Market Failure Topic 8

What failure? In general, competition gives better results than a monopoly in terms of output, price & consumer surplus But in some cases competition does not give desirable results, and Government intervention becomes necessary.

Sources of Market Failure Produce the wrong amounts of goods or services due to externalities or ‘spillovers’ Failure to allocate sufficient resources to the production of certain goods, called ‘public’ or ‘social’ goods Information constraints Rent seeking & monopoly Non-market goals

Externalities (or spillovers) Definition: Costs or benefits associated with the production or consumption of a good (or service) that flow on to 3rd parties outside the market transaction External Costs e.g. pollution from cars, smoke from factories etc External Benefits e.g. development of new technology can also benefit the society as well as the firm concerned Buyer Seller 3rd Party

External Costs or Diseconomies External cost = bf Over allocation of resources Qe equilibrium output Q0 socially optimal output Society’s loss = cbf Conclusion: When the supply curve fails to include external costs, the equilibrium price is artificially too low and the equilibrium quantity is artificially too high (ie. there is an overallocation of resources) Includes external costs Excludes external costs

External Costs or Diseconomies Policy implications: Try to internalise (or capture) external costs Ban the products Impose additional duties and taxes Property rights (eg. in the case of environmental pollution)

Correcting for External Costs P S TAX Over-allocation corrected D Q Q0 Qe

External Benefits or Economies External benefit = gk Under allocation of resources Qe equilibrium output Q0 socially optimal output Society’s loss = gkh Policy implications: Government produces the goods Subsidize producers or buyers Property rights (patents etc.) Includes external benefits Excludes external benefits

Correcting for External Benefits P Dt S D Subsidy to consumer Under-allocation corrected Q

Correcting for External Benefits St Subsidy to producers increases supply P S′t Under-allocation corrected D Q Qe Q0

Characteristics of Private Goods Goods that are produced through the market system. Divisible: goods comes in units small enough to be bought by individual buyers. Excludable: people who are willing and able to pay the equilibrium price will consume the product, but the people who are unable or unwilling to pay are excluded from the benefits provided by that particular product.

Characteristics of Public Goods Goods would not be produced at all by the market system. Indivisible: goods that cannot be divided into “units” so that they can be sold to individual buyers. Non- Excludable : there is no effective way of excluding individuals from the benefit available from the consumption of public goods once these goods have been produced. Goods that have both characteristics are referred to as pure public goods.

Public Goods vs. Private Goods Produced through the market system Divisible Excludable (ie. subject to the exclusion principle) Examples ? Public goods Not provided by the market system Indivisible/joint consumption possible Non-excludable (ie. not subject to the exclusion principle) – free rider problem Examples ?

Free - Rider Problem Free-Rider Problem: when people can receive benefits from the consumption of goods and services without contributing directly to its costs. Given the inapplicability of the exclusion principle (free-rider problem), there is no economic incentive for private firms to supply public goods. As a result, government has to step in to provide the good (or service) because of its substantial social benefits

Characteristics of Quasi (near) public goods Joint consumption is possible up to a certain capacity Exclusion is possible Eg. public transport (bus, train travel), museums, libraries, a football match, etc NOTE: In some cases Public / Quasi public goods can be privately produced. In this case “public” does not mean “Government owned or made”.

Information Constraints Consumers may not have complete information (or understanding) about some products e.g. medicines, houses, cars, TV sets etc If the consequences of having incomplete or wrong information are severe, the Government may intervene Interventions could be in the form of warranties, production standards, product liability etc.

Rent seeking Rent seeking involves any unproductive activity undertaken to earn supernormal profits e.g. lobbying for quotas, market protection from imports, changes in tax/duties, monopoly rights etc. There is a double loss: (a) resources wasted on rent seeking (b) loss because of misallocation of resources (due to the quota, tariff etc) The Government needs to handle such situations using specific policies

Non market Goals We have always considered profit maximisation to be the ultimate economic goal for a firm Some activities are not driven by profit (or may not even generate any revenue) socially desirable e.g. orphanages, animal shelters, free primary education etc. Left to itself, the market will not produce such goods. Thus Government intervention is required.

Past Exam Question When the market fails to operate efficiently, the government may be required to intervene. Outline the type of measures the government would be expected to take when the market failure was due to: (i) an external cost (or external diseconomy) (ii) the commodity involved being a public good.