Managerial Economics
Market Failure and
Government Intervention
Aalto University
School of Science
Department of Industrial Engineering and Management
January 12 – 28, 2016
Dr. Arto Kovanen, Ph.D.
Visiting Lecturer
General points
 Thus far we have assumed that market transactions
are, for the most part, free of government interference
 In reality, however, government intervenes in private
transactions in the form of taxes and regulations
 Government interventions may be motivated by the
failure of the free market to provide a socially optimal
allocation of goods and services
 We have seen this as a result of e.g. monopoly
 Other sources of market failures are externalities and
public goods
General points (cont.)
 A perfectly competitive market structure provides a
model for evaluating economic efficiencies.
 But the conditions are quite demanding:
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Large number of buyers and sellers
Homogeneous products
Perfect information (buyers and sellers)
Easy entry and exit by approximately identical firms
Absence of economies of scale
No government intervention in the market place (where
are we seeing that)
Antitrust legislation (U.S.)
 A host of antitrust legislation in the U.S. is aimed at
promoting competition in the market place
 Sherman Act of 1890 was designed to prevent the
growth and exercise of monopoly power
 Clayton Act of 1914 was aimed at clarifying the
Sherman Act. It outlawed price discrimination,
contracts that led customers to purchase one good as
a precondition for an other product, contingent
purchases (i.e., in order to buy a good from one firm
required that the customer refused to buy other
goods from competitors) and so on
Price regulations
 The production of some goods and services can
generate substantial economies of scale and
therefore be valued
 The large scale, however, leads to “natural
monopolies” and it may be in the public’s best
interest to allow the monopolies to exist, but under
regulation
 Example: utilities companies (electricity/water)
 In return to a privileged market position,
government reserves the right to regulate product
prices
 The goal is to eliminate the deadweight loss
Price regulations (cont.)
 This can be an effective way to produce at socially
optimal level of production (where P = MC)
 In practice, it is not easy to assure the correct level of
market supply and demand, which could lead to an
undesirable allocation of goods
 Example: suppose that a monopolist market has the
following demand and total cost functions
Q = 2,000 – 5P
TC = 100 + 4Q + 0.4Q2
Price regulations (cont.)
 What is the profit-maximizing price and
output?
 What is the value of consumers and
producers deadweight loss?
 At what price should the government
regulate the monopoly’s output to eliminate
society’s deadweight loss?
 With the regulated price, what will be the
production?
Externalities
 Market failure can also occur when a third party is
positively or negatively affected by a transaction of
someone
 Externalities can be positive or negative
 Examples: smoking by a room mate (negative),
public road to facilitate transportation of goods to
market (positive), pollution by a factory (air/water)
 Government interventions: emission standards and
fees, permits (e.g., US Clean Air Act), and taxes
Externalities (cont.)
 Common property resources are those to which
anyone has free access
 Negative externalities can arise due to overuse (e.g.,
use of fishing rights)
 A way to solve the problem is to allow a single entity
to manage the property who charges others a fee
equal to the marginal cost, so that the use is at the
optimal level
 Sometimes not practical, which leads to government
intervention or ownership
Asymmetric information
 Can exist if sellers of a product have better
information about its quality than the buyers
 There is nothing wrong with having both high quality
and low quality goods in the market
 But consumers need to know what the quality of the
product is when they are buying it
 Example: used cars; 5-star restaurant vs. Joe’s Grill
 Asymmetric information can lead to market failure if
 Prices are driven down because lack of knowledge of
quality
Asymmetric info (cont.)
 Sellers are unwilling to sell high quality products
 Results in a situation where only low quality goods
exist
 Use warranties, money back guarantees etc. to
signal the quality of the product
 Signaling: high quality producers can send credible
and informative signal about the quality
 Benefit of signal exceeds costs to high quality
producer
 Cost exceed benefits to low quality producer
 That is, only the high quality producer sends a
signal
Asymmetric info (cont.)
 Adverse selection: exists when buyer knows more
about the actual cost of service than the seller
 Example: All-you-can-eat restaurant – big eaters
more likely to use them, eating into seller’s profits
 Example: insurance – buyer know his/her health
better than the insurer (extra life insurance)
 Moral hazard: customer modifies behavior after
entering into an agreement
 Example: investors likely to ask few questions when
the investment has a government guarantee
Lemons (example)
 Assume that 100 individuals want to sell their used cars
and 100 individuals want to buy used cars. It is known
that 50% of used cars are good and 50% lemons. Current
owners know the quality of their cars, but the buyers
do not know that.
 The owners of lemons ask for $1,000 and the owners of
good quality cars ask for $2,000. The buyers are willing
to pay $1,200 and $2,400, respectively, for these cars.
 What will happen in the market?
 The expected cost of a car is $1,800 for the buyer
Lemons (cont.)
 At this “average” price sellers of good cars
are unwilling to sell, hence only lemons will
be offered for sale
 If the buyer were aware with certainty that
he would get a lemon, he would not pay
more than $1,200, not $1,800!
 Market failure arises because no good cars
are sold in the market
Public goods
 Two characteristics distinguish public goods from
private goods
 Nonexcludability – nobody can be barred from
consuming it
 Nondepetability – one’s consumption does not reduce
the amount others can consume
 Examples: public street lights, national defense, and
clean air, radio transmission (excl. satellite radio)
 Problem with public goods is to find out how much
each of us value the good and how much we are
willing to pay for having them
Public goods (cont.)
 This gives rise to a free-rider problem: that is, a
person is not willing to pay for the provision of public
good because he/she thinks other will pay for it (but
will like to use it)
 Example: street lights
 There are good safety-related arguments for having
them
 When you inquire how much people value street lights,
the outcome may be that there is limited support for
the (due to the concern that it will be paid for by tax
increases)
 Hence public support may not be there
Public goods (cont.)
 How many street lights should the city install?
 Assume that each individual have a personal demand
for street lights given by the following demand curve
Pi = 100 – 2Q where Q = number of street lights
 Let us assume that i = 3 and that the marginal cost of
installing a street light is $90.
 Socially optimal number of street lights is therefore
given by 3*(100 – 2Q) = 90, which results in Q = 35
Public goods (cont.)
 Each individuals, however, are only willing to pay $30
for a street light at the optimum (but 3*$30 = $90)
 Because of this, each of them will wait others to pay
the cost of street lights; in the end no one will pay
and no street lights will be provided
 To overcome the problem, the city council could
decide to provide the street lights and levy a tax to
pay them
 Will this lead to an efficient allocation of public good?
Public goods (cont.)
 If individuals view that the cost of public good is
small to them individually (e.g., close-to-free
healthcare), it is likely that individuals prefer too
much of it and thus the provision of public good
exceeds the optimum.
 In the street light example, if individuals view that
the cost to them is zero, i.e., Pi = 0 is zero for each i,
then the optimal Q = 50, which is more than socially
optimal amount.
 What about free higher education or medical care?