3.1. Problems of Market Failures (1)  In reality, no market such a perfectly competitive market. Market tends to be imperfect  Hence, Pareto Efficiency cannot be achieved if rely on market mechanism in allocating resource in the economy

3.1. Problems of Market Failures (2)  More over, efficiency in allocation of resources is not the only concern of people.  People need some other than resource allocation efficiency, such as more equal distribution of income, good condition of environment, elimination of unemployment and popverty

3.1. Problems of Market Failures (3)  All these are beyond market concern. Since, the market only deals with efficiency  Government intervention is required to satisfy these other needs of people

3.1. Problems of Market Failures (4)  In short, if market fails to achieve pareto efficiency and fail to deliver the other needs of people the government has to substitute the role of market to satisfy all these  Market failures  government intervention  to improve welfare of the society

3.2. Sources of Market Failures  Public goods  Externalities  Natural monopoly  Imperfect information  Merit goods  Income distribution/equality  Unemployment  Inflation

3.3. Public Goods (1)  Three main characters:  Non-rivalry  Non-excludable  Non-congest

3.3. Public Goods (2)  Three types public goods:  Excludable, non-rival public good  impure public goods  Non-excludable, rival public goods  impure public goods  Non-excludable, non-rival public good  pure public goods

3.3. Public Goods with Excludable, Non-rival Characters (1)  Example: Free way  Exclusion makes the service marketable  Price > 0 even though MC =0  provision by private sector becomes feasible  But, private provision will not be Pareto optimum.  Since, price will be determined not by market mechanism (S and D)  MC = P, MC = 0, hence P = 0

3.3. Public Goods with Excludable, Non-rival Characters (2)  Price must be determined by mechanism other than market mechanism, such as government decision  Consequently, the determined price may be too high or too low  Provision will not be optimum  Though not achieve ‘Pareto Efficiency’, private provision will result in social improvement

3.4. Public Goods with Non- Excludable, Rival Public Characters (1)  Common property resource  Example, ocean fishing ground  If market mechanism  over fishing  Tragedy of the Common  Individual rationality leads to collective disaster

3.4. Public Goods with Non- Excludable, Rival Public Characters (2)  Resource depletion and dissipation of economic rent  Economic rent  incentive for conservation  Pareto inefficiency  Government intervention is desirable to improve the condition

3.5.Public Goods with Non-Excludable, Non- Rival Public Characters (1)  Example, lighthouse  Collective action to build  Free rider as constraint for collective action to take place  If free rider problem is not controlable  lighthouse will not be present  Hence, government intervention is desirable in building the lighthouse

3.5.Public Goods with Non-Excludable, Non-Rival Public Characters (2)  However, when ‘ a privilege group’ exists  private provision of the lighthouse is feasible even though free riders are at large  But, the private provision will not be pareto efficiency  undersupply  Hence, government intervention is desirable to improve the supply

3.6. Externalities (1)  Two types by characters :  Negative  e.g. air pollution by manufactures  Positive  e.g. fresh air produced by Bogor botanical garden  Two types by sources :  Consumption  demand curve  Production  supply curve  Government intervension is desirable

3.7. Positive Externalities: Problem of Under Supply of Goods Generating Positive Externalities MSB MPB MPC Qm Qs Pm Ps Price Socially Optimum Note: Qm < Qs

3.8. Negative Externalities: Problem of Over Production of Goods Generating Negative Externalities MSC MPC MB Price Qm Qs Pm Ps Supply Curve Demand Curve Socially Optimum Note: Qm > Qs

3.8. Natural Monopoly (1)  Natural Monopoly?  Cost production declines as scale operation increase  economies of scale  Cause  large total fixed cost  Example,  Production electricity  Airport service for airline landing and take-off

3.8. Natural Monopoly(2)  Large economies of scale  production is best by a single big firm  If monopoly right is granted to a private firm, it may not produce the required goods at the lowest cost  Instead, it may produce at level that satisfy MR = MC to earn extra profit

3.8. Natural Monopoly(3)  If produced at MR = MC  P > MC. Thus, social loss will prevail  Social loss  pareto inefficiency  Government intervention is required to correct the condition  Government own firms (e.g. PT PLN and PT Angkasa Pura)  But, government own firms often create another kind of inefficiency problem ?

3.9. Imperfect Information (1)  Facts  Information is imperfect  Information is costly to acquire  Direct consequence  Asymmetric information between market actors  E.g Buyer vs seller, employee vs employer

3.9. Imperfect Information (2)  Consequences :  Moral hazard problem  Adverse selection problem  Missing markets (e.g absence of crop insurance in Indonesia )  Government intervention is desirable to improve the condition

3.10. Other Market Failures  Market is not concern about all these:  Provision of merit goods  Controlling inflation  Poverty alleviation  Controlling Unemployment  Income redistribution  Government intervention is desirable to address and solve them

3.11. Government Failures (1)  Government intervention often fail to make improvement. Instead, it makes even worsened  Example, provision of electricity power by the government controlled monopolizing firm is often criticized of being inefficient

3.11. Government Failures (2)  Why government failures occur?  Conflict of interest’  Political motives  Rent seeking activities

3.12. Readings  Stiglitz, Joseph E “Economics of the Public Sector”. New York: W.W. Norton and Company. Chapters 4 and 5  Weimer, David L. and Vining, Aidan R “Policy Analysis: Concepts and Practice”. New Jersey: Prentice Hall. Chapters 3,4 and 5.