Topic 8: Market v. State
Agenda, Friday 3rd December 2010
A: Alternative Mechanisms for
Allocation of (Society’s) Resources
B: Market and Market Failures
C: Private Solutions v. Public Solutions
D: State Failures
E: Market (Failures) v. State (Failures)
A: Alternative Mechanisms
for Allocation of
(Society’s) Resources
Alternative Mechanisms
 Market
(or more realistically Regulated
Market), e.g. restaurant meals, mobile
phone, …
 Command System, e.g. North Korea,
within organisations, …
 Majority Rule, e.g. voting on alternative
tax-and-spend menus, committees, …
 Contest, e.g. CAO points, Oscars, mobile
telephony licence, beauty contest, …
Alternative Mechanisms





First-Come, First-Served, e.g. tickets (Take That,
All-Ireland, Rugby v. NZ, …
Sharing (Equally?), e.g. votes, air, water,
household waste collection?, health?,
education?, …
Lottery, e.g. raffle, Medicine TCD = 575*, selling a
house?, …
Personal Characteristics, e.g. beauty contest,
finding partner(s), discrimination, …
Force, e.g. theft, “taxation Is theft”?, …
B: Market and Market
Failures
Market: Welfare Theorems
 First
Fundamental Theorem of
Welfare Economics
 Second Fundamental Theorem of
Welfare Economics
First Welfare Theorem (Efficiency)
 Perfect
Competition
 D = SMB (= P) & S = SMC (= PMC =
MC)
 P = MC (Allocative Efficiency)
 Perfect Competition + Market →
Pareto Efficiency
Market Equilibrium: Consumer Surplus
and Producer Surplus
Price A
D
Supply
Consumer
surplus
Equilibrium
price
E
Producer
surplus
B
Demand
C
0
Equilibrium
quantity
Quantity
Second Welfare Theorem (Equity)
 Perfect
Competition + Lump-Sum
Taxes and Subsidies + Market → Any
Specific Pareto Efficiency
 Perfect Competition + Lump-Sum
Taxes and Subsidies + Market →
Pareto Optimality
Second Welfare Theorem (Equity)
 Existence
of Lump Sum Taxes and/or
Subsidies?
 Lump-Sum → No Distortion (e.g. no
distortionary wedges between
buying and selling price introduced)
 Poll Tax? Window Tax? … (State
Pension, Invalidity Pension)
 Second Welfare Theorem?
First Welfare Theorem (Efficiency)
 Perfect
Competition?
 D = SMB = P? & S = SMC = MC?
 P = MC?
 Second Best Theorem!
 Specific Market Failures:
Externalities, Public Goods,
Informational Problems, Market
Power, Equity? Distribution?
Externalities
 Non-priced
by-products
 Negative Production (e.g. pollution)
 Positive Production (e.g. orchards
and honey-producing bees)
 Negative Consumption (e.g. passive
smoking)
 Positive Consumption (e.g. vaccines
such as flu, MMR?)
Public Goods
 Non-rivalry
in consumption
 Non-exclusion in consumption
 Examples: defence, lighthouse?, …
 Pure v. Impure Public Goods
 Public Goods ≈ Positive Externalities
Informational Problems
 Adverse
Selection (“hidden information”,
e.g. second-hand car market is
incomplete)
 Moral Hazard (“hidden action”, e.g.
insurance markets are incomplete)
 Principal Agency (different interests →
conflict of interests, e.g. shareholders v.
board v. managers v. workers, “life”!)
Market Power
 Seller:
Monopoly, Oligopoly
 Buyer: Monopsony (→ buy too little)
C: Private Solutions v
Public Solutions
Private Solutions
 Coase
Theorem
Property Rights (State = “Night
Watchman” role)
 Transactions Costs
 Negotiations

 Efficiency!
remain)
(Distributional considerations
Public Solutions
 State
Provision
 Nationalisation
 Command & Control
 Regulation (“exercise of control by a
public agency over economic and
social activities”)
Public & Private Solutions
 State
& Market-Based Solutions (e.g.
Tax, Subsidy, Pollution Permits)
 State Ownership/Provision facilitated
by market mechanisms (e.g. road
building, hospital building, … )
 Public-Private Partnerships (PPPs)
D: State Failures
Role of State: Public
Interest/Finance Perspective
 Benevolent
Social Planner/Dictator
Examples
 Stabilization Policy
 Optimal Taxation
Role of State: Private Interest
Perspective
 Public
Choice (Economic Theory of
Regulation)
Politicians (& Self Interest)
 Bureaucrats (& Self Interest)
 Regulators, e.g. regulatory capture

 Interest
Group Perspective
 Force of Ideas Perspective
E: Market (& Failures) v.
State (& Failures)
Examples
 Efficiency-Equity
Trade-Off
Arthur Okun’s Leaky-Bucket?
 Equity: Equality of Opportunity v.
Equality of Outcome