Market Failure

And

Government Policy

Market Failure

And

Government Policy

A’lam Asadov

aasadov@mdis.uz

Markets and the Role of GovernmentMarkets and the Role of Government

• Government intervention and social objectives

• The objective of social efficiency– marginal social benefits and costs

• MSB > MSC produce (or consume) more• MSC > MSB produce (or consume) less

– socially efficient output where MSB = MSC• Equity

– concepts of fairness• Trade-offs between equity and efficiency

• Government intervention and social objectives

• The objective of social efficiency– marginal social benefits and costs

• MSB > MSC produce (or consume) more• MSC > MSB produce (or consume) less

– socially efficient output where MSB = MSC• Equity

– concepts of fairness• Trade-offs between equity and efficiency

Types of Market FailureTypes of Market Failure

• Externalities

– An externality refers to the uncompensated impact of one person’s actions on the well-being of a bystander.

– Externalities cause markets to be inefficient, and thus fail to maximize total surplus.

– There are two types of externalities:

Negative and Positive externalities

• Externalities

– An externality refers to the uncompensated impact of one person’s actions on the well-being of a bystander.

– Externalities cause markets to be inefficient, and thus fail to maximize total surplus.

– There are two types of externalities:

Negative and Positive externalities

Externalities and Market Failure Externalities and Market Failure

• Negative Externalities– Automobile exhaust– Cigarette smoking– Barking dogs (loud pets)– Loud stereos in an apartment building

• Negative Externalities– Automobile exhaust– Cigarette smoking– Barking dogs (loud pets)– Loud stereos in an apartment building

Externalities and Market FailureExternalities and Market Failure

• Positive Externalities– Education– Restored historic buildings– Research into new technologies

• Positive Externalities– Education– Restored historic buildings– Research into new technologies

Types of Market FailureTypes of Market Failure

• Externalities in production

– External costs of production MSC > MC

– External benefits of production MSC < MC

• Externalities in production

– External costs of production MSC > MC

– External benefits of production MSC < MC

Q1

External costs in productionExternal costs in production

O

MC = S

DP

Co

sts

and

be

nef

its

Quantity

O

MC = S

DP

MSC

Co

sts

and

be

nef

its

Quantity

External cost

Q1Q2

Social optimum

External costs in productionExternal costs in production

External benefits in productionExternal benefits in production

O

DP

MC = S

Q1

Co

sts

and

be

nef

its

Quantity

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

Types of Market FailureTypes of Market Failure

• Externalities in consumption

– External costs of consumption MSB < MB

– External benefits of consumption MSB > MB

• Externalities in consumption

– External costs of consumption MSB < MB

– External benefits of consumption MSB > MB

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

Types of Market FailureTypes of Market Failure

• Public goods

– non-rivalry

– non-excludability and the free-rider problem

• Public goods

– non-rivalry

– non-excludability and the free-rider problem

Public vs. Private goods Public vs. Private goods

Goods can be classified according to two attributes:

whether they are excludable and

whether they are rival in consumption

A good is excludable if the supplier of that good can prevent people who do not pay from consuming it.

A good is rival in consumption if the same unit of the good cannot be consumed by more than one person at the same time.

Characteristics of GoodsCharacteristics of Goods

There are four types of goods:

Private goods, which are excludable and rival in consumption, like bread or personal computer

Public goods, which are non-excludable and non-rival in consumption, like a public sewer system

Common resources, which are non-excludable but rival in consumption, like clean water in a river

Artificially scarce goods, which are excludable but non-rival in consumption, like pay-per-channel Satellite broadcasting.

There are four types of goods. The type of a good depends on (1) whether or not it is excludable— whether a producer can prevent someone from consuming it; and (2) whether or not it is rival in consumption—whether it is impossible for the same unit of a good to be consumed by more than one person at the same time.

Types of Market FailureTypes of Market Failure

• Market power

– lack of social efficiency

– deadweight welfare loss under monopoly

• Market power

– lack of social efficiency

– deadweight welfare loss under monopoly

O

£

Q

Ppc

Qpc

AR = D

Consumersurplus

Producersurplus

MC(= S under perfect competition)

(a) Industry equilibrium under perfect competition

a

Perfectcompetition

Deadweight loss under monopolyDeadweight loss under monopoly

MRO

£

Q

Ppc

Qpc

AR = D

a

Qpc

Pm

bConsumer

surplus

Producersurplus

Deadweightwelfare loss

MC(= S under perfect competition)

(b) Industry equilibrium under monopoly

Monopoly

Deadweight loss under monopolyDeadweight loss under monopoly

Types of Market FailureTypes of Market Failure

• Ignorance and uncertainty

– by consumers

– by firms

• Immobility of factors and time lags

• Protecting people’s interests

– dependants

– merit goods

• Ignorance and uncertainty

– by consumers

– by firms

• Immobility of factors and time lags

• Protecting people’s interests

– dependants

– merit goods

Government Intervention in the MarketGovernment Intervention in the Market

• Taxes and subsidies– to correct externalities

• Taxes and subsidies– to correct externalities

Q1O

MC = S

DP

Co

sts

and

be

nef

its

Quantity

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

O

MC = S

DP

MSC

Co

sts

and

be

nef

its

Quantity

External cost

Q1Q2

Social optimum

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

Q2

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

O

DP

MC = S

Q1

Co

sts

and

be

nef

its

Quantity

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

O

MSC

DP

Q1

External benefit

Co

sts

and

be

nef

its

Quantity

MC = S

Q2Social optimum

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

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 in the MarketGovernment Intervention in the Market

• Taxes and subsidies (cont.)– to correct for monopoly

• use of lump-sum taxes plus subsidies

– advantages of taxes and subsidies• can vary the rate according to the size of the

market distortion

– disadvantages of taxes and subsidies• infeasible to use different tax and subsidy rates

• lack of knowledge

• Taxes and subsidies (cont.)– to correct for monopoly

• use of lump-sum taxes plus subsidies

– advantages of taxes and subsidies• can vary the rate according to the size of the

market distortion

– disadvantages of taxes and subsidies• infeasible to use different tax and subsidy rates

• lack of knowledge

Government Intervention in the MarketGovernment Intervention in the Market

Other forms of government intervention• Changes in property rights

– the problem of limited property rights

– extending property rights

– limitations of this solution

• Laws prohibiting behaviour that imposes external costs

– advantages of legal restrictions

– disadvantages of legal restrictions

• Regulatory bodies

Other forms of government intervention• Changes in property rights

– the problem of limited property rights

– extending property rights

– limitations of this solution

• Laws prohibiting behaviour that imposes external costs

– advantages of legal restrictions

– disadvantages of legal restrictions

• Regulatory bodies

Government Intervention in the MarketGovernment Intervention in the Market

Other forms of government intervention (continued)

• Price controls– high minimum prices– low maximum prices

• Provision of information• Direct provision of goods and services

– justification• social justice• large positive externalities• dependants• ignorance

Other forms of government intervention (continued)

• Price controls– high minimum prices– low maximum prices

• Provision of information• Direct provision of goods and services

– justification• social justice• large positive externalities• dependants• ignorance

More or less intervention?More or less intervention?

• Drawbacks of government intervention– shortages and surpluses

– poor information

– bureaucracy and inefficiency

– lack of market incentives

– shifts in government policy

– voters’ ignorance

– unrepresentative government

– lack of freedom for the individual

• Drawbacks of government intervention– shortages and surpluses

– poor information

– bureaucracy and inefficiency

– lack of market incentives

– shifts in government policy

– voters’ ignorance

– unrepresentative government

– lack of freedom for the individual

Private Solutions to ExternalitiesPrivate Solutions to Externalities

• Government action is not always needed to solve the problem of externalities.

There might be some private solutions to externalities such as:

• Moral codes and social sanctions• Charitable organizations• Integrating different types of businesses• Contracting between parties

• Government action is not always needed to solve the problem of externalities.

There might be some private solutions to externalities such as:

• Moral codes and social sanctions• Charitable organizations• Integrating different types of businesses• Contracting between parties

Question ???Question ???