MARKET FAILURES

Externalities - markets will not lead to efficiency if actions of

producers or consumers affect people other than themselves

- when these effects are positive they are external benefits,

whenever they are adverse they are external costs

Thus the full cost to society (the social cost) of the production

of any good or service is the private cost plus and externalities

(positive or negative)

Four major types of externality

1. External costs of production (MSC > MC)

2. External benefits of production (MSC<MC)

3. External costs of consumption (MSB<MB)

4. External benefits of consumption (MSB>MB)

EXTERNALITIES - EXAMPLES

1. External costs of production (MSC > MC)When a chemical firm dumps waste into a river or pollutes the air thecommunity bears costs additional to those borne by the firm

2. External benefits of production (MSC < MC)If a bus company spends money training its bus drivers and some leave eachyear to join coach and haulage companies these companies costs are reducedas they do not have to train drivers

3. External costs of consumption (MSB < MB)When people use their cars there are costs (negative externalities) with respectto other people e.g. exhaust fumes, noise, congestion etc. This means that the actual level of consumption will be too great fromsociety’s point of viewOther examples - noisy radios in public places, smoke from cigarettes and litter

EXTERNALITIES - EXAMPLES (con)

4. External benefits of consumption (MSB > MB)

When people travel by train rather than by car other people benefit from less

congestion, less pollution and fewer accidents on the road

Whenever there are external benefits too little will be produced by the market;

Whenever there are external costs too much will be produced by the market

In short intervention with respect to market forces is justified whenever

externalities arise

Environmental Problems such as emissions of CO2 gas point to the extremely

important implications of negative externalities

fig

O

MC = S

DP

MSC

Co

sts

and

be

nef

its

Quantity

External cost

Q1Q2

Social optimum

External costs in productionExternal costs in production

fig

O

MSC

DP

Q1

External benefit

Co

sts

and

be

nef

its

Quantity

MC = S

Q2Social optimum

External benefits in productionExternal benefits in production

O

MC = S

DP

Q1Q2

Cos

ts a

nd b

enef

its (

£)

Quantity

MSC

External cost

(a ) External costs

O

DP

Q2Q1

Cos

ts a

nd b

enef

its (

£)

Quantity

MSCMC = S

External benefit

(b) External benefits

External costs and benefits in productionExternal costs and benefits in production

figQ2

(MB)MU = D

O

DP

Co

sts

and

be

nef

its

Quantity

External cost

MSB

Q1

External costs in consumptionExternal costs in consumption

Social optimum

figQ2

(MB)MU = D

O

DP

Q1

Co

sts

and

be

nef

its

Quantity

External benefit

MSB

External benefits in consumptionExternal benefits in consumption

Social optimum

O

MB

PP

Cos

ts a

nd b

enef

its (

£)

Car miles

MSB

External cost

O

MB

PP

Q1

Cos

ts a

nd b

enef

its (

£)

Rail miles

Q2

MSB

External benefit

(a ) External costs (b) External benefits

External costs and benefits in consumptionExternal costs and benefits in consumption

Q1Q2

PUBLIC GOODS

• With some goods and services, the positive externalities are so great that the market (free or imperfect) may not produce at all

These are called public goods e.g. lighthouses, street lighting, public servicesuch as police, national security etc

Public goods have two important characteristics: non-rivalry and non- excludabilityUnlike a bar of chocolate, the benefits of street lighting to one individual does not exclude equal benefits to neighbours. So in this sense they are not rivals with respect to obtaining benefits.

However money spent by an individual on improving drainage on a roadwould not exclude benefits to other users. Therefore there would be noincentive for others who would benefit (free riders) to undertake suchexpenditure

MONOPOLY POWER

• Even without externalities, a monopoly will fail to produce the socially efficient output

• There is what is referred to as a deadweight loss under monopoly - consumer and producer surplus

fig

MRO

£

Q

Ppc

Qpc

AR = D

a

Qpc

Pm

bConsumer

surplus

Producersurplus

Deadweightwelfare loss

MC(= S under perfect competition)

(b) Industry equilibrium under monopoly(b) Industry equilibrium under monopoly

Monopoly

Deadweight loss under monopolyDeadweight loss under monopoly

OTHER MARKET FAILURES

• Lack of information and uncertainty

- consumers may not be properly informed on prices, aware of quality or

perhaps may be unduly influenced by advertising

Immobility of factors and time-lags in response

Protecting people’s interests

- dependents

- principal-agent problem

Merit and demerit goods

Unequal distribution of income

GOVERNMENT INTERVENTION

• Where a marginal external cost is involved e.g. pollution from an industrial chimney a tax should be imposed (equal to the marginal pollution cost)

• If a monopolist makes excessive profits (i.e. supernormal profits) a lump sum tax can be imposed up to the amount of the excess tax

• Then if the monopolist is producing less than the cost efficient output a subsidy should be imposed to encourage production up to that level

Other methods would involve legal restrictions, regulatory authorities, changes

in property rights, provision of information and the direct provision of goods

and services

figQ2

MC

Q1O

P

Co

sts

and

be

nef

its

Quantity

Optimum tax = MSC – MC

MC = SMSC

D

Using taxes to correct a market distortionUsing taxes to correct a market distortion

fig

MC

O

P

Q2Q1

Co

sts

and

be

nef

its

Quantity

Optimum subsidy

= MC – MSC

MSCMC = S

D

Using subsidies to correct a market distortionUsing subsidies to correct a market distortion

GOVERNMENT INTERVENTION - TAXES AND SUBSIDIES

• Used by Gov. to

(a) to create greater social efficiency by altering production or consumption

(b) to redistribute income

Tax should be made equal to marginal external cost (of product or service) and

subsidy made equal to marginal external benefit

- advantages: can address market imperfections while still allowing market to operate

- Disadvantages: impractical to use a range of different taxes and subsidies:

can be a lack of knowledge of how to measure external costs and benefits

GOVERNMENT INTERVENTION – LAWS AND REGULATIONS

• Three types of regulation:

- those that prohibit or regulate behaviour that imposes external costs

- those that prevent false or misleading information

- those that prevent or regulate monopolies and oligopolies

Advantages: simple and clear to understand; when dangers are great easier to

ban outright than attempt other regulations; easy to take emergency action

when required

Disadvantages: tend to be a rather blunt instrument - for example if

a minimum pollution standard is required to be met by regulation, a firm will

have no incentive to improve on that standard

REGULATORY BODIES

• In most industrial countries “competition policy” is in place to deal with restrictive practices and monopoly practices; here substantial fines (and even prison sentences) can be imposed on offenders

• Special regulatory bodies are often put in place in key sectors (with an important public interest)

- for example in Ireland there are special regulatory bodies in place with

respect to:

electricity

telecommunications

insurance

taxis etc.

OTHER FORMS OF GOVERNMENT INTERVENTION

• Changes in property rights

- generally only practical when the number of offenders is few e.g. laws

preventing noise from neighbours and even here problems can exist with

respect to the costs and effectiveness of litigation

- there can also be a question of equity

e.g. property owners may strive to limit access to walkways that were

formerly treated as rights of way

• Provision of information

- information on jobs provided by employment centres can facilitate both

firms and job seekers

OTHER FORMS OF GOVERNMENT INTERVENTION (con)

• Direct provision of goods and services

- provision of public goods

- considerations of social justice

- large positive externalities (e.g. free treatment of an infectious disease)

- to protect dependants (e.g. provision of primary education)

- ignorance (consumers may not realise how much they will benefit from a

certain facility

DRAWBACKS OF INTERVENTION

• When government fixes prices, this can lead to shortages (e.g. rented accommodation) and surpluses (food)

• Poor information

• Bureaucracy and inefficiency

• Lack of market incentives e.g. where subsidies to firms may allow inefficient to survive

• Shifts in government policy - may make it difficult for firms to plan efficiently ahead

• Lack of freedom for individuals

ADVANTAGES OF FREE MARKET

• Automatic adjustments

• Dynamic advantages of capitalism

• A high degree of competition even under monopoly/oligopoly

- excessively high profits can encourage others to enter market

- competition from closely related industries

- threat of foreign competition

- countervailing powers

- competition for corporate control

HEALTH SECTORCase of Multiple Market Failures - leading to considerable government intervention

• Distribution of Income: People may not be able to afford treatment

• Uncertainty: Difficulty for people in predicting their future medical needs

- to some extent can be dealt with through insurance

• Externalities: Health care generates a number of benefits external to the patient (e.g. inoculation against an infectious disease)

• Patient Ignorance:

- patients may delay seeking treatment until considerable damage is in

evidence

- the principle agent problem is in evidence

• In market system considerable oligopoly likely to exist in terms of provision of health services

The Environment: a Case Study

• Policy alternatives– charging for use of the environment

• emissions charges• user charges• optimum charge = external cost

– green taxes and subsidies• use of such taxes around the world

– laws and regulations• advantages and disadvantages

– education– tradable permits

• the European Emissions Trading Scheme• advantages and disadvantages

– laws and regulations• advantages and disadvantages

– education– tradable permits

• the European Emissions Trading Scheme• advantages and disadvantages

The Environment: a Case Study

• How much can we rely on governments?

– governments must have the will to protect the environment

• depends on attitudes of various interest groups

– must be able to identify problems and appropriates solutions

– when problems are global:

• may require international agreements

• governments are likely to be more concerned with their own national interests