.


The free rider problem:



As public good is non-exclusive in consumption, it is difficult to recognize & prevent free-riders (non-payers) from consuming the good.



This free-rider problem may appear under all kinds of pricing schemes.



As a result, the revenue collected would be further reduced.





Any remedy?

Pricing



The visible hand faces similar problems as the invisible hand.




Zero pricing



Finance the production of public good by tax revenue



Unfair to taxpayers who bear the cost but do not consume the public good.



The sectors being taxed suffer inefficiency



When the gov’t estimate

MSB from surveys, consumers may overstate their MUVs and cause over-production


Q16.7:

“To achieve consumption efficiency, a private good should be consumed by the individual with the highest MUV, while a public good should be consumed by all individuals with positive MUVs.”

Comment.


Q16.8:

Radio broadcast is a public good.

What are the problems in its pricing?

What are the ways to overcome the problems so that it can be provided privately?

Is the situation efficient?


Counter Argument

--- the Market Works


Zero transaction cost – Coase theorem

Coase theorem ( 高斯理論 )

 regardless of the initial assignment of property rights

 the market equilibrium is identical and efficient

 provided that property rights are well-defined and transaction costs are negligible.


Illustration of the theorem

A factory in upstream

Mr. B

Ms. A


A farm in downstream

Initial situation:

The bleaching factory discharges sewage into the river.

The sewage pollutes the river and brings loss to the farm.


Case I: The farm does not have the right of enjoying clean water.

Assumptions:

1. No law restricting water pollution (pollution continues)

2. To min. loss, farm owner Mr. B negotiates with Ms. A and pay her to cut her output and pollution.



Max. amount that Mr. B is willing to offer to Ms. A is the marginal external cost he borne = MSC - MPC



Min. amount that Ms. A is willing to accept is her net receipt from producing that unit = MPB MPC

= MSB - MPC


In equilibrium,

( Max. amount offered by

Mr. B = External cost)

=

MSC - MPC

( Min. amount accepted by

Ms. A = Net receipt)

MSB - MPC

MSC = MSB


Case II: The farm has the right of enjoying clean water

Assumptions:

1. A law restricting water pollution (& prod. is banned)

2. To min. loss, factory owner Ms. A negotiates with

Mr. B and pay him to allow her production & pollution.



Max. amount that Ms. A is willing to offer to Mr. B is the her net receipt from production = MPB - MPC

= MSB - MPC



Min. amount that Mr. B is willing to accept is the external cost he borne = MSC - MPC


In equilibrium,

( Max. amount offered by Ms. A = Net receipt)

=

MSB - MPC

( Min. amount accepted by Mr. B = External cost)

MSC - MPC

MSB = MSC


Conclusion

If transaction cost is zero, by Coase theorem, private contracting would occur. As a result, the private optimum is the social optimum .



Efficiency is achieved.



N o deadweight loss.

Notice that the initial assignment of property rights has no influence on the allocation of resources.


Remarks: 1. Optimal level of pollution

If pollution cannot be avoided in production,

(because the cost of preventing or eliminating pollution is extremely high)

 it is efficient to allow pollution provided that the MSB of production can cover the MSC

(including the loss brought by pollution).



So there exists an optimal level of pollution.


Remarks: 2. Reciprocal nature of the problem



There exists no reason why someone should have the right of a resource (e.g., clean water) instead of others.



Yet, whoever has the right will gain and whoever has to buy the right will lose.



Which party bears the loss is reciprocal , depending on the assignment of rights.


Prohibitively high transaction cost

Achieving efficiency without reallocating resources



If TC in reallocating resources to restore efficiency & eliminate the deadweight loss > the deadweight loss itself,

 no private contracting or reallocation of resources is worth taking place.



Although the private optimum is different from the ideal social optimum (under zero TC) & deadweight loss results, the resource allocation is still efficient (cannot be improved).



No market failure results & no government intervention is needed.


Assignment of property rights affects the allocation of resources (when TC is prohibitively high)

$


0

Q

S

Q

P1


MSC

If the farm does not have the right and the

TC is prohibitively high,

MPC

MPB=MSB

Q of factory

 the factory will produced at Q

P1

$


MSC

If the farm has the right and the TC is prohibitively high,

0=Q

P2

Q

S


MPC

 the factory will be banned from production, i.e., Q

P2

= 0

MPB=MSB

Q of factory

Government Intervention is

Unnecessary and Inappropriate


Gov’t intervention is unnecessary and inappropriate



As resource allocation by the invisible hand must be efficient, there is no market failure.



No government intervention is needed



The use of visible hand may be of undesirable motive, involve high administrative and information cost, and restrict individual freedom.

 So even if there were “market failure”, the use of visible hand might not be appropriate .


Correcting Misconceptions:

1. Public good is a good produced by the government.

2. The market demand curve for a public good is the horizontal sum of MUV curves of all individuals in the market.

3. To achieve efficiency, private goods should be provided by the private sector and public goods should be provided by the public sector.



4. To achieve efficiency, pollution should be eliminated.

5. The existence of deadweight loss implies inefficiency.

6. Pareto efficiency requires zero transaction costs.

7. Pareto efficiency requires an even distribution of wealth.



8. Pareto efficiency implies the maximization of social welfare.

9. To achieve efficiency, a polluting firm should be banned from production or it should compensate the victims.

10. There is no divergence between private and social costs.

11. As the market fails to allocate resources efficiently, the government should intervene.


Survival Kit in Exam

Question16.1:

“A price-searching market allocates resources inefficiently.” Comment.


Survival Kit in Exam

Question16.2:

The construction of a rubbish collection point causes a fall in the value of nearby properties.

To attain economic efficiency, which of the following options should be adopted?

(a) The rubbish collection point should compensate the nearby property owners.

(b) The rubbish collection point should install pollution reduction device.

(c) The rubbish collection point should be relocated.

(d) The nearby properties should be relocated.


Ch 16 Market failure

Chapter 16

Market Failure?

Contents:

Examples of Market Failure

Counter Argument

--- the Market Works

Zero transaction cost – Coase theorem

Government Intervention is

Unnecessary and Inappropriate

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Support

Ch 16 Market failure

Chapter 16

Market Failure?

Contents:

Examples of Market Failure

Counter Argument

--- the Market Works

Zero transaction cost – Coase theorem

Government Intervention is

Unnecessary and Inappropriate

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