Market Failures and Government Policy

Market Failures: Externalities and Public Goods Society's microeconomic objectives equity social efficiency marginal social benefits and costs production where MSB = MSC

Market Failures: Externalities and Public Goods External costs of production MSC > MC

External costs in production MC = S Costs and benefits D P Q1 O Quantity

External costs in production MSC MC = S Costs and benefits P D Q2 External cost O Q1 Social optimum Quantity

Market Failures: Externalities and Public Goods External costs of production MSC > MC External benefits of production MSC < MC

External benefits in production MC = S Costs and benefits P D O Q1 Quantity

External benefits in production MC = S MSC External benefit Costs and benefits P D Q1 Q2 O Social optimum Quantity

External costs and benefits in production MSC MC = S MC = S MSC External benefit Costs and benefits (£) Costs and benefits (£) P D P D External cost O Q Q O Q Q 2 1 1 2 Quantity Quantity (a ) External costs (b) External benefits

Market Failures: Externalities and Public Goods External costs of production MSC > MC External benefits of production MSC < MC External costs of consumption

Market Failures: Externalities and Public Goods External costs of production MSC > MC External benefits of production MSC < MC External costs of consumption MSB < MB

External costs in consumption (MB) MU = D Costs and benefits P D Q1 O Quantity

External costs in consumption (MB) MU = D External cost Costs and benefits P D Q2 MSB O Q1 Social optimum Quantity

Market Failures: Externalities and Public Goods External costs of production MSC > MC External benefits of production MSC < MC External costs of consumption MSB < MB External benefits of consumption

Market Failures: Externalities and Public Goods External costs of production MSC > MC External benefits of production MSC < MC External costs of consumption MSB < MB External benefits of consumption MSB > MB

External benefits in consumption (MB) MU = D Costs and benefits P D O Q1 Quantity

External benefits in consumption (MB) MU = D External benefit Costs and benefits P D Q2 MSB O Q1 Social optimum Quantity

External costs and benefits in consumption External benefit Costs and benefits (£) External cost Costs and benefits (£) P P P P MSB MB MB MSB O O Q 2 Q 1 Q 1 Q 2 Car miles Rail miles (a ) External costs (b) External benefits

Market Failures: Externalities and Public Goods External costs of production MSC > MC External benefits of production MSC < MC External costs of consumption MSB < MB External benefits of consumption MSB > MB Public goods

Market Failures: Externalities and Public Goods External costs of production MSC > MC External benefits of production MSC < MC External costs of consumption MSB < MB External benefits of consumption MSB > MB Public goods non rivalry

Market Failures: Externalities and Public Goods External costs of production MSC > MC External benefits of production MSC < MC External costs of consumption MSB < MB External benefits of consumption MSB > MB Public goods non rivalry non-excludability

Market Failures: Monopoly Power The demand curve under monopoly production at less than the social optimum

A monopolist producing less than the social optimum MC £ AR MR P1 Q1 MC1 O Q Monopoly output

A monopolist producing less than the social optimum £ MC = MSC P1 P2 = MSB = MSC MC1 AR = MSB MR O Q1 Q2 Q Monopoly output Perfectly competitive output

Market Failures: Monopoly Power The demand curve under monopoly production at less than the social optimum Deadweight loss under monopoly consumer and producer surplus consumer surplus

Market Failures: Monopoly Power The demand curve under monopoly production at less than the social optimum Deadweight loss under monopoly consumer and producer surplus consumer surplus producer surplus

Market Failures: Monopoly Power The demand curve under monopoly production at less than the social optimum Deadweight loss under monopoly consumer and producer surplus consumer surplus producer surplus total surplus

Deadweight loss under monopoly £ MC (= S under perfect competition) Consumer surplus a Ppc Qpc Producer surplus AR = D O Q (a) Industry equilibrium under perfect competition

Market Failures: Monopoly Power The demand curve under monopoly production at less than the social optimum Deadweight loss under monopoly consumer and producer surplus consumer surplus producer surplus total surplus the effect of monopoly on total surplus

Deadweight loss under monopoly £ MC (= S under perfect competition) MR Deadweight welfare loss Consumer surplus b Pm Qpc a Ppc Producer surplus AR = D O Qpc Q (b) Industry equilibrium under monopoly

Deadweight loss under monopoly £ MC (= S under perfect competition) Perfect competition Consumer surplus a Ppc Qpc Producer surplus AR = D O Q (a) Industry equilibrium under perfect competition

Deadweight loss under monopoly £ MC (= S under perfect competition) Monopoly MR Deadweight welfare loss Consumer surplus b Pm Qpc a Ppc Producer surplus AR = D O Qpc Q (b) Industry equilibrium under monopoly

Market Failures: Monopoly Power The demand curve under monopoly production at less than the social optimum Deadweight loss under monopoly consumer and producer surplus consumer surplus producer surplus total surplus the effect of monopoly on total surplus Other problems with monopoly

Market Failures: Monopoly Power The demand curve under monopoly production at less than the social optimum Deadweight loss under monopoly consumer and producer surplus consumer surplus producer surplus total surplus the effect of monopoly on total surplus Other problems with monopoly Possible advantages from monopoly

Other Market Failures Ignorance and uncertainty Immobility of factors and time lags Protecting people's interests dependants the principal–agent problem the problem of asymmetric information the need for monitoring poor economic decision making by people merit goods Macroeconomic goals Economists and policy advice

Government Intervention: Taxes and Subsidies The use of taxes and subsidies to correct externalities the optimum size of a tax

Using taxes to correct a market distortion MC = S Costs and benefits D P Q1 O Quantity

Using taxes to correct a market distortion MSC MC = S Costs and benefits P D Q2 External cost O Q1 Social optimum Quantity

Using taxes to correct a market distortion MSC MC = S Optimum tax = MSC – MC Costs and benefits P D Q2 MC O Q1 Quantity

Government Intervention: Taxes and Subsidies The use of taxes and subsidies to correct externalities the optimum size of a tax the optimum size of a subsidy

Using subsidies to correct a market distortion MC = S Costs and benefits P D O Q1 Quantity

Using subsidies to correct a market distortion MC = S MSC External benefit Costs and benefits P D Q1 Q2 O Social optimum Quantity

Using subsidies to correct a market distortion MC = S MSC MC Optimum subsidy = MC – MSC Costs and benefits P D O Q1 Q2 Quantity

Government Intervention: Taxes and Subsidies The use of taxes and subsidies to correct for monopoly use of lump-sum taxes Advantages of taxes and subsidies Disadvantages of taxes and subsidies infeasible to use different tax and subsidy rates lack of knowledge

Government Intervention: Laws and Regulation The use of laws and regulation Advantages of legal restrictions simple to understand safer when size of problem is potentially great quick to implement a good way of dealing with imperfect information Disadvantages of legal restrictions a 'blunt weapon'

Government Intervention: Laws and Regulation Types of regulation The system of regulation in the UK UK regulatory bodies price-cap regulation the RPI–X formula Advantages of the UK system discretionary flexible incentive for firms to reduce costs Disadvantages of the UK system

Other Forms of Government Intervention Changes in property rights the problem of limited property rights extending property rights limitations of this solution impractical in many situations problems of litigation questions of equity Provision of information consumer information information on jobs information to firms

Other Forms of Government Intervention Direct provision of goods and services the provision of public goods the need to evaluate costs and benefits of publicly provided goods the provision of other goods and services by the government social justice large positive externalities dependants ignorance

More or Less Intervention? Drawbacks of government intervention shortages and surpluses poor information bureaucracy and inefficiency lack of market incentives shifts in government policy lack of freedom for the individual

More or Less Intervention? Advantages of the free market automatic adjustments dynamic advantages of capitalism possibly high degree of competition even under monopoly/oligopoly Judging the arguments Should there be more or less intervention in the market? important to consider both costs and benefits of intervention moral issues problem of predicting effects of intervention

The Environment: a Case Study The environmental problem global and local environmental problems causes of the problems Market failures environment as a common resource externalities ignorance inter-generational problems

The Environment: a Case Study Policy alternatives charging for use of the environment emissions charges

An emissions charge MSC MB = MSB P2 L2 P1 = 0 L1 Costs and benefits (£) P2 L2 P1 = 0 L1 Level of emission

The Environment: a Case Study Policy alternatives charging for use of the environment emissions charges user charges

The Environment: a Case Study Policy alternatives charging for use of the environment emissions charges user charges optimum charge = external cost

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

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

Green tax revenues as a % of GDP

Green tax revenues as a % of GDP

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

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

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

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 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 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