MARKET FAILURES AND GOVERNMENT INTERVENTION

Transcription

1 MARKET FAILURES AND GOVERNMENT INTERVENTION Market System - compared with alternatives, decentralized markets are flexible and leave scope for adaption to change at any moment in time and for quicker adjustment over time. - it allows for coordination without anyone needing to understand how the system works or to do the coordinating. - provides stimulus to innovation and growth in the form of profit - when relative prices reflect relative costs, producers and consumers use the nation s resources in a manner that is consistent with allocative efficiency - the price system sets into motion forces that correct disequilibrium The well functioning of markets is dependent on markets being complete (no externalities, property rights defined) and convexity. When markets do work: - every competitive equilibrium is Pareto optimal. - every Pareto optimum can be sustained as a competitive equilibrium. Pareto optimum: it is not possible to reallocate resources, so as to make one person better off without harming someone else. Conditions for Pareto optimum (1) production efficiency: MRTS equal within each industry and across industries. (PPF) (2) exchange efficiency: MRS equal (3) MRS = MRT Some Definitions

2 2 Externality: when one economic agent imposes costs (benefits on another agent that are unaccounted for. Moreover, there is no mechanism to account for these costs/benefits. Internalization of externality: a tax/subsidy is charged to account for the external effect. Nonrivalry of consumption: the consumption of a unit of the good does not detract, in the slightest, from the consumption opportunities still available from that same unit to others. Nonexcludable benefits: once provided, the benefits of the good goes to everyone. Free rider: Easy rider: Private good: this arises from nonexcludable benefits. An agent who consumes the public good s benefits does not willing pay for this benefits. Nonrevelation of preferences means that public provision may be necessary. the person s payment for the public good is less than the benefits conferred to society. excludable and rival (e.g., food) Pure Public Good: nonexcludable and nonrival (e.g., removal of pollution, deterrence). Excludable and nonrival: knowledge, TV signal Nonexcludable and rival: oil pool Excludable and partially rival (club good): highways and parks Case for Intervention Market Failure: when free markets do not produce an efficient allocation of resources and some form of intervention is needed

3 3 1. MONOPOLY POWER - although productive efficiency is achieved, allocative efficiency is not achieved. MSB not equal to MSC and sum of PS and CS is not maximized. - monopoly power is tied to e and potential rivals. p 2. Externalities - private cost measures the value of best alternative uses of the resources available to the producer. - social cost measures the value of the best alternative uses of the resources available to whole society. - social benefit measures the value to society of the last unit consumed. Ideally it is measured by price. MSC not equal to MSB but MPC = MPB known as third-party effects; neighborhood effects Examples: noise from apartment, burning leaves, pollution, terrorism in a host country with collateral damage on foreigners

4 4 - note MSB = MPC + MEC vertical sum - MEC = marginal external cost (difficult to measure) - Pigouvian tax = distance ab which also equals distance ab between MEC and horizontal axis - standard set at Q (supported by producers) S - Q < Q S M - do case of subsidy

5 5 3. ASYMMETRIC INFORMATION - One party to transaction can take advantage of special knowledge in ways that change the nature of the transaction itself. - Moral hazard (hidden action): one party to transaction has both the incentive and knowledge (ability) to shift costs onto the other party. Insurance contracts, doctors, lawyers. - Adverse selection (hidden types): the tendency of people who are most at risks to buy the insurance. Rely on hidden information to gain an advantage through misrepresentation. 4. PUBLIC GOOD - Sum of MRS = MC - Vertical sum of demand (MRS) curves - Free riding problem - Discrete versus continuous choice A: B: Don t Contribute Contribute Don t * Contribute 0, 0 5, -1 Contribute -1, 5 4, 4 Benefit of 5 per unit Cost of 6 per unit Prisoner s Dilemma with a dominant strategy not to contribute A Nash equilibrium of no contributions - Do a case where benefits are 6 per unit and costs are 5 per unit. Privileged game.

6 - Do a case where it is weakest link, need a unit from each before positive benefits. Benefits per unit of 10 and costs 12. Assurance game Number of other five nations curbing 6 0 curbs 1 curbs 2 curb 3 curb 4 curb 5 curb i Don t * Curb Curb Curb by 25% implies a per-unit benefit of 10 at a cost of 14 All zeros at N.E. versus all 46 at Pareto optimum $ MC P 2 Sum of demands D 2 P 1 D 1 0 X* X

7 7 RESPONDING MARKET FAILURES 1. Public Provision in case of public goods 2. Standards or rule making 3. Pigouvian taxes/subsidies 4. Coase solution (bargaining) 5. Courts; liability assignment 6. Structuring incentives: taxes, fines, scholarships, subsidies 7. Creation of institution 8. Do nothing 9. Issue permits and allow them to be traded to go to highest valued use (Tradeable emission permits) 10. Government regulation (e.g., fisheries) 11. Redistribution of income and social insurance programs CAUSES OF GOVERNMENT FAILURES 1. Information asymmetries (Principal-Agent problems) 2. Incentive problems of government officials 3. Too costly to correct problem (high transaction costs) 4. Failure to consider private alternatives 5. Arrow paradox of voting/logrolling/lobbying 6. Myopia 7. Rent seeking 8. Rigidities 9. Inefficient means chosen 10. Governments as monopolies Governments have two legitimate goals - correct externalities and provide public goods - engineer redistribution of income Note: Pollution control must minimize cost of pollution control. MAC = MAC MAC = marginal abatement cost 1 2