MARKET FAILURES
Externalities - markets will not lead to efficiency if actions of
producers or consumers affect people other than themselves
- when these effects are positive they are external benefits,
whenever they are adverse they are external costs
Thus the full cost to society (the social cost) of the production
of any good or service is the private cost plus and externalities
(positive or negative)
Four major types of externality
1.
External costs of production (MSC > MC)
2.
External benefits of production (MSC<MC)
3.
External costs of consumption (MSB<MB)
4.
External benefits of consumption (MSB>MB)
EXTERNALITIES - EXAMPLES
1.
External costs of production (MSC > MC)
When a chemical firm dumps waste into a river or pollutes the air the
community bears costs additional to those borne by the firm
2.
External benefits of production (MSC < MC)
If a bus company spends money training its bus drivers and some leave each
year to join coach and haulage companies these companies costs are reduced
as they do not have to train drivers
3.
External costs of consumption (MSB < MB)
When people use their cars there are costs (negative externalities) with respect
to other people e.g. exhaust fumes, noise, congestion etc.
This means that the actual level of consumption will be too great from
society’s point of view
Other examples - noisy radios in public places, smoke from cigarettes and
litter
EXTERNALITIES - EXAMPLES (con)
4.
External benefits of consumption (MSB > MB)
When people travel by train rather than by car other people benefit from less
congestion, less pollution and fewer accidents on the road
Whenever there are external benefits too little will be produced by the market;
Whenever there are external costs too much will be produced by the market
In short intervention with respect to market forces is justified whenever
externalities arise
Environmental Problems such as emissions of CO2 gas point to the extremely
important implications of negative externalities
External costs in production
Costs and benefits
MSC
P
MC = S
D
External cost
O
Q1
Q2
Social optimum
fig
Quantity
External benefits in production
Costs and benefits
MC = S MSC
External benefit
P
O
D
Q1
fig
Quantity
Q2
Social optimum
External costs and benefits in production
D
P
External cost
O
Q2
Q1
Quantity
(a ) External costs
MC = S MSC
Costs and benefits (£)
Costs and benefits (£)
MSC MC = S
External benefit
P
O
D
Q1
Q2
Quantity
(b) External benefits
Costs and benefits
External costs in consumption
External cost
P
D
(MB)
MU = D
MSB
O
Social optimum
Q2
Q1
fig
Quantity
External benefits in consumption
Costs and benefits
External benefit
P
D
MSB
(MB)
MU = D
O
Q1
fig
Quantity
Q2
Social optimum
External cost
P
P
Costs and benefits (£)
Costs and benefits (£)
External costs and benefits in consumption
External benefit
P
P
MSB
MB
MB
MSB
O
Q2
Q1
Car miles
(a ) External costs
O
Q1
Q2
Rail miles
(b) External benefits
PUBLIC GOODS
• With some goods and services, the positive externalities are so great that
the market (free or imperfect) may not produce at all
These are called public goods e.g. lighthouses, street lighting, public service
such as police, national security etc
Public goods have two important characteristics: non-rivalry and non
- excludability
Unlike a bar of chocolate, the benefits of street lighting to one individual does
not exclude equal benefits to neighbours. So in this sense they are not rivals
with respect to obtaining benefits.
However money spent by an individual on improving drainage on a road
would not exclude benefits to other users. Therefore there would be no
incentive for others who would benefit (free riders) to undertake such
expenditure
MONOPOLY POWER
• Even without externalities, a monopoly will fail to produce the socially
efficient output
• There is what is referred to as a deadweight loss under monopoly consumer and producer surplus
Deadweight loss under monopoly
MC
£
(= S under perfect competition)
Monopoly
Pm
Ppc
Consumer
surplus
Deadweight
welfare loss
b
a
Producer
surplus
AR = D
MR
O
Qpc
Qpc
fig
(b) Industry equilibrium under monopoly
Q
OTHER MARKET FAILURES
• Lack of information and uncertainty
- consumers may not be properly informed on prices, aware of quality or
perhaps may be unduly influenced by advertising
Immobility of factors and time-lags in response
Protecting people’s interests
- dependents
- principal-agent problem
Merit and demerit goods
Unequal distribution of income
GOVERNMENT INTERVENTION
• Where a marginal external cost is involved e.g. pollution from an industrial
chimney a tax should be imposed (equal to the marginal pollution cost)
• If a monopolist makes excessive profits (i.e. supernormal profits) a lump
sum tax can be imposed up to the amount of the excess tax
• Then if the monopolist is producing less than the cost efficient output a
subsidy should be imposed to encourage production up to that level
Other methods would involve legal restrictions, regulatory authorities, changes
in property rights, provision of information and the direct provision of goods
and services
Using taxes to correct a market distortion
Costs and benefits
MSC
MC = S
Optimum tax = MSC – MC
P
D
MC
O
Q1
Q2
fig
Quantity
Using subsidies to correct a market distortion
MC = S MSC
Costs and benefits
MC
Optimum subsidy
= MC – MSC
P
O
D
Q1
fig
Quantity
Q2
GOVERNMENT INTERVENTION - TAXES AND
SUBSIDIES
• Used by Gov. to
(a) to create greater social efficiency by altering production or consumption
(b) to redistribute income
Tax should be made equal to marginal external cost (of product or service) and
subsidy made equal to marginal external benefit
-
advantages: can address market imperfections while still allowing market
to operate
-
Disadvantages: impractical to use a range of different taxes and subsidies:
can be a lack of knowledge of how to measure external costs and benefits
GOVERNMENT INTERVENTION – LAWS AND
REGULATIONS
• Three types of regulation:
- those that prohibit or regulate behaviour that imposes external costs
- those that prevent false or misleading information
- those that prevent or regulate monopolies and oligopolies
Advantages: simple and clear to understand; when dangers are great easier to
ban outright than attempt other regulations; easy to take emergency action
when required
Disadvantages: tend to be a rather blunt instrument - for example if
a minimum pollution standard is required to be met by regulation, a firm will
have no incentive to improve on that standard
REGULATORY BODIES
• In most industrial countries “competition policy” is in place to deal with
restrictive practices and monopoly practices; here substantial fines (and
even prison sentences) can be imposed on offenders
• Special regulatory bodies are often put in place in key sectors (with an
important public interest)
- for example in Ireland there are special regulatory bodies in place with
respect to:
electricity
telecommunications
insurance
taxis etc.
OTHER FORMS OF GOVERNMENT
INTERVENTION
• Changes in property rights
- generally only practical when the number of offenders is few e.g. laws
preventing noise from neighbours and even here problems can exist with
respect to the costs and effectiveness of litigation
- there can also be a question of equity
e.g. property owners may strive to limit access to walkways that were
formerly treated as rights of way
• Provision of information
- information on jobs provided by employment centres can facilitate both
firms and job seekers
OTHER FORMS OF GOVERNMENT
INTERVENTION (con)
• Direct provision of goods and services
- provision of public goods
- considerations of social justice
- large positive externalities (e.g. free treatment of an infectious disease)
- to protect dependants (e.g. provision of primary education)
- ignorance (consumers may not realise how much they will benefit from a
certain facility
DRAWBACKS OF INTERVENTION
• When government fixes prices, this can lead to shortages (e.g. rented
accommodation) and surpluses (food)
• Poor information
• Bureaucracy and inefficiency
• Lack of market incentives e.g. where subsidies to firms may allow
inefficient to survive
• Shifts in government policy - may make it difficult for firms to plan
efficiently ahead
• Lack of freedom for individuals
ADVANTAGES OF FREE MARKET
• Automatic adjustments
• Dynamic advantages of capitalism
• A high degree of competition even under monopoly/oligopoly
- excessively high profits can encourage others to enter market
- competition from closely related industries
- threat of foreign competition
- countervailing powers
- competition for corporate control
HEALTH SECTOR
Case of Multiple Market Failures - leading to considerable government intervention
•
Distribution of Income: People may not be able to afford treatment
•
Uncertainty: Difficulty for people in predicting their future medical needs
- to some extent can be dealt with through insurance
•
Externalities: Health care generates a number of benefits external to the patient (e.g.
inoculation against an infectious disease)
•
Patient Ignorance:
- patients may delay seeking treatment until considerable damage is in
evidence
- the principle agent problem is in evidence
•
In market system considerable oligopoly likely to exist in terms of provision of
health services
The Environment: a Case Study
• Policy alternatives
– charging for use of the environment
• emissions charges
• user charges
• optimum charge = external cost
– green taxes and subsidies
• use of such taxes around the world
– laws and regulations
• advantages and disadvantages
– education
– tradable permits
• the European Emissions Trading Scheme
• advantages and disadvantages
The Environment: a Case Study
• How much can we rely on governments?
– governments must have the will to protect the environment
• depends on attitudes of various interest groups
– must be able to identify problems and appropriates solutions
– when problems are global:
• may require international agreements
• governments are likely to be more concerned with their own
national interests