2. 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. 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

4. 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

5. 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

6. 3.2. Sources of Market Failures  Public goods  Externalities  Natural monopoly  Imperfect information  Merit goods  Income distribution/equality  Unemployment  Inflation

7. 3.3. Public Goods (1)  Three main characters:  Non-rivalry  Non-excludable  Non-congest

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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 ?

21. 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

22. 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

23. 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

24. 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

25. 3.11. Government Failures (2)  Why government failures occur?  Conflict of interest’  Political motives  Rent seeking activities

26. 3.12. Readings  Stiglitz, Joseph E. 2000. “Economics of the Public Sector”. New York: W.W. Norton and Company. Chapters 4 and 5  Weimer, David L. and Vining, Aidan R. 1992. “Policy Analysis: Concepts and Practice”. New Jersey: Prentice Hall. Chapters 3,4 and 5.