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

3.1. 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

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

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

3.2. Sources of Market FailuresPublic goods Externalities Natural monopoly Imperfect informationMerit goods Income distribution/equalityUnemploymentInflation

3.3. Public Goods (1)

Three main characters:Non-rivalryNon-excludableNon-congest

3.3. Public Goods (2) Three types public goods:

Excludable, non-rival public good impure public goodsNon-excludable, rival public goods impure public goods Non-excludable, non-rival public good pure public goods

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

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 optimumThough not achieve ‘Pareto Efficiency’,

private provision will result in social improvement

3.4. Public Goods with Non-Excludable, Rival Public Characters (1)

Common property resource Example, ocean fishing ground If market mechanism over fishingTragedy of the Common Individual rationality leads to collective

disaster

3.4. Public Goods with Non-Excludable, Rival Public Characters (2)Resource depletion and dissipation of

economic rentEconomic rent incentive for

conservationPareto inefficiencyGovernment intervention is desirable to

improve the condition

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 presentHence, government intervention is

desirable in building the lighthouse

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

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

3.7. Positive Externalities: Problem of Under Supply of Goods Generating Positive Externalities

MSB

MPBMPC

Qm Qs

Pm

Ps

Price SociallyOptimum

Note: Qm < Qs

3.8. Negative Externalities: Problem of Over Production of Goods Generating Negative Externalities

MSC

MPC

MB

Price

QmQs

Pm

Ps

Supply Curve

Demand Curve

Socially Optimum

Note: Qm > Qs

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

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

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 ?

3.9. Imperfect Information (1)

Facts Information is imperfect Information is costly to acquire

Direct consequence Asymmetric information between market actorsE.g Buyer vs seller, employee vs employer

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

3.10. Other Market Failures Market is not concern about all these:

Provision of merit goods Controlling inflation

Poverty alleviationControlling Unemployment Income redistribution

Government intervention is desirable to address and solve them

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

3.11. Government Failures (2)Why government failures occur?

Conflict of interest’Political motivesRent seeking activities

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.