market failure & role of regulation

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Market Failure & Role of

Regulation


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Market Failure


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Market Failure

Definition:

Where the market mechanism fails toallocate resources efficiently

Social Efficiency

Allocative Efficiency

Technical Efficiency

Productive Efficiency


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Market Failure

Social Efficiency = where external costsand benefits are accounted for

Allocative Efficiency = where societyproduces goods and services at minimum

cost that are wanted by consumers Technical Efficiency = production of

goods and services using the minimumamount of resources

Productive Efficiency = production ofgoods and services at lowest factor cost


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Market Failure

Allocative efficiency:

Also referred to as

Pareto Efficient Allocation resourcescannot be readjusted to make oneconsumer better off without making

another worse off zero opportunity cost!


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Market Failure

Market Failure occurs where: Knowledge is not perfect - ignorance

Goods are differentiated

Resource immobility Market power

Services/goods would or could not be providedin sufficient quantity by the market

Existence of external costs and benefits

Inequality exists


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Market Failure

Imperfect Knowledge:

Consumers do not have adequate technicalknowledge

Advertising can mislead or mis-inform Producers unaware of all opportunities

Producers cannot accurately measureproductivity

Decisions often based on past experiencerather than future knowledge


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Market Failure

Goods/Services are differentiated

Branding

Designer labels - they cost three times as muchbut are they three times the quality?

Technology lack of understanding of the impact

Labelling and product information


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Market Failure

Resource Immobility Factors are not fully mobile

Labour immobility geographical andoccupational

Capital immobility Not the financial one.

Land cannot be moved to where it might beneeded!


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Market Failure

Market Power:

Existence of monopolies and oligopolies

Collusion

Price fixing Abnormal profits

Rigging of markets

Barriers to entry


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Market Failure

Inadequate Provision:

Merit Goods and Public Goods

Merit Goods Could be provided by the

market but consumers may not be able toafford or feel the need to purchase marketwould not provide them in the quantitiessociety needs

Sports facilities?


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Market Failure

Merit Goods

Education nurseries, schools,colleges, universities could all beprovided by the market but wouldeveryone be able to afford them?


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Market Failure

Public Goods

Markets would not provide such goods andservices at all!

Non-excludabilityPerson paying for thebenefit cannot prevent anyone else from alsobenefiting - the free rider problem. Buyinghouse near the main road.

Non-rivalry

Large external benefits relative to cost socially desirable but not profitable tosupply! Like govt. libraries


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Market Failure

De-Merit Goods

Goods and services provided by themarket which are not in our best interests!

Tobacco and alcohol Drugs

Gambling


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Market Failure

External Costs and Benefits

External or social costs

The cost of an economic decision to a third

party External benefits

The benefits to a third party as a result of adecision by another party

Examples in next pages


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Market Failure

External Costs Decision makers do not take into

account the cost imposed on society

and others as a result of theirdecision e.g. pollution, traffic congestion,

environmental degradation, depletion ofthe ozone layer, misuse of alcohol,

tobacco, anti-social behaviour, drugabuse, poor housing

The difference between the


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External CostsPrice

Quantity Bought and Sold

MSB

MPC

Rs 5

100

MSC = MPC + External Cost

Rs12

Social CostValue of the negativeexternality (Welfare Loss)Rs 7

80

Socially efficient output is whereMSC = MSB The Marginal Social

Benefit curve (MSB)represents the sum of the

benefits to consumers insociety as a whole theprivate and socialbenefits. The MarginalPrivate Cost (MPC) curverepresents the costs tosuppliers of producing agiven output.

The MPC does not take into account thecost to society of production. At anoutput level of 100, the private cost tothe supplier is Rs 5 per unit but thecost to society is higher than this (Rs12).

The true cost therefore is theMSC (the MPC plus the externalcost). Current output levelstherefore (100) represent someelement of market failure price does not accurately reflecthe true cost of production.

The difference between thevalue of the MSB and the MSCrepresents the welfare loss tosociety of 100 units beingproduced.


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Market Failure

External benefits by products of production and

decision making that raise the

welfare of a third party e.g. education and training, public

transport, health education andpreventative medicine, refuse collection,investment in housing maintenance, law

and order


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External Benefits

Price

Quantity Bought and Sold

MPB

MSC

Rs 5

100

Value of the positive

externality (Welfare Loss)

Socially efficient outputis whereMSC = MSB

MSB

Rs10

Rs 6.50

140

Social Benefits

There can be a positionwhere output is less than

would be sociallydesirable (education forexample?) In this case,the sum of the benefits tosociety is greater than theprivate benefit to theindividual.


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Market Failure

Inequality:

Poverty absolute and relative

Distribution of factor ownership

Distribution of income Wealth distribution

Discrimination

Housing


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Market Failure

Measures to correct market failure State provision Extension of property rights Taxation

Subsidies Regulation Prohibition Positive discrimination

Redistribution of income


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Emergence of Broad Framework of Study

Are we regulating or de-regulating?

Feedback Market failures -> Regulation


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Free MarketCompetitiveForces

MarketEfficiency

MarketFailure

Regulation

Regulation EquitableDistribution

Objective of Regulation

Market Efficiency and Equitable Distribution

What is a Regulation


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Types of Market

Perfectly Competitive Market Goods/services offered are all same Numerous buyers and sellers and no single buyer or seller can

influence the market price - price takers

Oligopoly Few sellers Each participant is aware of the actions of the others

Monopolistic Goods/services are slightly differentiated Numerous sellers each seller has some ability to influence

the price

Monopoly No substitute available for the goods/services offered Only one seller and this seller sets the price price maker


MarketEfficiency


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Perfectly Competitive Market

Free markets allocate Supply of goods to the

buyers who values themmost

Demand for goods to thesellers who can produce

them at least cost

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

Competitive forces efficientlyallocate the scarce resources


MarketEfficiency


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The Invisible Hand

Adam Smith stated in 1776, while he intendsonly his own gainhe is led by an invisiblehandto promote an end which was no part of hisintention that is to maximize the wealth ofthe nation

The 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


MarketEfficiency


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What is a Market Failure

Market 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

Market

FailureRegulation

M k t


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Brief History of Market Failure Preclassical economics primarily government regulation;

nineteenth century classical economics harmonization ofself interest and social interest; neoclassical economics presence of market failures and government to act as anefficient coordinating force

The concept of market failure initially appeared as a means ofexplaining in economic terms why the need for governmentexpenditures should arise normative judgement about therole of government

As it matured the market failure concept on an additionalcharacteristics diagnostic tool by which policy makerslearned how to objectively determine the exact scope andtype of intervention.

Market

FailureRegulation

Market


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Definition of Market Failure

Market failure when the competitive outcome ofmarkets is not efficient from the point of view ofthe 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

Market

FailureRegulation

Market


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Main causes of Market Failure

Externalities causing private and social costsand/or benefits to diverge

Public goods and Common Resources

Market dominance and abuse of monopoly power

Equity issues Markets can generate an

unacceptable distribution of income and socialexclusion

MarketFailure

Regulation

Market


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Market Failure due to Externalities

Externalities 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

Market

FailureRegulation

Market


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Negative Externalities

Over production of goods where the social costs >private cost

Over consumption of demerit goods where social benefit

< private benefit

Positive Externalities

Under consumption/provision of merit goods where thesocial benefit > private benefit

Information failure may lead to under-consumption(individuals not fully aware of the benefits to themselvesof consuming a merit good)

MarketFailure

Regulation

Market


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Negative Externalities Positive Externalities

MarketFailure

Regulation

Negative externalities lead markets to produce a larger quantity than socially

desirable; Positive externalities lead markets to produce a smaller quantity than

is socially desirable

Market


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Market Failure due to Public Good

Free market economy will fail to deliver the efficient quantityof public goods because of their characteristics

A problem arising from public goods is the free rider issue

People take a free ride when they benefit from consuminga good or a service without paying for the costs ofprovision

Many goods have a public element but they are not purepublic goods congested motorway

MarketFailure

Regulation

MarketR l i


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Market Failure due to Market Power

Monopoly A price maker compared to pricetaker of a firm in competitive market

A firm is monopoly because of It owns a key resources The government provide a single firm an exclusive right

to produce some good or service patents andcopyrights given by the government

Provide incentive for research and creativity activity offsetby the monopoly prices

Natural Monopoly - The costs of production make asingle producer more efficient than a larger number ofproducers

MarketFailure

Regulation

MarketR l ti


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Market Failure due to Market Power -

Monopoly In a competitive firm price equals marginal

cost 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 that

the 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

MarketFailure

Regulation

MarketR l ti


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Market Failure due to Natural Monopoly

High fixed costs of entering anindustry which causes long runaverage costs to decline as outputexpands

The marginal cost of producing one

more unit is constant averagecost declines as output increasesover a much large range of outputlevels.

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

MarketFailure

Regulation

MarketRegulation


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Market Failure due to Oligopoly In reality a firm is neither perfectly competitive or monopoly in

nature 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 collusion

However the self interest is hindrance to co-operate (example of twoprisoners) dominant strategy leading to Nash equilibrium which is lessthan what monopolist would make profit

As the number of sellers in an oligopoly grows larger, an oligopolisticmarket looks more like a competitive market. The price approaches

marginal 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.

FailureRegulation

MarketRegulation


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Moral HazardsShirking of Workers

The higher the current rate of unemployment, and the higher the wagepaid over the market wage, the more effective will be the threat ofdismissal

FailureRegulation

MarketRegulation


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Government Intervention to Correct Market

Failure 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 income

and wealth

Several forms of government intervention are possible to correctfor perceived market failure

To 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 a

necessary, not a sufficient justification for public policyinterventions. A double market failure test is required.

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

FailureRegulation

MarketRegulation


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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

FailureRegulation

MarketRegulation


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FailureRegulation

Problem Intervention Evaluation

Zero provision of

public goodsDirect provision of public goods

Negative

externalities

Financial intervention: taxes (equal to the

monetary value of the MEC) are imposed on

individuals or a firm, internalizing ECs

AdvantagesLeaves space for market forces to interactProvision of revenue for the government

DisadvantagesDifficulty in valuating ECOvervaluation means output is below social

optimum, as with undervaluation means that output

is not sufficiently lowered (ie, societys welfare is not

always maximized)Effectiveness of tax dependent on PED

Legislation: laws and administrative rules are

passed to prohibit or regulate behaviour that

imposes an EC, e.g. pollution permits

Enforcement is difficult and expensive

Education, campaigns and advertisements solve

the problem of imperfect information by

allowing the external costs to be made known to

the consumer, discouraging demand

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

MarketRegulation


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Positive

Externalities

Financial intervention: subsidies made to the

producer or consumer

AdvantagesConsidered the most effective way of solving

underconsumption as it is easily implementedDisadvantagesLike taxes, the valuation of EB is difficultHigh government expenditure is requiredOkuns leaky bucket: each dollar transferred from a

richer to a poorer individual, results in less than adollar increase in income for the recipient. Leaks

arise as a result of administrative costs, changes in

work effort, attitudes etc. arising from the

redistribution

Legislation include regulation seatbelt usage,

compulsory education etc.

Enforcement requires constant checking which may

translate to high costs.


FailureRegulation

MarketRegulation


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Non provision of

merit goodsThere is a need to produce merit goods (which are naturally underconsumed) at low prices or for free due

to four reasons1.Social justice: they should be provided according to need and not ability to pay2.Large positive externalities, for example in the provision of free health services helps to contain and

combat the spread of disease3.Dependants are subject to their guardians decision which are not necessarily the best, therefore the

provision of services like free education and dental treatment is needed to protect dependants from

uninformed or bad decisions4.Ignorance: The problem of imperfect information makes consumers unaware of the positive

externalities and benefits that arise from consumption

Imperfect

markets

Imposition of a lump-sum tax on a monopolist (shifts AC upwards), and supernormal profits are taken as

tax. Governments may also regulate MC/AC pricing for monopolies.

Government may impose regulations to control a monopolies1.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)

FailureRegulation

MarketF il

Regulation


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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)

FailureRegulation

MarketF il

Regulation


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Some regulating act in India

Sectors Type of MarketFailure

Regulator Type of Regulation Relevant Statutes

Utilities Natural Monopoly,Externalities, PublicGood,

CERC, SERCs Licensing, Tarifffixation, QoSstandards, DisputeResolution

Electricity Act 2003

Oil & Gas Natural Monopoly,Externalities

Petroleum and NaturalGas Regulatory Board

Licensing, Tarifffixation, QoSstandards, DisputeResolution

Petroleum and NaturalGas Regulatory BoardAct 2006

Petroleum Act 1934

Petroleum and MineralsPipelines Act, 1962

Tele Communications Monopolistic,Oligopoly

TRAI Licensing, Tarifffixation, QoS

standards,Interconnection,Spectrum Management(Advisory)

TRAI Act 1997

Banking InformationAsymmetry,

RBI Monetary policy

Supervision &Regulation

Banking Act 1959

FailureRegulation

Regulation Equitable

Distribution


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Theorem of Welfare Economics First 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 Theorem If household indifference maps and firm production sets are convex, if

there is a full set of markets, if there is perfect information, and iflump 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

Distribution

Regulation Equitable

Distribution


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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

Distribution


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Regulation - Summary The possibility of market failure underpin the economic

rationale 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 the

consumers 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 - Summary

Regulation cannot be limited to economic issues means to ultimately achieve non-economic ends

Intentions and outcomes are therefore defined by acombination of economic, social, political andbureaucratic factors and cannot be attributed to oneset of factors alone

Involvement 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)

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 - Summary

Regulation 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 consumer

surplus); ensure adequate profits are earned to finance the proper

investment needs of the industry (earn at least a normal rate of

return on capital employed); provide an environment conducive for new firms to enter the

industry 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 naturally

monopolistic (statutory monopolies that are not necessarilyjustified in terms of either economies of scale or scope); take into consideration social and environmental issues (e.g.

when removing cross subsidization of services).


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ReferencesBooks

1. Mankiw, N. Gregory. (2007). Principles of Economics. 3rd Indian Edition,

2. Friedman, D. (1990). Market Failures. Chapter 18. Price Theory. SouthwesternPublishing

3. Djolov, G. George. (2008). The Economics of Competition The Race to Monopoly.Jaico publishing house

4. Michael, A. & Hahnel, R,.A quiet revolution in welfare economics. Online book.

Journals1. Dollery, B. and Worthington, A. (1996). The Evaluation of Public Policy.Normative Economic Theories of Government Failure. Journal of InterdisciplinaryEconomics 7(1):pp. 27-39.

2. Medema, G. Steven. (2004). Mill, Sidgwick, and the evolution of the theory ofmarket failure. History of Political Economy

3. Stigler, J. George. (1971). The theory of economic regulation. Bell Journal ofEconomics 2(1), Page 3-21


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References

4. Shleifer, Andrei. Understanding Regulation. European School ofManagement, Vol 11, No. 4, 2005, pp 439 451

5. Hammond, J. Peter. (1997).The Efficiency Theorems and MarketFailure. Elements of General Equilibrium Analysis, Basil Blackwell

6. Parker, D. (1999). Regulation of privatized public utilities in theUK: performance and governance. International Journal of PublicSector Management. Vol 12, pp 213-236.

7. Dollery, B., & Wallis, J. (2001). The theory of market failure andpolicy making in contemporary Local Government. Working Paperin Economics

8. Consultation Paper(2006).Approach to Regulation: Issues andOptions. Planning Commission, Government of India


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market failure & role of regulation

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