MARKET FAILURES MARKET FAILURES AND GOVERNMENT AND GOVERNMENT

INTERVENTIONINTERVENTIONInna Ushcatz and Ieta ShamsInna Ushcatz and Ieta Shams

Market FailureMarket Failure The difference between a socially optimum level of The difference between a socially optimum level of

production and the market level production is a market production and the market level production is a market failure. failure.

In a free market economy it is sometimes possible for In a free market economy it is sometimes possible for individual parties to work out a solution, but government individual parties to work out a solution, but government intervention is needed when: intervention is needed when: Property rights are unclear Property rights are unclear The number of people concerned is large The number of people concerned is large Bargaining costs are highBargaining costs are high

Market fails because it does not allocate resources Market fails because it does not allocate resources efficiently. efficiently.

Types of InefficiencyTypes of InefficiencyThe resulting inefficiency of market The resulting inefficiency of market

failures:failures: Productive inefficiency: businesses are not Productive inefficiency: businesses are not

maximizing their outputs. More output, could have maximizing their outputs. More output, could have satisfied more wants and needs. Costs are higher; satisfied more wants and needs. Costs are higher; productivity is lower than could have been. productivity is lower than could have been.

Allocative inefficiency: businesses misallocate Allocative inefficiency: businesses misallocate resources and produce goods and services that are resources and produce goods and services that are not wanted by the consumers. Resources could not wanted by the consumers. Resources could have been used more efficiently.have been used more efficiently.

Government InterventionGovernment Intervention In a market failure the unrestrained In a market failure the unrestrained

market creates more harm than market creates more harm than good.good.

In a market failure the government In a market failure the government has a role to play in correcting or has a role to play in correcting or internalizing the market failure. internalizing the market failure.

Government intervention aims to Government intervention aims to achieve economic efficiency. achieve economic efficiency.

Roots Causes of Market Roots Causes of Market FailuresFailures

Externalities in production and Externalities in production and consumptionconsumption

Public Goods (missing market) Public Goods (missing market)

Lack of Competition (Monopoly) Lack of Competition (Monopoly)

Poverty and Inequality in an EconomyPoverty and Inequality in an Economy

Externalities Externalities -Marginal Benefit--Marginal Benefit-

Marginal analysis is Marginal analysis is used to study used to study externalities.externalities.

Marginal Private Benefit Marginal Private Benefit (MPB): belongs to the (MPB): belongs to the producer or consumer producer or consumer of the good.of the good.

Marginal External Marginal External Benefit (MEB): the Benefit (MEB): the spillover. spillover.

MPB + MEB = Marginal MPB + MEB = Marginal Social Benefit (MSB)Social Benefit (MSB)

Quantity

Price

Demand(private value)

Socialvalue

Supply(private cost)

QMARKET QOPTIMUM

Externalities Externalities -Marginal Cost--Marginal Cost-

Marginal Private Cost Marginal Private Cost (MPC): the cost incurred (MPC): the cost incurred by the producer or by the producer or consumer. consumer.

Marginal External Cost Marginal External Cost (MEC): is the spillover or (MEC): is the spillover or the externality. the externality.

MPC + MEC = Marginal MPC + MEC = Marginal Social Cost (MSC)Social Cost (MSC)

Market prices generally Market prices generally reflect only private costs reflect only private costs and benefits. and benefits.

PriceCost of

pollution

Equilibrium

Quantity0

Demand(private value)

Supply(private cost)

Socialcost

QOPTIMUM

Optimum

QMARKET

Externalities Externalities -Common Government Approaches--Common Government Approaches-

ProblemProblem Resource Allocation Resource Allocation of Outcome of Outcome

Ways to Correct Ways to Correct

Spillover costs Spillover costs (negative (negative externalities) externalities)

Over allocation of Over allocation of resources resources

1.1. Individual Individual bargaining bargaining

2.2. Liability rules and Liability rules and lawsuitslawsuits

3.3. Tax on producers Tax on producers 4.4. Quantity controls Quantity controls 5.5. Market for Market for

externality rights externality rights Spillover Benefits Spillover Benefits (positive externalities)(positive externalities)

Under allocation of Under allocation of resources resources

1.1. Individual Individual bargaining bargaining

2.2. Subsidy to Subsidy to consumers consumers

3.3. Subsidy to Subsidy to producers producers

4.4. Government Government provisionprovision

Externalities Externalities -Quantity Control- -Quantity Control-

The most common form of government regulation The most common form of government regulation is setting a quantity control on the production of a is setting a quantity control on the production of a good or service.good or service.

A direct control sets absolute levels.A direct control sets absolute levels. The total amount of the good which can be The total amount of the good which can be

produced under the quantity control is called the produced under the quantity control is called the quota limit. The government limits quantity in a quota limit. The government limits quantity in a market by issuing licenses for production. market by issuing licenses for production. 

Quantity controls typically create undesirable side-Quantity controls typically create undesirable side-effects:effects: Inefficiencies, or missed opportunities, in the form of Inefficiencies, or missed opportunities, in the form of

mutually beneficial transactions that don’t occur.mutually beneficial transactions that don’t occur. Incentives for illegal activitiesIncentives for illegal activities  

Externalities Externalities -Subsidies--Subsidies-

Shift of the demand curve to the Shift of the demand curve to the right, raising the output level right, raising the output level closer to the socially optimum closer to the socially optimum level. level.

Shift of the supply curve to the Shift of the supply curve to the right, again correcting the under right, again correcting the under allocation. allocation.

Subsidy to the BuyerSubsidy to the Buyer Subsidy to the SellerSubsidy to the Seller

•Where there are spillover benefits, government often uses subsidies to correct the under allocation that the free market would produce. •Subsidies can be paid either to the buyers or the sellers.

•Subsidies create undesirable side-effects:Inefficient producers remain in business Serves as a burden for the taxpayers

Externalities Externalities -Tax on Producers--Tax on Producers-

A way to solve negative externalities is through A way to solve negative externalities is through issuing excise taxes. Excise taxes on producers will issuing excise taxes. Excise taxes on producers will raise the marginal cost, and decrease supply.raise the marginal cost, and decrease supply.

Sellers pass as much of the added cost on to Sellers pass as much of the added cost on to buyers as possible, by increasing selling price. This buyers as possible, by increasing selling price. This will maintain the same profit margin, and allow the will maintain the same profit margin, and allow the consumer to cover the producers purchase costs. consumer to cover the producers purchase costs. 

Taxes on producers  create the following Taxes on producers  create the following undesirable side-effects:undesirable side-effects: inefficiency as a result of the excess burden or inefficiency as a result of the excess burden or

deadweight loss caused by the tax. deadweight loss caused by the tax. They also encourage illegal activity in attempts to avoid They also encourage illegal activity in attempts to avoid

the tax.the tax.

Externalities Externalities -Effects of a Tax--Effects of a Tax-

A tax places a wedge between the price A tax places a wedge between the price buyers pay and the price sellers receive. buyers pay and the price sellers receive.

Because of this tax wedge, the quantity Because of this tax wedge, the quantity sold falls below the level that would be sold falls below the level that would be sold without a tax.sold without a tax.

The size of the market for that good The size of the market for that good shrinks.shrinks.

A deadweight loss is the fall in total surplus that results A deadweight loss is the fall in total surplus that results from a market distortion, such as a tax.from a market distortion, such as a tax.

Externalities Externalities -The Effects of a Tax--The Effects of a Tax-

Size of tax

Quantity

Price

Price buyerspay

Price sellersreceive

Demand

Supply

Pricewithout tax

Quantitywithout tax

Quantitywith tax

Externalities Externalities -Public Provision of Goods and -Public Provision of Goods and

Services-Services-Government provides previously decided upon Government provides previously decided upon

public goods with tax money collected from all public goods with tax money collected from all citizens. citizens.

Government cannot use price as a signal of Government cannot use price as a signal of value in the way that a market would, because value in the way that a market would, because price does not fully reflect the value of most price does not fully reflect the value of most public goods. public goods.

Government must use other methods, such as: Government must use other methods, such as: Public surveysPublic surveys Market research Market research Voting for certain political candidatesVoting for certain political candidates

Monopolies Monopolies -Market Failures--Market Failures-

Increased competition in a market means Increased competition in a market means that a market is more likely to provide that a market is more likely to provide allocative efficiency by providing the allocative efficiency by providing the socially optimum amount of a good. socially optimum amount of a good.

  Some markets will organize themselves to Some markets will organize themselves to hinder competition, essentially creating a hinder competition, essentially creating a monopoly. monopoly.

The government aims to make industry The government aims to make industry more competitive. more competitive.

MonopoliesMonopolies-Government Responses--Government Responses-

Antitrust Policies: Laws that aim to curb monopoly Antitrust Policies: Laws that aim to curb monopoly power.power.Antitrust laws make the following practices Antitrust laws make the following practices

illegal: illegal: Collusive price fixing Collusive price fixing Separation of marketsSeparation of markets Tying contracts Tying contracts Interlocking directorates Interlocking directorates Price discrimination when it reduces competitionPrice discrimination when it reduces competition

Antitrust laws strengthen government powers to Antitrust laws strengthen government powers to promote competition. promote competition.

   InequalityInequality

--Disparities in the Distribution of Economic Disparities in the Distribution of Economic Resources-Resources-

Questions to ask when measuring inequality: Questions to ask when measuring inequality: – How much people are in our society? How much people are in our society? – How many people live in poverty? How many people live in poverty? – How often do people move amongst income classes? How often do people move amongst income classes?

Failure to properly distribute income leads to a Failure to properly distribute income leads to a inequality (a form of market failure)inequality (a form of market failure)

Change in technology and outsourcing, has decreased Change in technology and outsourcing, has decreased demand for unskilled labour and made their incomes demand for unskilled labour and made their incomes extremely low. extremely low.

It is believed that everyone has an equal opportunity to It is believed that everyone has an equal opportunity to succeed, but the misallocation of resources proves this succeed, but the misallocation of resources proves this wrong. wrong.

Inequality Inequality -Solutions--Solutions-

Policies that are imposed in order to decrease Policies that are imposed in order to decrease Inequality:Inequality:– Minimum wages: If labour is inelastic, this policy is effective Minimum wages: If labour is inelastic, this policy is effective

at reducing inequality. If labour is elastic, not so much.at reducing inequality. If labour is elastic, not so much.– Welfare: government programs that supplement the income Welfare: government programs that supplement the income

of the needyof the needy– Negative Income Tax: High income families pay tax, low Negative Income Tax: High income families pay tax, low

income families receive the “negative tax”income families receive the “negative tax”– In-kind Transfers: Things given to the poor in the form of In-kind Transfers: Things given to the poor in the form of

goods and servicesgoods and services

Distribution of Income US 2007

Lorenz CurveLorenz Curve

The Lorenz Curve: A curve The Lorenz Curve: A curve that shows the degree of that shows the degree of inequality. Illustrates how inequality. Illustrates how income is distributed income is distributed unequally in a society. unequally in a society.

The pink shaded area The pink shaded area labelled A represents labelled A represents inequality present in a inequality present in a society.society.

The Gini Coefficient finds the The Gini Coefficient finds the area of inequality, divides it area of inequality, divides it by the total area to find the by the total area to find the percentage of inequality. percentage of inequality.

Factor Distribution & the Gini Factor Distribution & the Gini CoefficientCoefficient

Gini coefficient: An number between zero and one Gini coefficient: An number between zero and one that is used to measure inequality as it relates one that is used to measure inequality as it relates one variable to another. For perfect equality the Gini variable to another. For perfect equality the Gini coefficient is 0. However, absolute inequality yields a coefficient is 0. However, absolute inequality yields a coefficient of 1.coefficient of 1.

The Gini Coefficient can be found from the Lorenz The Gini Coefficient can be found from the Lorenz Curve by dividing area A by the combination of area Curve by dividing area A by the combination of area A and BA and B

Thus, A/(A+B)Thus, A/(A+B)

Factor Distribution of Income: is the division of total Factor Distribution of Income: is the division of total income among labor, land and capital. income among labor, land and capital.

VideoVideo http://http://www.youtube.com/watch?vwww.youtube.com/watch?v

=8DuWQVDi9bQ&list=PL71234D006=8DuWQVDi9bQ&list=PL71234D006E682C13&index=1&feature=E682C13&index=1&feature=plpp_videoplpp_video

Practice Multiple Choice Practice Multiple Choice QuestionQuestion

1.1. In the case of a market in which a negative In the case of a market in which a negative externality is produced, which of the following externality is produced, which of the following is true of marginal social cost? is true of marginal social cost?

a)a) MSC=MPCMSC=MPCb)b) MSC=MPBMSC=MPBc)c) Government can intervene to cause MSC=MECGovernment can intervene to cause MSC=MECd)d) Marginal social cost is not reflected in the Marginal social cost is not reflected in the

supply curvesupply curvee)e) Bystanders are bearing the marginal social cost Bystanders are bearing the marginal social cost

Practice Multiple Choice Practice Multiple Choice QuestionQuestion

1.1. At the socially efficient output and price At the socially efficient output and price for a good whose production causes for a good whose production causes pollution, we can expect thatpollution, we can expect thata)a) The offending pollution will be eliminated The offending pollution will be eliminated b)b) The marginal social cost of production will exceed The marginal social cost of production will exceed

the marginal social benefit of productionthe marginal social benefit of productionc)c) The private cost of production will equal the private The private cost of production will equal the private

benefit of production benefit of production d)d) The marginal social benefit of production will equal The marginal social benefit of production will equal

the marginal social cost of productionthe marginal social cost of productione)e) Too little of the good will be producedToo little of the good will be produced

Practice Free- Response Practice Free- Response

1.1. Assume that product X is produced in a Assume that product X is produced in a perfectly competitive market and yields costs perfectly competitive market and yields costs that are borne by third party individuals. Using that are borne by third party individuals. Using a correctly labeled graph, show the market a correctly labeled graph, show the market output and price if the market ignores the output and price if the market ignores the externality. externality.

a)a) Identify the problem in this market. Identify the problem in this market. b)b) Identify and explain a remedy to the problem of Identify and explain a remedy to the problem of

misallocation of resources. misallocation of resources. c)c) Amend the graph to show how your remedy has Amend the graph to show how your remedy has

changed the output to the socially optimum amount. changed the output to the socially optimum amount.

To be Marked Free Response To be Marked Free Response Question to be marked: Question to be marked:

– http://www.diigo.com/bookmark/http%3A%2http://www.diigo.com/bookmark/http%3A%2F%2Ftw.neisd.net%2Fwebpages%2FdmayerF%2Ftw.neisd.net%2Fwebpages%2Fdmayer%2Ffiles%2Fap_micro_frq.htm?tab=%2Ffiles%2Fap_micro_frq.htm?tab=people&unamepeople&uname==mscuttlemscuttle