Reasons for

Government Intervention

in the Market

Markets 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

Types of Market Failure

• Externalities

– External costs of production MSC > MC

Q1

External costs in production

O

MC = S

DP

Co

sts

and

ben

efits

Quantity

O

MC = S

DP

MSC

Co

sts

and

ben

efits

Quantity

External cost

Q1Q2

Social optimum

External costs in production

Types of Market Failure

• Externalities

– External costs of production MSC > MC

– External benefits of production MSC < MC

External benefits in production

O

DP

MC = S

Q1

Co

sts

and

ben

efits

Quantity

O

MSC

DP

Q1

External benefit

Co

sts

and

ben

efits

Quantity

MC = S

Q2Social optimum

External 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 production

Types of Market Failure

• Externalities

– External costs of production MSC > MC

– External benefits of production MSC < MC

– External costs of consumption MSB < MB

Q1

(MB)MU = D

External costs in consumption

O

DP

Co

sts

and

ben

efits

Quantity

Q2

(MB)MU = D

O

DP

Co

sts

and

ben

efits

Quantity

External cost

MSB

Q1

External costs in consumption

Social optimum

Types of Market Failure

• Externalities

– External costs of production MSC > MC

– External benefits of production MSC < MC

– External costs of consumption MSB < MB

– External benefits of consumption MSB > MB

(MB)MU = D

O

DP

Q1

Co

sts

and

ben

efits

Quantity

External benefits in consumption

Q2

(MB)MU = D

O

DP

Q1

Co

sts

and

ben

efits

Quantity

External benefit

MSB

External 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 consumption

Q1Q2

Types of Market Failure

• Public goods

– non-rivalry

– non-excludability and the free-rider problem

Types of Market Failure

• Market power

– lack of social efficiency

MC1

Q1

MC

MRAR

A monopolist producing less than the social optimum

O

P1

£

Monopoly outputQ

O

P1

MC1

MC = MSC

Q1

MRAR = MSB

Q2

P2 = MSB

= MSC

£

QMonopoly output Perfectly competitive output

A monopolist producing less than the social optimum

Types of Market Failure

• Market power

– lack of social efficiency

– deadweight welfare loss under monopoly

O

£

Q

Ppc

Qpc

AR = D

Consumersurplus

Producersurplus

Deadweight loss under monopolyMC

(= S under perfect competition)

(a) Industry equilibrium under perfect competition(a) Industry equilibrium under perfect competition

a

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

Deadweight loss under monopoly

O

£

Q

Ppc

Qpc

AR = D

Consumersurplus

Producersurplus

MC(= S under perfect competition)

(a) Industry equilibrium under perfect competition(a) Industry equilibrium under perfect competition

a

Perfectcompetition

Deadweight 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(b) Industry equilibrium under monopoly

Monopoly

Deadweight loss under monopoly

Types of Market Failure

• Ignorance and uncertainty

– by consumers

– by firms

• Immobility of factors and time lags

• Protecting people’s interests

– dependants

– merit goods

Government Intervention in the Market

• Taxes and subsidies

– to correct externalities

Q1O

MC = S

DP

Co

sts

and

ben

efits

Quantity

Using taxes to correct a market distortion

O

MC = S

DP

MSC

Co

sts

and

ben

efits

Quantity

External cost

Q1Q2

Social optimum

Using taxes to correct a market distortion

Q2

MC

Q1O

P

Co

sts

and

ben

efits

Quantity

Optimum tax = MSC – MC

MC = SMSC

D

Using taxes to correct a market distortion

O

DP

MC = S

Q1

Co

sts

and

ben

efits

Quantity

Using subsidies to correct a market distortion

O

MSC

DP

Q1

External benefit

Co

sts

and

ben

efits

Quantity

MC = S

Q2Social optimum

Using subsidies to correct a market distortion

MC

O

P

Q2Q1

Co

sts

and

ben

efits

Quantity

Optimum subsidy

= MC – MSC

MSCMC = S

D

Using subsidies to correct a market distortion

Government 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

Government Intervention in the Market

• 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 Market

• 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

The Case for Laissez-faire

• 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

The Case for Laissez-faire

• Advantages of the free market– automatic adjustments

– dynamic advantages of capitalism

– high degree of competition even under monopoly/oligopoly• possible market contestability

• competition from other closely related industries

• threat of competition from abroad

• countervailing powers

• competition for corporate control

• Judging the arguments

Firms and Social Responsibility

• The classical view on social responsibility

– managers solely responsible to shareholders

– justification and criticisms of this view

• The socio-economic view

– a stakeholding society

– corporate social responsibility

– environmental scanning

Firms and Social Responsibility

• The virtue matrix– a framework for analysing corporate social

responsibility

– the civil foundation• laws and regulation

• social and moral norms

– the frontier• socially beneficial and potentially profitable activities

• socially beneficial but unprofitable activities

The Virtue Matrix:generating corporate social responsibility

Response tosocial norms

Response tolaws and

regulations

Socially beneficial and

potentially profitable

Socially beneficial and unprofitable

CIVIL FOUNDATION

THE'FRONTIER'

Firms and Social Responsibility

• The virtue matrix– a framework for analysing corporate social

responsibility

– the civil foundation• laws and regulation

• social and moral norms

– the frontier• socially beneficial and potentially profitable activities

• socially beneficial but unprofitable activities

– development of corporate social responsibility over time

The Virtue Matrix:generating corporate social responsibility

Response tosocial norms

Response tolaws and

regulations

Socially beneficial and

potentially profitable

Socially beneficial and unprofitable

CIVIL FOUNDATION

THE'FRONTIER'

Firms and Social Responsibility

• The virtue matrix– a framework for analysing corporate social

responsibility

– the civil foundation• laws and regulation

• social and moral norms

– the frontier• socially beneficial and potentially profitable activities

• socially beneficial but unprofitable activities

– development of corporate social responsibility over time

– globalisation and corporate social responsibility

Firms and Social Responsibility

• Economic performance and social responsibility

– possible costs to the firm

– possible benefits to the firm

• improved economic performance

• enhancing the brand

• attracting and retaining employees

• access to capital