Managerial Economics Market Failure and Government Intervention Aalto University School of Science Department of Industrial Engineering and Management January 12 – 28, 2016 Dr. Arto Kovanen, Ph.D. Visiting Lecturer

 Thus far we have assumed that market transactions are, for the most part, free of government interference  In reality, however, government intervenes in private transactions in the form of taxes and regulations  Government interventions may be motivated by the failure of the free market to provide a socially optimal allocation of goods and services  We have seen this as a result of e.g. monopoly  Other sources of market failures are externalities and public goods General points

 A perfectly competitive market structure provides a model for evaluating economic efficiencies.  But the conditions are quite demanding:  Large number of buyers and sellers  Homogeneous products  Perfect information (buyers and sellers)  Easy entry and exit by approximately identical firms  Absence of economies of scale  No government intervention in the market place (where are we seeing that) General points (cont.)

 A host of antitrust legislation in the U.S. is aimed at promoting competition in the market place  Sherman Act of 1890 was designed to prevent the growth and exercise of monopoly power  Clayton Act of 1914 was aimed at clarifying the Sherman Act. It outlawed price discrimination, contracts that led customers to purchase one good as a precondition for an other product, contingent purchases (i.e., in order to buy a good from one firm required that the customer refused to buy other goods from competitors) and so on Antitrust legislation (U.S.)

 The production of some goods and services can generate substantial economies of scale and therefore be valued  The large scale, however, leads to “natural monopolies” and it may be in the public’s best interest to allow the monopolies to exist, but under regulation  Example: utilities companies (electricity/water)  In return to a privileged market position, government reserves the right to regulate product prices  The goal is to eliminate the deadweight loss Price regulations

 This can be an effective way to produce at socially optimal level of production (where P = MC)  In practice, it is not easy to assure the correct level of market supply and demand, which could lead to an undesirable allocation of goods  Example: suppose that a monopolist market has the following demand and total cost functions Q = 2,000 – 5P TC = Q + 0.4Q 2 Price regulations (cont.)

 What is the profit-maximizing price and output?  What is the value of consumers and producers deadweight loss?  At what price should the government regulate the monopoly’s output to eliminate society’s deadweight loss?  With the regulated price, what will be the production? Price regulations (cont.)

 Market failure can also occur when a third party is positively or negatively affected by a transaction of someone  Externalities can be positive or negative  Examples: smoking by a room mate (negative), public road to facilitate transportation of goods to market (positive), pollution by a factory (air/water)  Government interventions: emission standards and fees, permits (e.g., US Clean Air Act), and taxes Externalities

 Common property resources are those to which anyone has free access  Negative externalities can arise due to overuse (e.g., use of fishing rights)  A way to solve the problem is to allow a single entity to manage the property who charges others a fee equal to the marginal cost, so that the use is at the optimal level  Sometimes not practical, which leads to government intervention or ownership Externalities (cont.)

 Can exist if sellers of a product have better information about its quality than the buyers  There is nothing wrong with having both high quality and low quality goods in the market  But consumers need to know what the quality of the product is when they are buying it  Example: used cars; 5-star restaurant vs. Joe’s Grill  Asymmetric information can lead to market failure if  Prices are driven down because lack of knowledge of quality Asymmetric information

 Sellers are unwilling to sell high quality products  Results in a situation where only low quality goods exist  Use warranties, money back guarantees etc. to signal the quality of the product  Signaling: high quality producers can send credible and informative signal about the quality  Benefit of signal exceeds costs to high quality producer  Cost exceed benefits to low quality producer  That is, only the high quality producer sends a signal Asymmetric info (cont.)

 Adverse selection: exists when buyer knows more about the actual cost of service than the seller  Example: All-you-can-eat restaurant – big eaters more likely to use them, eating into seller’s profits  Example: insurance – buyer know his/her health better than the insurer (extra life insurance)  Moral hazard: customer modifies behavior after entering into an agreement  Example: investors likely to ask few questions when the investment has a government guarantee Asymmetric info (cont.)

 Assume that 100 individuals want to sell their used cars and 100 individuals want to buy used cars. It is known that 50% of used cars are good and 50% lemons. Current owners know the quality of their cars, but the buyers do not know that.  The owners of lemons ask for $1,000 and the owners of good quality cars ask for $2,000. The buyers are willing to pay $1,200 and $2,400, respectively, for these cars.  What will happen in the market?  The expected cost of a car is $1,800 for the buyer Lemons (example)

 At this “average” price sellers of good cars are unwilling to sell, hence only lemons will be offered for sale  If the buyer were aware with certainty that he would get a lemon, he would not pay more than $1,200, not $1,800!  Market failure arises because no good cars are sold in the market Lemons (cont.)

 Two characteristics distinguish public goods from private goods  Nonexcludability – nobody can be barred from consuming it  Nondepetability – one’s consumption does not reduce the amount others can consume  Examples: public street lights, national defense, and clean air, radio transmission (excl. satellite radio)  Problem with public goods is to find out how much each of us value the good and how much we are willing to pay for having them Public goods

 This gives rise to a free-rider problem: that is, a person is not willing to pay for the provision of public good because he/she thinks other will pay for it (but will like to use it)  Example: street lights  There are good safety-related arguments for having them  When you inquire how much people value street lights, the outcome may be that there is limited support for the (due to the concern that it will be paid for by tax increases)  Hence public support may not be there Public goods (cont.)

 How many street lights should the city install?  Assume that each individual have a personal demand for street lights given by the following demand curve P i = 100 – 2Q where Q = number of street lights  Let us assume that i = 3 and that the marginal cost of installing a street light is $90.  Socially optimal number of street lights is therefore given by 3*(100 – 2Q) = 90, which results in Q = 35 Public goods (cont.)

 Each individuals, however, are only willing to pay $30 for a street light at the optimum (but 3*$30 = $90)  Because of this, each of them will wait others to pay the cost of street lights; in the end no one will pay and no street lights will be provided  To overcome the problem, the city council could decide to provide the street lights and levy a tax to pay them  Will this lead to an efficient allocation of public good? Public goods (cont.)

 If individuals view that the cost of public good is small to them individually (e.g., close-to-free healthcare), it is likely that individuals prefer too much of it and thus the provision of public good exceeds the optimum.  In the street light example, if individuals view that the cost to them is zero, i.e., P i = 0 is zero for each i, then the optimal Q = 50, which is more than socially optimal amount.  What about free higher education or medical care? Public goods (cont.)