PUBLIC POLICY
Unit - 1.2
Theorem, Market & Externalities
The Fundamental Theorem of Welfare
Economics
• Theorem 1:
Features
a) So many buyers & sellers
b) No individual can affect the market price
c) Leads to a Pareto efficient allocation of
resources.
d) Implies that a competitive economy will obtain
some point along the utility possibility schedule.
contd..
Theorem 2:
Features:
• “Every point on the utility possibilities schedule
can be attained by a competitive economy
provided we begin with the correct income
distribution of resources.”
• Pareto optimal does not say anything how “good”
the income distribution is. If the income
distribution is “not good” we need not abandon
the market mechanism. If the initial wealth can
be redistributed, leave the rest to the competitive
market--.
Contd…
The second theorem would say that “every
pareto efficient allocation can be attained by
means of a decentralized market mechanism”
(Decentralized in the sense that competitive firms
would act as good as “social planners”. If these
conditions hold good then “the study of public
finance could be limited to an analysis of the
appropriate governmental redistribution of
resources.” (stiglitz (1986) pp77-78)
Failure of Competition
• Difficulty in ascertaining whether markets are competitive:
a) Close substitutes may exist.
b) Markets may be limited geographically (large
Transportation Costs)
c) Creation of monopolies by the government.(eg, granting
patent system for a limited period for invention)
d) Barriers to entry due to monopoly arising due to
increasing returns to scale.( This is called “natural
monopoly”.
Example: New telecommunication technology
Entry of other firm is not costless.
contd…
What is the role of Government in
such cases?
• Government may regulate such monopolies.
In some cases monopolies are not regulated.
Unregulated monopolies (whether natural or
not) tend to restrict output to raise price to
high level.
Supplement the notes from Kraft & Furlong
(Public policy) on Public Goods:
• Public Goods: Those goods that either will not be
supplied by the market or if supplied will be
supplied in an insufficient quantity.
- Two critical properties:
(i) Marginal cost for an additional individual to
enjoy such good is zero.(eg, national defense)
(ii) Refers to “pure” public good.. it is difficult or
impossible to exclude individuals from
enjoyment of the public good.
How do Government respond to
externalities?
• By regulation
• Using price mechanism to
- put penalty on those who cause/impose cost
on others*
- reward those who confer benefits on others
(*for example, by charging on roads, at least at
peak times. The govt. can make road users
aware of the congestion cost. )
Contd..
In Singapore, EPR is higher at peak traffic hours
than on non-peak hours. The rates of
peak/no-peak (toll tax) are quite different. In
London also, taking cars in certain areas in
peak hours, one has to pay high toll tax.
The following cases of Market failure are also not
explicitly mentioned in Kraft & Furlong(2007)
• Incomplete Markets:
(i)
This refers to cases “wherever private markets fail to provide a
good or service, even though the cost of providing it is less than
what individuals are prepared to pay”
For example,
providing insurance & loans in some areas where individuals face
considerable risks .
Bank failure in Great Depression: Government may set up funds
to cover losses to public – Government intervention. – Private
sector would not cover such losses.
Flood insurance
Urban Riots
Farm price fluctuations : Government sets up minimum support
price.
contd……
(ii) Capital Markets:
- Loans to finance college education:
Government guarantees for such loans? In
USA ,yes.
- Or, low interest on student loans (subsidy)
contd….
(iii) Complementary Market:
 Cases when each individual/ entrepreneur “acting alone would not
be able to pursue the public interest, but acting together they
could”
Examples:
(a) Coffee producer not bothering about sugar production. Sale of both
may be affected together because together they make good market
– (not a very suitable example in the Indian context!)
Think of a very attractive tourist site. It takes long to reach there but
a tourist cannot return the same day. They cannot stay over there
because no guest room/motels built over there. Tourism gets
seriously affected. If bus operators & motel owners act together
they can take care of public interest & make good business. Or, a big
entrepreneur takes care of both transport & motels. However, such
cases can be handled by market/private sectors.
contd…
(b) Coordination on Large Scale:
There are cases when co-ordination is required on a large scale,
particularly in less developed countries. For example: Urban
Renewal program- Coordination required among factories, retailers,
landlords, businessman- Government has to step in for such a large
scale venture.
High Transaction Costs
Some categories of loans may have high risk of default. Banks may
not step in such cases. Government may have to step in.
Contd….
• Unemployment, Inflation & Disequilibrium
This considers a macro situation. High rate of
Unemployment (in developed market economies)
provides convincing case for Govt. intervention –
market/economy is not functioning well…. It remains
a debatable issue.
In developing countries – with underemployment/
poverty – provide a good case for government
intervention/subsidy through programs of
employment generation/poverty alleviation.