Government Intervention and the
Market System
Session 4 (chs 8, 6, 7, 9)
Professor Dermot McAleese
OUTLINE
Government spending in the economy
Case for government intervention
 Types of government intervention
 Problem of government failure
Government spending (% GDP)
1937
1960
1970
1984 2000
Eur 12
Japan
US
29.0
25.4
8.6
32.2
17.1
27.0
37.4
19.4
31.6
50.0
32.9
35.6
44.0
31.8
33.4
France
Germany
Netherlands
Ireland
Italy
UK
29.0
42.4
19.0
…
24.5
30.0
34.6
32.5
33.7
28.0
30.1
32.2
38.9
38.5
42.4
39.6
34.2
37.3
52.5
47.6
59.6
51.3
49.4
45.3
47.7
44.0
42.1
29.5
44.2
36.8
Sources: European Economy, OECD; pre-Second World War figures taken from Vito Tanzi
and Ludger Schuknecht, ‘The Growth of Government and the Reform of the State in
Industrial Countries’, IMF Working Paper, December 1995
General government net debt (% GDP)
1978
1990
1995
2000
EU(15)
23.9
40.8
75.2
68.5
Japan
US
11.3
21.3
9.5
31.5
76.2
74.5
112.8
60.2
Belgium
Italy
57.2
62.4
124.9
103.7
129.8
123.1
109.8
112.9
Greece
29.4
89.0
108.7
103.8
Netherlands
40.2
75.6
75.5
56.5
Denmark
21.9
65.8
73.9
50.8
Portugal
Germany
France
37.6
30.1
31.0
65.3
42.0
39.5
65.9
59.1
59.3
58.8
63.5
63.9
Spain
14.4
48.5
68.4
65.7
UK
58.6
39.1
58.9
49.7
Ireland
65.7
92.6
80.8
42.9
Source: European Monetary Institute, First Annual Report, April 1995; OECD Economic
Outlook,, various issues.
Elderly dependency ratios
1960
2000
2050
US
9.2
12.4
21.2
Japan
6.1
16.5
30.4
EC15
10.6
16.1
27.6
Source: Eurostat
65+ as % total population
Table. 6 Public sector debt and net public pensions
liabilities, 1990 (% GDP)
Public debt
Net
pensions
liabilities
Extended
public debt
US
56
43
99
Japan
70
200
270
Germany
44
160
204
France
47
216
263
Italy
101
233
334
UK
35
100
135
Source: Van Noord and Herd (1994)
ADAM SMITH: THE REASONS FOR
GOVERNMENT INTERVENTION
 Monopoly
 Defence/national security
 Police and justice system
 Public health
Modern Case for Government
Intervention
• Income Distribution
• Market Failure
INCOME DISTRIBUTION
 Income equalisation
 utility maximised by distributing from rich to poor
adverse effect on incentive to work and enterprise
 Efficiency
efficiency less ambiguous objective
Pareto efficiency
than equality
(an outcome where nobody can be made better off without making at
least one other individual less well off)
 Equality/efficiency trade-off
EMPIRICAL EVIDENCE ON INCOME
DISTRIBUTION
Governments are concerned about inequality
 Market forces can produce highly unequal income
distribution
Government redistribution reduces inequality
Declining emphasis on redistribution through taxation
 More emphasis on targeting expenditure to the poor
GINI INDICES FOR SELECTION OF HIGH-INCOME COUNTRIES
before redistribution
after redistribution
Sweden
Norway
Germany
UK
Australia
Canada
Netherland
France
US
Switzerland
0
0.1
0.2
0.3
0.4
0.5
Soruces: Gini coefficients: A. Atkinson, Income Inequality in OECD countries: evidence from CIS
data, paris: OECD, 1995.
MARKET FAILURES
 Monopoly power (dead-weight loss, X-efficiency loss, etc.)
 Externalities (congestions, pollution, …)
 Public goods (‘free rider’ problem)
 Information asymmetries (insurance, banking, taxis, health)
Begin with monopoly – one
seller only -- the extreme case of
absence of competition
THE THEORY OF MONOPOLY
 Static Efficiency effect
 Income distribution effect
 Dynamic effects
THE SINGLE MONOPOLIST
Price
R
MC
Pm
AC
S
F
T
D
MR
0
Qm
Quantity
Profit maximisation dictates
that firms in the market system
are motivated to discover,
exploit and ruthlessly protect a
monopoly niche.
MONOPOLY vs. COMPETITION
Price
D
Same costs
R
Pm
S
Pc
T
D
0
Qm
Qc
Deadweight loss = RST
Quantity
MONOPOLY vs. COMPETITION
Higher costs under monopoly
Price
R
Costs under monopoly
S
A
MC = AC
Cost under competition
MC = AC
B
V
D
0
Qm
Qx
Qc
Quantity
MONOPOLY PRICE DISCRIMINATION
Price
Price
Price
P2
P1
C
C
C
MR1
Q1
Quantity
E
MR2
Q2
Quantity
MC
CMR
Q(1+2)
Quantity
FOUR REASONS FOR A MONOPOLY
 Economies of scale
 Government policies
 Ownership know-how
 Ownership of natural resources
SUSTAINING MARKET POWER
Distinctive capability
 Architecture
 Reputation
 Innovation
Strategic entry-deterrent measures
 Setting price deliberately below profit-maximising level in
order to reduce attractiveness of the industry to the outsiders
 Conceasing profit figures for monopolised parts of business
 Below cost selling, predatory pricing and dumping
 Deliberate over-investment in capacity and extension of
product range
MARKET POWER WITH A FEW FIRMS
 The case of cartel
 Price leadership
 Kinked oligopoly model
 Non-price competition
CONCLUSIONS
 Large section of modern industrial economies can be
described as ‘effectively competitive’
 Yet monopolies influence and market power are
important realities in the business world
 Hence need for competition policy
MARKET STRUCTURE IS DETERMINED BY
Numbers and size-distribution of sellers and buyers
Characteristics of the product and degree of market
segmentation
Barriers to entry into the industry
Barriers to exit from the industry
MARKET STRUCTURE AND FIRMS
PERFORMANCE
Contestability – firms may be few in number and yet
competition can be intense
Innovation – thrives more in competitive conditions
than under monopoly
COMPETITION
– ADVANTAGES OVER MONOPOLY
 It makes organisations internally more efficient
 It allows the more efficient organisations to prosper at the
expense of the inefficient (selection process)
 It improves dynamic efficiency by stimulating innovation
EXTERNALITIES
ORIGIN
Production
Consumption
Primary education
4
Training employees in
general skills
Aesthetic company
EFFECT headquarter buildings
6
Vaccine against
contagious disease
Neighbour’s well-kept
garden
Air, water and noise
pollution
Congestion
Ugly factory buildings
Radio noise
NEGATIVE PRODUCTION EXTERNALITY
Chemical Plant Polluting River
SMC
£
PMC
P
E
Demand

Q2
Q1
Q 1- private profit maximum output level
Q2 - social optimum level
Output of
chemical plant
DEFINITION OF A PUBLIC GOOD
 Non-Rivalrous
the marginal cost of an additional individual
consuming the good is zero, at least up to a certain
level
 Non-Excludable
the cost of excluding an individual from consuming
it is prohibitively high
Note: Public goods are not the same as merit goods
PUBLIC GOODS
Apples
Cars
Marginal cost of
consumption
(rivalry)
Fire service
Cinemas
City Parks
Art Galleries
Motorways
Bridges
Clean Air
National Parks
Innovation –basic
research
National Defence
TV Programme
Monetary stability
Ease of excludability
Private Goods and Public Goods
Examples of Information
Asymmetries
•
•
•
•
Medical bills – inflated demand
Fake antiques
Gasoline
Bank deposits
Government Action is needed to
Prevent or Correct Market
Failure
COMPETITION POLICY IN ACTION
– THE EXAMPLE OF EU
 Prohibited agreements
 Abuse of dominant position
 Control of mergers
 State aids
COMPETITION POLICY IN ACTION
Horizontal restraints
restraints in markets for close substitutes
(e.g. price fixing, market sharing)
presumption of illegality
Vertical restraints
 restraints between producers of complementary
goods and services
 presumption of legality unless interest of
consumers, existing competitors, potential entrants
are shown to be damaged
COMPETITION LAW WITH TEETH
Breaches of competition law can carry severe penalties. In 1999, two top
European companies were fined a record $725 million in the US for their
part in a worldwide conspiracy to control the market in vitamins.
According to US investigators, the executives met once a year to fix the
annual “budget” of a fictitious company Vitamins Inc. In practice this
involved setting prices, sharing geographic markets and setting sales
volume. The annual summit was followed by meetings, quarterly
reviews and frequent correspondence. The cartel controlled the most
popular vitamins including vitamins A, C and vitamin premixes. A
former executive of Roche agreed to serve a four-month prison sentence;
he was the first European national to submit to such a sentence for antitrust offences. The European Commission said it was investigating the
same matter. Practices that once would have been tolerated if not
condoned in the past are now being subjected to the full rigour of the
law.
COMPETITION AND GLOBALISATION
 A more open market is more competitive
 A need for ‘level playing field’
 Monopoly power by giant multinationals
COMPETITION POLICY DOES NOT SOLVE ALL
PROBLEMS …
Natural monopolies – the core activities
where economies of scale dominate
Can be controlled by
1. Regulation
2. Outcontracting and franchising
3. Privatisation
REASONS FOR PRIVATISATION
new managerial ‘culture’
source of funds for government
disposes of loss making
weaken trade unions
encourage efficiency
(access to capital, avoid policy confusion)
develop and expand domestic capital market
engender competition
METHODS OF PRIVATISATION
Share flotation
(British Telecom 1984)
Direct sale to existing private sector business
or institutional buyers
(Rover cars to British Aerospace)
Management buy-outs
(National Freight corporation 1982)
Contracting out
(competitive tender)
EFFECTS OF PRIVATISATION
Efficiency
Government revenue
Income distribution
Privatsation not necessarily superior
to state ownership
(Railways, London underground)
DEREGULATION –
THE CASE OF NATURAL MONOPOLY
Isolate the core natural monopoly element in the industry
Deal with the natural monopoly element:
 Pricing:
 P = MC;
 break-even or average return on K;
 RPI minus X
 Access
 Quality
REGULATION
Costs of direct regulation can be high
Incentive regulation can also be problematic
- RPI minus X (UK)
- ‘Fair’ return on capital (US)
 Competition the best solution
- Break up into separate competing firms
- Competitive tendering for provision of services
- Encourage new entrants (including foreign)
- Separate ‘natural’ monopoly (network) and regulate that only
Solutions to Market Failure -Externalities
 Taxes and subsidies
 Regulation
 State provision
COASE THEOREM
Externalities do not necessarily
require government intervention.
Market system can correct
externalities, provided property rights
are defined and transactions costs are
low.
REGULATION
Regulation is costly …
 High administrative costs
 Insufficient flexibility in implementation
 Stultifying effects of standardisation on industrial innovation
… but necessary …
 Natural monopolies
 Asymmetric information
 When risks of catastrophic failure exists
 When the pollution generated by the polluter cannot be measured
When major health risks are involved
Solutions to Market Failure –
Public Goods
Asymmetric Information
YOUR SOLUTIONS!
GOVERNMENT FAILURE
Government failure arises when the cost of
attempting to ‘correct’ free market distortions turn
out to be greater than the cost of the original
distortion itself.
CAUSES OF GOVERNMENT FAILURE
 Absence of ‘invisible hand’
 Absence of full information
 Theory of public choice
‘political parties formulate policies in order to win elections, rather than win
elections in order to formulate policies’ Prof. Anthony Down
 Distortions created by taxes and subsidies
(rent-seeking society and the ‘grantepreneurs’)
RESPONSE TO GOVERNMENT FAILURE
Reduce direct public provision (1)
privatisation
out-contracting
Standards
regulation
Response (2)
Use market incentives instead of regulation where
possible
Reform public sector – learning from the private
sector
 Management by objectives
 Incentives
Example: The Polluter Pays
Principle
Tax the polluter, get as near to the
source of the problem as possible, use
market incentive instead of regulation
The Polluter Pays Principle
• Gives firm incentive
to reduce pollution
• Cuts down on
compliance and
monitoring costs
• Incentive to
innovation with
pollution costs
integrated into market
signals
• Pollution may not be
costly or impossible to
measure accurately
• Lessens government
control over amount of
pollution created
FUNCTIONS OF THE STATE
Addressing market failure
Minimal
functions
Improving equity
Providing pure public goods:
Protecting the poor:
Defence, property rights, law and order, public health,
macroeconomic management
Antipoverty progrems,
disaster relier
Overcoming
imperfect
information:
Providing social
insurance:
Addressing
externalities:
Basic education,
Intermediate environmental
functions
protection
Regulating
monopoly:
Insurance, financial Redistributive pensions,
Utility regulation, regulation,
family allowances,
aniitrust policy
consumer protection unemployment insurance
Co-ordinating private acivity:
Activist
functions
Redistribution:
Progressive income taxes,
wealth taxes, biasing
Fostering markets, cluster initiatives, regional development expenditure towards lower
Source: The State in a Changing World, World Development Report 1977, Jun, p. 27.