market failure & role of regulation (1)

7/31/2019 Market Failure & Role of Regulation (1)

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Market Failure & Role of Regulation

Ganesh kawadia


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Framework

Free Market CompetitiveForcesMarketEfficiency

MarketFailure Regulation

Regulation EquitableDistribution

Objective of Regulation Market Efficiency and Equitable Distribution


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Types of MarketPerfectly Competitive Market

Goods/services offered are all sameNumerous buyers and sellers and no single buyer or seller caninfluence the market price - price takers

OligopolyFew sellersEach participant is aware of the actions of the others

MonopolisticGoods/services are slightly differentiatedNumerous sellers each seller has some ability to influencethe price

MonopolyNo substitute available for the goods/services offeredOnly one seller and this seller sets the price price maker



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Perfectly Competitive MarketFree markets allocate

Supply of goods to thebuyers who values themmostDemand for goods to thesellers who can producethem at least cost

Free market produces thequantity of goods thatmaximizes the sum of consumerand producer surplus

Competitive forces efficientlyallocate the scarce resources

(



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The Invisible HandAdam Smith stated in 1776, while he intendsonly his own gainhe is led by an invisiblehand to promote an end which was no part of hisintention that is to maximize the wealth of

the nationThe competitive market guides and controls theself seeking activities of each individual tomaximize the wealth of the nation.

Laissez faire Allow them to do opposes stateeconomic interventionism (George Whatley,Principles of Trade, 1774)



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What is a Market FailureMarket failure occurs when freelyfunctioning markets, operating withoutgovernment intervention, fail to deliver an

efficient or optimal allocation of resources

Therefore economic and social welfaremay not be maximized

This leads to a loss of economic efficiency



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Definition of Market FailureMarket failure when the competitive outcome of markets is not efficient from the point of view of the economy as a whole

This is usually because the benefits that themarket confers on individuals or firms carryingout a particular activity diverge from the benefitsas a whole

a case in which a market fails to efficientlyprovide or allocate goods and services incomparison to some ideal standard, such as theperfect competition model



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Main causes of Market FailureExternalities causing private and social costs and/or benefits todiverge

Public goods and Common Resources

Market dominance and abuse of monopoly power

Imperfect AsymmetryAdverse Selection Ignorant party lacks information while negotiating atransaction (Akerlof Lemon s Problem);Moral Hazards ignorant party lacks information about performance of

the of the agreed upon transaction (Peltzman argument on insureddriver taking more risks);

Equity issues Markets can generate an unacceptable distributionof income and social exclusion



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Private GoodsPrivate goods are those that peopleindividually buy and consumePrivate firms can profitably provide

because they keep people who do notpay from receiving the benefits.Two characteristics of private goods

are:Rivalry (in consumption)Excludability


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Public GoodsPublic goods are those that everyonecan simultaneously consume and fromwhich no one can be excluded, even if they do not pay.Two characteristics of public goods are:

Nonrivalry (in consumption)

Nonexcludability


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Public GoodsNonrivalry and nonexcludability createa free-rider problem ; once aproducer has provided a public good,

everyone including nonpayers canobtain the benefit.This makes it impossible for firms to gatherresources and profitably provide the good.

In order to have the good, society mustdirect the government to provide it.Surveys and public votes may be used todetermine the demand for a public good.


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Market Failure due to ExternalitiesExternalities create divergence between privateand social costs and benefits

Individual consumers and producers may fail totake externalities into account when makingconsumption and production decisions

Consumers and suppliers are assumed toconsider their own private costs and benefits



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Externalities

An externality occurs when some of thecosts or the benefits of a good are passedon to or spill over to someone otherthan the immediate buyer or seller.Externalities can be positive or negativeand can affect production or consumption.


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Negative Externalities

Negative externalities, or spillover costs ,are production or consumption costs thataffect a third party without compensation.

When negative externalities occur, theproducers supply curve lies to the right of the full-cost supply curve.

The equilibrium output is greater than theoptimal output; resources are overallocated tothe production of this commodity.


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Positive Externalities

Positive externalities are spillover production or consumption benefitsconferred on third parties without

compensation from them.When positive externalities occur, themarket demand curve lies to the left of the full-benefits demand curve.

The equilibrium output is less than the optimaloutput; the market fails to produce enough of the good.


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Externalities


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Market Failure due to ExternalitiesNegative Externalities

Over production of goods where the social costs >private costOver consumption of demerit goods where social benefit

< private benefit

Positive ExternalitiesUnder consumption/provision of merit goods where thesocial benefit > private benefitInformation failure may lead to under-consumption(individuals not fully aware of the benefits to themselvesof consuming a merit good)



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Market Failure due to Externalities

Negative Externalities Positive Externalities


Negative externalities lead markets to produce a larger quantity than sociallydesirable; Positive externalities lead markets to produce a smaller quantity than

is socially desirable


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Market Failure due to Public Good

In the case of public goods and common resources, externalities arisesbecause something of value has no price attached to it.

goods which will enjoy in common in the sense that each individuals

consumption of such a good leads to no subtractions from any other individuals consumption of that good (Samuleson, 1954)



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Market Failure due to Market PowerMonopoly A price maker compared to pricetaker of a firm in competitive market

A firm is monopoly because of It owns a key resourcesThe government provide a single firm an exclusive rightto produce some good or service patents andcopyrights given by the government

Provide incentive for research and creativity activity offset

by the monopoly pricesNatural Monopoly - The costs of production make asingle producer more efficient than a larger number of producers



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Market Failure due to Market Power -Monopoly

In a competitive firm price equals marginalcost while in the case of monopolized marketprice exceeds marginal cost

Monopolist charges a higher price thereforeearning a higher profit

Also there is a deadweight loss implying thatthe monopolist produces less than the sociallyefficient quantity of output.

Monopolist chooses to produce and sell thequantity of output at which the marginalrevenue and marginal cost curve intersect;while the social planner would choose thequantity at which the demanded marginal costcurves intersect.

The monopoly may also use some of its profitpaying for its monopoly profits paying forthese additional costs. Therefore the socialloss from monopoly includes both these costsand the deadweight loss resulting from a priceabove marginal cost



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Market Failure due to Natural MonopolyHigh fixed costs of entering anindustry which causes long runaverage costs to decline as outputexpands

The marginal cost of producing onemore unit is constant averagecost declines as output increasesover a much large range of outputlevels.

Telecommunications, electricity,water, railways etc. are somenatural monopolies

(Mankiw, 2007)



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Market Failure due to OligopolyIn reality a firm is neither perfectly competitive or monopoly innature rather somewhere between.

Oligopoly is a market with only a few sellers:A key feature of oligopoly is the tension between co-operation and self-interest.

The group of oligopolists is best off co-operating and acting like amonopolist producing small quantity of output and charging a priceabove marginal cost cartel or collusionHowever the self interest is hindrance to co-operate (example of twoprisoners) dominant strategy leading to Nash equilibrium which is lessthan what monopolist would make profitAs the number of sellers in an oligopoly grows larger, an oligopolisticmarket looks more like a competitive market. The price approachesmarginal cost, and the quantity produced approaches the sociallyefficient level

Co-operation between oligopolists is undesirable from thestandpoint of society to move the allocation of resources closer tosocial optimum, policy makers should try to induce firms in anoligopoly to compete rather than co-operate.



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Government Intervention to Correct MarketFailure

The economic rationale for Government intervention(i) Correction for market failure/loss of economic efficiency(ii) Desire for greater degree of equity in the distribution of incomeand wealth

Several forms of government intervention are possible to correct

for perceived market failureTo employ the diagnostic approach, analysts attempt to identifyboth the precise type of problem that gives rise to the marketfailure

Policy analysts argue that existence of a market failure provides anecessary, not a sufficient justification for public policyinterventions. A double market failure test is required. (Weimer & Vining, 1992).

Sufficiency is established when the gains from governmentintervention outwieghs the dangers of government intervention



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Government Intervention to Correct Market Failure

(1) Command and Control technique (including regulation)

(2) Government subsidy and other forms of financialassistance (including research grants and taxallowances/tax exemptions)

(3) Taxation (including indirect taxes designed to controlpollution)

(4) Policies to increase competition and reduce theimmobility of factors of production

(5) Provision and finance of public and merit goods

(6) Introduction/expansion of market based incentives tochange both consumer and producer behaviour



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Problem Intervention Evaluation

Zero provision of public goods

Direct provision of public goods

Negativeexternalities

Financial intervention: taxes (equal to themonetary value of the MEC) are imposed onindividuals or a firm, internalizing ECs

Advantages Leaves space for market forces to interact Provision of revenue for the government

Disadvantages

Difficulty in valuating EC Overvaluation means output is below social

optimum, as with undervaluation means that outputis not sufficiently lowered (ie, societys welfare is notalways maximized) Effectiveness of tax dependent on PED

Legislation: laws and administrative rules arepassed to prohibit or regulate behaviour thatimposes an EC, e.g. pollution permits

Enforcement is difficult and expensive

Education, campaigns and advertisements solvethe problem of imperfect information byallowing the external costs to be made known tothe consumer, discouraging demand

Benefits must outweigh the costs of implementation. A lot of time may be needed for effects to be felt

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PositiveExternalities

Financial intervention: subsidies made to theproducer or consumer

Advantages Considered the most effective way of solving

underconsumption as it is easily implemented Disadvantages

Like taxes, the valuation of EB is difficult High government expenditure is required Okuns leaky bucket: each dollar transferred from a

richer to a poorer individual, results in less than adollar increase in income for the recipient. Leaksarise as a result of administrative costs, changes inwork effort, attitudes etc. arising from theredistribution

Legislation include regulation seatbelt usage,compulsory education etc.

Enforcement requires constant checking which maytranslate to high costs.



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Government Intervention to Correct Market FailureNon provision of merit goods

There is a need to produce merit goods (which are naturally underconsumed) at low prices or for free dueto four reasons 1.Social justice : they should be provided according to need and not ability to pay 2.Large positive externalities , for example in the provision of free health services helps to contain andcombat the spread of disease 3.Dependants are subject to their guardians decision which are not necessarily the best, therefore theprovision of services like free education and dental treatment is needed to protect dependants fromuninformed or bad decisions

4.Ignorance : The problem of imperfect information makes consumers unaware of the positiveexternalities and benefits that arise from consumption

Imperfectmarkets

Imposition of a lump-sum tax on a monopolist (shifts AC upwards), and supernormal profits are taken astax. Governments may also regulate MC/AC pricing for monopolies.

Government may impose regulations to control a monopolies 1.Forbidding the formation of monopolies (e.g., antitrust laws) 2.Forbidding monopolistic behaviour (like predatory pricing) 3.Ensuring standards of provision. 4.Ensuring competition exists (e.g., deregulation)


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Natural Monopolies In the case of Natural Monopoly the essence of regulation is the explicit replacementof competition with governmental orders with principal institutional device forassuring good performance.

In the case of natural monopoly the primary guarantor of acceptable performance isconceived to be not competition or self restraint but direct governmental prescriptionof major aspects of their structure and economic

There are four principal components of this regulation that in combinationdistinguish the public utility from other sectors of the economy: control of entry,price fixing, prescription of quality and conditions of service, and an imposition of anobligation to serve all applicants under reasonable conditions.

(The principles of economic regulation, A.E.Kahn)



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R l ti Equitable


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Theorem of Welfare EconomicsFirst Theorem

If (1) households and firms act perfectly competitively, taking price asparametric, (2) there is a full set of markets, and (3) there is perfectinformation, then a competitive equilibrium, if it exists, is Paretoefficient

Second TheoremIf household indifference maps and firm production sets are convex, if there is a full set of markets, if there is perfect information, and if lump sum transfers and taxes may be carried out costlessly, then andPareto efficient allocation can be achieved as a competitive equilibriumwith appropriate lump sum transfers and taxes (The size of output isnot shrunk)Ideally, this would be achieved through measures that did not destroythe efficiency properties, and much of welfare economics is based onthe assumption that non-discriminatory taxes and transfers can becarried out

(Albert & Hahnel)


Reg lation Equitable


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Policies to reduce poverty

Minimum Wage Laws

Welfare

Negative Income Tax

In-kind transfers

Antipoverty programs and work incentives

Trade-off between equality and efficiency

(Mankiw, 2007)



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Regulation - SummaryThe possibility of market failure underpin the economicrationale for state regulation of market economies.

Regulations can take different forms with different roles

Health, safety regulations and environmental regulations canbe rationalized on the basis of imperfect information andexternalities

Economic regulation of public utilities can be explained byeconomies of scale and scope and need to protect theconsumers from monopoly exploitation

Aspects of fiscal policy can be rationalized on the basis interms of wealth and income redistribution

Regulatory intervention for universal service obligations etc.


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Regulation - SummaryRegulation cannot be limited to economic issues means to ultimately achieve non-economic endsIntentions and outcomes are therefore defined by acombination of economic, social, political andbureaucratic factors and cannot be attributed to oneset of factors aloneInvolvement of disciplines other than economics (law,political science, sociology etc.)Broad definition the use of public authority to setand apply rules and standards (Hood et al, 1999) (Economic Regulation A Preliminary literature review and summary of research questions Parker)

As an effort by the state to address social risk, marketfailure or equity concerns through rule based directionof individual and society (Planning Commissionconsultation paper on Regulation)


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Regulation - SummaryRegulation is a complex balancing act between advancing theinterests of consumers, competitors and investors, whilepromoting a wider, public interest agenda.

minimum prices to benefit the consumer (maximize consumersurplus);ensure adequate profits are earned to finance the properinvestment needs of the industry (earn at least a normal rate of return on capital employed);provide an environment conducive for new firms to enter theindustry and expand competition (police anti-competitivebehavior by the dominant supplier);preserve or improve the quality of service (ensure higherprofitability is not achieved by cutting services to reduce costs);identify those parts of the business which are naturallymonopolistic (statutory monopolies that are not necessarily justified in terms of either economies of scale or scope);take into consideration social and environmental issues (e.g.when removing cross subsidization of services).

(Parker, 2000)


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market failure & role of regulation (1)

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