Market Failures. Lecture 13: Market Failure and Government Action. Insufficient Competition. Insufficient Competition. Insufficient Competition

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1 Slide 17-1 Lecture 13: Market Failure and Government Action Market Failures Markets can fail to be efficient: Readings: Chapters 13 (pp ), 16, 17 Public goods And Markets can be unfair: Inequality Poverty Slide 17-2 Q: How do governments intervene in markets which have insufficient competition? A: The main policy instruments are: Regulation Public ownership Anti-combine law Q: How does government supply regulation? A: Regulatory agencies vary in size and scope. But there are certain features common to all agencies. Government appoints the senior bureaucrats who are the key decision makers. Each agency adopts a set of practices or operating rules for controlling prices, product standards, and other aspects of economic performance. Agency certifies firms to serve a particular market. Slide 17-3 Slide 17-4 Q: What determines government provision of regulation? A: It is a product of the political process, and hence will reflect a political equilibrium. In recent years, the equilibrium has shifted towards de-regulation (a reduction in the provision of regulation) Q: Why has there been a move towards de-regulation? A: There has been growing evidence that regulation to protect the public frequently only succeeds in protecting the regulated firms from competition. Capture theory says that regulations are supplied to satisfy the demand of producers to maximize economic profit. Slide 17-5 Slide 17-6

2 Slide 17-7 Q: Why have regulation at all? A: If a firm has diminishing average costs, it will be a natural monopoly. With no competition, there will be severe under-supply and prices will be dramatically higher than marginal costs. Regulation is one way of forcing output up and prices down. Price and cost (dollars per household per month) Natural Monopoly: Profit Maximization Economic profit Consumer surplus Deadweight loss MR Quantity (millions of households) D ATC Slide 17-8 Natural Monopoly: Marginal Cost Pricing Natural Monopoly: Average Cost Pricing Price and cost (dollars per household per month) Total surplus Loss per household Quantity (millions of households) D ATC Slide 17-9 Price and cost (dollars per household per month) Consumer surplus Producer surplus Deadweight loss Quantity (millions of households) D ATC Slide 17- Q: Does price regulation reduce the excess burden from natural monopoly? A: Capture theory predicts that the producer will get the regulator to set rules that allow it to charge the same price and produce the same output as an unregulated monopoly. Firms can do this by exaggerating their costs. Slide Price and cost (dollars per household per month) Natural Monopoly: Inflating Costs Economic profit Profit is maximized MR Quantity (millions of households) ATC (inflated) ATC D Slide 17-12

3 Slide Q: Is regulatory capture a real problem? A: A test of whether natural monopoly regulation is in the public interest or producer interest by measuring rates of return in regulated monopolies. Many natural monopolies in Canada earn higher rates of return than the economy average. (i.e. cable television service; telephone service) Q: What is the alternative to regulation? A: Formation of crown corporations: Canada Post, Ontario Hydro, etc. Q: Are crown corporations efficient? A: With a public subsidy, a crown corporation can supply the market at marginal cost and achieve the efficient output level. Slide Price and cost (dollars per tonne) Crown Corporation: Efficient Outcome Consumer surplus Tax payment Subsidy per tonne: efficient output D ATC Quantity (billions of tonnes per year) Slide Q: Have Crown Corporations served the public interest? A: Over time, a different sort of capture may set in. Managers will tend inflate costs, and make themselves the residual claimants. Slide Crown Corporation: Budget Maximization Price and cost (dollars per tonne) Subsidy per tonne: efficient output but maximizing budget Quantity (billions of tonnes per year) D ATC (inflated) ATC Slide Q: Are crown corporations inefficient? A: Case study: CN had costs 14% higher than CP. Ontario Hydro routinely pays its workers wages above the market rate. In recent years, there has been a move to privatize publicly owned corporations. Petro-Canada (1991), Ontario Hydro (02) Slide 17-18

4 Slide Q: What are externalities? A: are costs or benefits that arise from economic transactions that fall on people who do not participate in the transaction. When externalities exist, the parties to the transaction consider only their own costs and benefits, and not those social costs accruing to third parties. There are two types of : A negative externality occurs whenever a person s well being or a firm s production capability is directly harmed by the actions of other consumers or firms. A positive externality occurs whenever a person s well being or a firm s production capability is directly improved by the actions of other consumers or firms. Slide 17- Q: How do negative externalities affect social outcomes? A: Negative externalities include: Acid Rain Ozone layer Depletion Smog alerts Global Warming Bacterial ground water contamination (Walkerton) heavy metal and persistent toxic chemical contamination of land and ground-water, etc. Q: Has economic growth doomed the environment? A: It has put tremendous pressure on it, but at the same time higher incomes has lead to the increased demands for a clean environment. Slide Slide : Air Pollution Q: Why do negative externalities occur? A: An absence of property rights. Property rights are social arrangements that govern the ownership, use, and disposal of productive resources and goods and services. Slide Slide 17-24

5 Slide Externality Impact Q: How does an absence of property rights create environmental problems? A: Because no one owns the air, the rivers, and the oceans, they are available for free use with no restriction. Users consider only their private interest in deciding how to use the productive resource. Cost and benefit of waste (dollars per tonne) Fishing club bears large cost... when factory maximizes its benefit by dumping waste MB MSC Quantity of waste (tonnes per week) Slide Q: What can the government do to correct market failures? A: The government has two options: 1. It can assert sole ownership over the commons resource and limit use: 1.1) pollution controls and standards 1.2) emission charges and taxes 2. It can distribute private property rights: 2.1) Common law rights 2.2) Marketable emission permits Slide Q: Do standards work? A: Economists have been concerned that standards have largely failed to be implemented effectively. Political equilibrium is susceptible to special interest group manipulation. Even when they have been implemented, they are not usually the most efficient method for reducing pollution. Slide Q: What s the problem with standards? A: Suppose the government decides that pollution should be reduced by 25% and orders all firms to reduce their pollution from current levels by 25%. Some firms may find this extremely expensive and close. Others could reduce their pollution by 75% at very little cost but are only required to reduce pollution by 25%. Slide Q: Can government policy force firms to distribute the burden of reduction in the most efficient manner possible? A: Emission charges: The government regulator sets a charge per unit of pollution. The efficient emission charge is set so that the marginal social cost of pollution is equal to its marginal social benefit. Slide 17-30

6 Slide : Emission Charges Cost and benefit of waste (dollars per tonne) 15 7 Efficient price per tonne MSC At $7/tonne, MSC > MB MB Emissions (millions of tonnes per year) Q: What if emission charges cannot be assessed (ie noise pollution). A: The government could introduce a Pigouvian Tax which discourages the activity that has the negative externality associated with it. Q: What is the correct Pigouvian tax? A: If the tax is set equal to the external marginal cost, then efficient outcome will be achieved. Slide Competitive markets oversupply if there is pollution Cost, price, and benefit (dollars per kilometre) SC 0 P 1 Point of allocative efficiency MSC = P + E E S = P External Cost at Competitive Equilibrium Cost, price, and benefit (dollars per kilometre) SC 0 P 1 MSC External cost S = P 0 Competitive equilibrium P 0 Competitive equilibrium C 1 D = MB C 1 D = MB 0 Q 1 Q 0 Quantity (kilometres) 0 Q 1 Q 0 Quantity (kilometres) Slide Slide Cost, price, and benefit (dollars per kilometre) SC 0 P 1 C 1 Pigouvian Tax 0 Point of allocative efficiency MSC D = MB Q 1 Q 0 Quantity (kilometres) S + T S = Slide Q: What are the problems with government asserting ownership over the commons? A: There are several: Political equilibrium may not be efficient. Business will resist the huge transfer to government implied by the government solution. (ie carbon tax resistance) Slide 17-36

7 Slide Q: What are the private property solutions to pollution? A: The government can clarify and extend common law rights, or it can establish and distribute marketable emission permits. Q: How does extending common law property rights solve the externality problem? A: Many problems occur because when no one owns a resource, everyone thinks they own it. Extending property rights would clarify who owns the resource. The owner could then set about limiting use of the resource. Slide Q: If common law property rights are extended, does it matter who gets them? A: According to the Coase theorem: 1. If transaction costs are low, the (common law) assignment of property rights will solve the externality. 2. It will not matter who receives the property right. Q: How does this work: A: It will depend on who receives the property right: If the polluted party is given control of the environment, they can force the polluter to reduce pollution. If the polluter is given control of the environment, the polluted party may choose to pay the polluter to reduce pollution. Slide Slide The Coase Theorem Cost and benefit of waste (dollars per tonne) MSC Efficient level of waste MB Quantity of waste (tonnes per week) Q: Can we rely on Coasian bargains to resolve all negative externalities? A: No! Transaction costs are frequently high because: 1) There are many affected parties 2) people bargain strategically, and fail to agree on a price. Slide Slide 17-42

8 Slide Q: How does a system of marketable emission permits work? A: A maximum allowable amount of pollution is determined. Permits which sum to this total are distributed to current polluters. A firm is permitted to only pollute up to the amount of the permits held. A firm can either buy or sell its permits. Q: Why is this system efficient? A: It will be expected that firms that can easily abate pollution will choose to sell their permits to firms that find it expensive to abate. The result is that the least cost method distribution of abatement will automatically be found. Slide Q: What sorts of positive externalities are there? A: There are many, among which include: Landscaping Inoculations Education Q: In what way does education have a positive externality associated with it? A: External benefits: Citizens who can better communicate and interact Good ideas/inventions can be copied Slide Slide Q: Does this create a market failure? A: Education and research and development decisions are made by comparing private marginal costs and private marginal benefits. When decision-makers neglect external benefits there will be underinvestment in education and R&D without government intervention. Q: How does the government solve this market failure? A: The government has three main policy instruments to correct the market failure: Subsidies Below-cost provision Patents and copyrights Slide Slide 17-48

9 Slide A subsidy is a payment made by the government to producers that depends on the level of output. Providing a subsidy to producers reduces their private marginal cost. If a subsidy is provided equal to the external benefit, an efficient outcome will be achieved. The Efficient Quantity of Education Cost, price, and benefit (thousands of dollars per student per year) Competitive equilibrium External benefit Efficient allocation D = MPB MSB Quantity (thousands of students per year) Slide Instead of offering subsidies to private schools, the government can provide its own schools that provide schooling below cost. It may still charge tuition equal to the marginal private benefit of education. It can also establish its own research facilities. In education, direct provision is larger; in R&D, subsidies are main tool. Slide Q: Is there a private property solution? A: Since knowledge is productive and creates external benefits, it is necessary to use public policies to ensure that there are incentives to develop new ideas. Intellectual property rights provide the creators of knowledge with property rights to their discoveries. Slide Patents or copyrights are government-sanctioned exclusive rights granted to the inventor or a good, service, or productive process. Obtaining a patent allows the developer of the new idea to prevent others from benefiting from the invention for a number of years. To obtain the patent, the inventor must make knowledge of the invention public. The economic cost of patent protection is the deadweight loss of monopoly. But without patents, the effort to develop new goods, services, or process is diminished, and the flow of new inventions would slow. Patent protection trades off the benefits of more invention against costs of monopoly over a limited time. Slide Slide 17-54

10 Slide Q: What are public goods? A: Public goods are goods or services that are consumed simultaneously by everyone and from which no one can be excluded. 1) Nonrivalry The consumption by one person does not decrease the consumption by another. Television show 2) Nonexcludable It is impossible, or extremely costly, to prevent someone from benefiting from a good. National defence Slide and Private Goods Pure private goods Nonexcludable & rival Fish in the ocean Air Food Car House Excludable & nonrival Cable television Bridge Highway Pure public goods Lighthouse National defence and The Free-Rider Problem A free rider is a person who consumes a good without paying for it. Public goods create a freerider problem because the quantity of the good that a person is able to consume is not influenced by the amount the person pays for the good...so why pay anything at all? Slide Slide Q: What is the social value of another unit of a public good? A: As everyone will jointly consume this additional unit of the public good, its total social value (its social marginal benefit) is the sum of every persons maximum willingness to pay. Social Marginal Benefit = sum of each individual s marginal willingness to pay. The social marginal benefit at each provision level can be derived by vertically summing each individual s demand for the public good. Slide Marginal benefit (dollars per acid-rain check) Benefits of a Public Good Lisa's Marginal Benefit MB L Marginal benefit (dollars per acid-rain check) Max's Marginal Benefit MB M Quantity (number of acid-rain checks) Quantity (number of acid-rain checks) Slide 17-60

11 Slide Benefits of a Public Good Marginal benefit (dollars per acid-rain check) Economy's Marginal Benefit MB Quantity (number of acid-rain checks) Contrast this with a private good. Only one person gets to consume a private good, so the social marginal benefit of one unit of the private good is the marginal benefit (maximum willingness to pay) of the person who gets to consume the good. By a little bit of thought you will be able to see that the social marginal benefit curve for a private good is the horizontal summation of the individual demand curves (maximum willingness to pay curves). Slide Q: What is the efficient provision level of the public good? A: The most efficient provision level is where the social surplus is maximized. This occurs where the social marginal benefit (SMB) equals the marginal cost. A rational strategy for finding the efficient provision level is to: increase provision if reduce provision if SMB > SMB < hold provision constant if SMB = Slide Total benefit and total cost (billions of dollars) Quantity (number of acid-rain checks) Quantity (number of acid-rain checks) The Efficient Provision of a Public Good Total Benefit & Total Cost TC Net benefit $2.0 billion TB Marginal benefit (billions of dollars per acid-rain check) 2.0 M 1.0 Marginal Benefit & Marginal Cost MB Efficient use of resources Slide Q: Is private market provision efficient? A: No! Because of the free rider problem, too little of the public good is provided. A private firm will not deliver the efficient quantity of a public good. It needs to charge consumers a price that will cover its costs but once it is produced, no one has an incentive to buy. Example: Lighthouse signal Q: Is government provision efficient? A: To answer this we have to examine what the political equilibrium delivers. Political parties do a what if analysis before determining their policy regarding the provision of public goods. They choose the platform that maximizes their chance of being elected: this means they must maximize the perceived net benefit of a winning coalition of voters. Slide Slide 17-66

12 Slide Public Provision Q: How does political competition between parties influence the platforms on offer? A: Competition for votes tends to move parties to the center. It is in the center that the median voter is found, and hence it is in the center that winning coalitions can be constructed. The implication is that all parties tend to advocate similar provision levels in equilibrium. The principle of minimum differentiation is the tendency for competitors to make themselves identical to appeal to the maximum number of clients or voters. Q: Will the winning platform be efficient? A: The winning platform on public good provision will tend to appeal to the median voter s preferences. Notice that this equilibrium is unrelated to the calculation of the efficient provision level. We therefore cannot expect that the democratic process will deliver an efficient amount of the public good. Slide Q: Is there anything that might complicate the political equilibrium? A: Politics is the art of the possible. Politicians rely heavily on the advice of bureaucrats as to what is possible, and the costs of these possibilities. A bureaucrat s interests are different from the interests of vote maximizing politicians. Slide Q: How do bureaucratic interests alter the political equilibrium? A: There are a number of theories. The simplest suggests that many bureaucrats may seek to maximize the size of their bureau so as to increase their pay and prestige. Such a bureaucrat will thus seek methods to influence the political equilibrium in a way that increases the size of the budget that they control. Slide Bureaucratic Overprovision Total benefit and total cost (billions of dollars) Goal of bureaucracy Efficient provision TC TB Quantity (number of acid-rain checks) Slide Q: How do bureaucrats influence the political equilibrium? A: Bureaucrats controls information about the costs and benefits of proposed public goods. If they exaggerate the benefits or underestimate the costs of a public good, they might be able to get a politician to adopt and implement a platform that promotes a larger provision level than is efficient. Example: Missile Defense Slide 17-72

13 Slide Bureaucratic Exaggeration Total benefit and total cost (billions of dollars) TC TB Q: Are bureaucrats the only group who wish to manipulate the political equilibrium? A: No special interests who have a private stake in public good provision are very active in attempting to manipulate political outcomes Quantity (number of acid-rain checks) Slide Q: How do special interest groups manipulate the political equilibrium? A: By manipulating information. Politicians and voters are uninformed about the costs and benefits of public goods, and interest groups will use advertising and political contributions to influence platforms. Q: Why might democracy be easily manipulated by special interests? A: Rational ignorance. Rational ignorance is the decision not to acquire information because the cost of doing so exceeds the expected benefit. Example: Softwood lumber dispute. Slide Slide Q: What are the most expensive public goods provided by government in wealthy countries? Concern for poor families and poor children has led to desire for the community to do something to help alleviate suffering. One response is to create social norms that laud charitable giving. This is found in virtually all religions of the world. A modern response is to get the State to provide a social safety net of welfare services. END This is a public good, because the benefit (relief that something is being done to help the poor) is shared communally, but the cost is subject to free riding. Public provision financed by taxation solves under-supply problem. Slide Slide 17-78

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