The Government and the Market Chapter 13 LIPSEY & CHRYSTAL ECONOMICS 12e

Learning Outcomes A perfectly competitive economy is allocatively efficient since it operates where price equals marginal cost. Free markets can fail to achieve an efficient outcome for one of several possible causes of ‘market failure’. Private markets will tend to overexploit common property resources. Goods that are jointly consumed by more than one person are called public goods and cannot be provided efficiently by the market.

Learning Outcomes The costs and benefits of production that are external to the producer cause the level of production that is achieved by the free market to deviate from the socially optimal level. Government policy towards competition is designed to encourage competitive practices and to discourage monopoly.

INTRODUCTION - MARKET FAILURE Basic Functions of Government Effective governments have a monopoly of violence. They also define and protect the rights and obligations of property owned by individuals and institutions. Key characteristics of market economies are [a] their ability to co-ordinate decentralized decisions without conscious control, [b] their determination of the distribution of income, and [c] compared with the alternatives, their minimization of arbitrary economic power.

INTRODUCTION - MARKET FAILURE Market Efficiency A perfectly competitive economy is allocatively efficient because it produces where price, which measures the value consumers place on the last unit produced, equals marginal cost, which measures the value to consumers that the resources used to produce the marginal unit could produce in other uses.

INTRODUCTION - MARKET FAILURE Market Efficiency Equating price to marginal cost maximises the sum of producers’ and consumers’ surpluses. Free markets can fail to achieve efficiency because of inefficient exclusion of users from facilities with excess capacity, common property resources, public goods, externalities, asymmetric information, missing markets, and market power.

Non-Rivalrous and Non-Excludable Goods The optimal price for the service of a facility with excess capacity is zero. Since private owners will charge a positive price, their facility will be inefficiently underused. INTRODUCTION - MARKET FAILURE

Non-Rivalrous and Non-Excludable Goods The private market will exploit a common property resource to the point where the average revenue per producer equals the production cost of a new entrant instead of to the socially optimal level, where the marginal addition to total product caused by a new entrant equals its production cost. INTRODUCTION - MARKET FAILURE

The optimal quantity of a public good is provided when the marginal cost of production is equal to the sum of the prices that all its consumers will be willing to pay for the marginal unit produced. This is difficult to attain because of the free rider problem – the incentive for individuals to understate the true value that they place on a public good. INTRODUCTION - MARKET FAILURE

Externalities The Coase theorem shows that if those parties that create an externality and those that are affected by it can bargain together with minimal transaction costs, all inefficiencies can be removed. Where private bargaining is impossible, the government can alleviate externalities by imposing rules and regulations or, more efficiently, by internalizing externalities through such measures as taxes and tradable permits to pollute. INTRODUCTION - MARKET FAILURE

Public Policy Towards Monopoly and Competition Government policy with respect to market power is designed to encourage competitive practices and discourage monopolistic ones. Direct control of pricing and entry conditions of some key oligopolistic industries has been common in the past, but deregulation is reducing such control. INTRODUCTION - MARKET FAILURE

Public Policy Towards Monopoly and Competition An important issue concerns the effect of market structure on economic growth. The productively ineffective resource allocation that results whenever firms have market power may be more conducive to the technological change than is the productively efficient allocation that results from perfect competition. INTRODUCTION - MARKET FAILURE

Four Types of Goods Rivalrous Non-rivalrous (up to capacity) Excludable Normal goods Apples Dresses TV sets Computers A seat on an aeroplane Art galleries Museums Fences Roads Bridges Non - Excludable Common property Fisheries Common land Air Streams Public goods Defence Police Public information Some navigation aids Broadcast signals

 If one person consumes some of a rivalrous good or service, that reduces the amount available for consumption by others.  If one person consumes some of a non-rivalrous good or service, the amount available for consumption by others is not reduced.  Producers of an excludable good or service can prevent people from consuming it and hence can charge for providing it.  Producers of a non-excludable good cannot prevent anyone form consuming it and hence cannot charge for providing it.  Normal goods, shown in the top left segment, are rivalrous and excludable. Four Types of Goods

 Many goods are non-rivalrous (up to the capacity of the producing unit) but are excludable (bottom left hand segment). Examples are listed in the bottom left segment.  These goods can be provided to an additional consumer (up to capacity) at a zero marginal cost.  Common property resources are rivalrous but non-excludable (top right hand segment). They will tend to be over used in free market conditions because additional users cannot be excluded.  Public goods are non-excludable and non rivalrous. They will not be provided by the free market. Four Types of Goods

Total cost: old technology T Total cost: new technology Value of total catch Number of Boats Over-fishing of a Common Property Fishery

 Adding boats to the fleet adds to the total catch but at a diminishing rate up to 140 boats.  After 140, additional boats lower the total catch.  With the old technology, the cost (capital and current) of running each boat is £10,000, giving the steeper of the two total cost curves.  The socially optimal level is 35 boats.  Here the addition to total catch, as shown by the slope of the tangent to the total catch curve, just equals the addition to the total cost of running one more boat, as shown by the slope of the total cost curve.  At that point there is a surplus of revenue over total cost of £150,000. Over-fishing of a Common Property Fishery

 However, at that fleet size, a new boat expects to catch about £14,300 (i e. £500,000/35) worth of fish, so entry is profitable from the private point of view.  With free entry the fleet will grow to 100 boats.  At 100 boats a new boat expects to catch £10,000 worth of fish, which just matches its cost.  Now let the technology change so that each boat costs only £4,000 to run.  Under free entry the fleet will expand to 200 boats.  It will catch £800,000 worth of fish.  This yields revenue of £4,000 per boat, which just matches cost.  Once again, production has been pushed beyond the point of negative marginal returns and hence well beyond the social optimum. Over-fishing of a Common Property Fishery

Quantity Price MC DmDm DbDb DaDa p1p1 p0p0 p2p2 q0q0 A Public Good

 The society’s demand curve for a public good is the vertical sum of all the individuals’ demand curves.  The demand curves D a and D b refer to two individuals.  Their collective demand is shown by D m which is the vertical summation of D a and D b.  For example:  individual a would pay p 0 for quantity q 0.  individual b would pay p 1 for the same quantity.  together they are willing to pay the sum of p 0 and p 1, which is p 2. A Public Good

 The optimal quantity of the good to produce is q 0, where the marginal cost curve MC cuts the collective demand curve.  At this point the marginal cost of another unit is just equal to the sum of the values that each person places on that unit. A Public Good

Production Price, cost MC s MC p Marginal private cost D p1p1 p0p0 q*q* Private and Social Cost q0q0 Market price Full marginal social cost Marginal external cost

 Negative externalities cause marginal social cost to exceed price in competitive equilibrium.  Marginal social cost, MC s, exceeds marginal private cost, MC p, by the amount of the external cost imposed on others.  At the competitive output, q 0, marginal private cost equals price, but marginal social cost exceeds it.  The socially optimal output is q*, where MC s = market price.  For every unit between q* and q 0, marginal social cost exceeds price and hence its production involves a social loss. Private and Social Cost

Firm B Firm A Cost per tonne eliminated [£] Tons of pollution eliminated 0 Pollution Abatement

 Efficient methods of abating pollution take account of differences in costs of abatement among firms.  For any given amount of abatement, firm A has a higher cost of a further unit of abatement than has B.  (1) Let each be ordered to reduce pollution by 90 units.  A’s marginal cost of £100 exceeds B’s marginal cost of £50.  This is inefficient.  A could cut its abatement by one unit, saving £100, while B increased its abatement by one unit, adding £50 to its costs.  Total abatement would then be unchanged but costs would fall by £50. Pollution Abatement

 (2) Now let an emissions tax of £80 per tonne of pollution be imposed.  Low-cost firm B now abates pollution by 120 tonnes.  High-cost firm A abates by 60 tonnes.  This is the efficient way of producing 180 tonnes of abatement since the two firms have the same abatement costs at the margin, thus minimizing the total cost of reducing pollution by 180 tonnes. Pollution Abatement

Firm B Firm A Cost per tonne eliminated [£] Tons of pollution generated 0 Tradable Pollution Abatement 30

Tradable pollution permits  Tradable permits achieve the same results as the most efficient tax.  Each firm produces 150 tonnes of pollution when no abatement procedures are followed.  Abatement reduces the amount of pollution but at a rising marginal cost.  Each firm is originally given an endowment of permits to emit 60 tonnes of pollution.

Tradable pollution permits  If no trading is allowed, the marginal costs of abatement are then £120 for A and £50 for B.  With trading, B sells 30 tonnes worth of permits to A.  Firm A then pollutes by 90 tonnes and firm B by 30 tonnes.  The price of a permit is £80.  This is the same as both firms’ marginal cost of abatement at their new levels of pollution.

[i]. Losses in a falling-cost industry Price Output 0 [i] Pricing Policies for Natural Monopolies MC ATC D1D1 q1q1 q1q1 p2p2 c1c1 p1p1

Pricing policies for natural monopolies (i) falling cost  Marginal cost pricing leads to losses:  The output at which marginal cost equals price is q 1.  The associated price is p 1.  Average costs are falling at output q 1 so marginal costs are less than the average cost of c 1.  There is a loss of c 1 – p 1 on each unit making a total loss equal to the dark blue area.  Average cost pricing is inefficient:  The output at which average cost equals price is q 2.  The associated price is p 2.  Marginal cost is less than price at q 2, so output is less than the socially optimal level.

[i]. Profits in a rising-cost industry Price Output 0 [ii] Pricing Policies for Natural Monopolies MC ATC D2D2 q1q1 q2q2 p2p2 c1c1 p1p1

Pricing policies for natural monopolies (ii) rising cost  Marginal cost pricing leads to profits:  The output at which marginal cost equals price is q 1.  The associated price is p 1.  Average cost of c 1 is less than price at output q 1.  There is a profit of p 1 - c 1 on each unit sold, making a total profit equal to the blue area.  Average cost pricing is inefficient:  The output at which average cost equals price is q 2.  The associated price is p 2.  Marginal cost exceeds price at q 2, so output is greater than the socially optimal level.