Government Intervention and the Market System Session 4 (chs 8, 6, 7, 9) Professor Dermot McAleese.
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Transcript of Government Intervention and the Market System Session 4 (chs 8, 6, 7, 9) Professor Dermot McAleese.
OUTLINE
Government spending in the economy
Case for government intervention
Types of government intervention
Problem of government failure
Government spending (% GDP)
Sources: European Economy, OECD; pre-Second World War figures taken from Vito Tanzi and Ludger Schuknecht, ‘The Growth of Government and the Reform of the State in Industrial Countries’, IMF Working Paper, December 1995
1937 1960 1970 1984 2000
Eur 12 29.0 32.2 37.4 50.0 44.0Japan 25.4 17.1 19.4 32.9 31.8US 8.6 27.0 31.6 35.6 33.4
France 29.0 34.6 38.9 52.5 47.7Germany 42.4 32.5 38.5 47.6 44.0Netherlands 19.0 33.7 42.4 59.6 42.1Ireland … 28.0 39.6 51.3 29.5Italy 24.5 30.1 34.2 49.4 44.2UK 30.0 32.2 37.3 45.3 36.8
General government net debt (% GDP)
Source: European Monetary Institute, First Annual Report, April 1995; OECD Economic Outlook,, various issues.
1978 1990 1995 2000
EU(15) 23.9 40.8 75.2 68.5
Japan 11.3 9.5 76.2 112.8
US 21.3 31.5 74.5 60.2
Belgium 57.2 124.9 129.8 109.8
Italy 62.4 103.7 123.1 112.9
Greece 29.4 89.0 108.7 103.8
Netherlands 40.2 75.6 75.5 56.5
Denmark 21.9 65.8 73.9 50.8
Portugal 37.6 65.3 65.9 58.8
Germany 30.1 42.0 59.1 63.5
France 31.0 39.5 59.3 63.9
Spain 14.4 48.5 68.4 65.7
UK 58.6 39.1 58.9 49.7
Ireland 65.7 92.6 80.8 42.9
Elderly dependency ratios
Source: Eurostat
65+ as % total population
1960 2000 2050
US 9.2 12.4 21.2
Japan 6.1 16.5 30.4
EC15 10.6 16.1 27.6
Table. 6 Public sector debt and net public pensions liabilities, 1990 (% GDP)
Source: Van Noord and Herd (1994)
Public debt
Net pensions liabilities
Extended public debt
US 56 43 99
Japan 70 200 270
Germany 44 160 204
France 47 216 263
Italy 101 233 334
UK 35 100 135
ADAM SMITH: THE REASONS FOR GOVERNMENT INTERVENTION
Monopoly
Defence/national security
Police and justice system
Public health
INCOME DISTRIBUTION
Income equalisation utility maximised by distributing from rich to poor
adverse effect on incentive to work and enterprise
Efficiency efficiency less ambiguous objective than equality
Pareto efficiency
(an outcome where nobody can be made better off without making at least one other individual less well off)
Equality/efficiency trade-off
EMPIRICAL EVIDENCE ON INCOME DISTRIBUTION
Governments are concerned about inequality
Market forces can produce highly unequal income distribution
Government redistribution reduces inequality
Declining emphasis on redistribution through taxation
More emphasis on targeting expenditure to the poor
GINI INDICES FOR SELECTION OF HIGH-INCOME COUNTRIES
Soruces: Gini coefficients: A. Atkinson, Income Inequality in OECD countries: evidence from CIS data, paris: OECD, 1995.
0 0.1 0.2 0.3 0.4 0.5
Switzerland
US
France
Netherland
Canada
Australia
UK
Germany
Norway
Sweden
before redistribution after redistribution
MARKET FAILURES
Monopoly power (dead-weight loss, X-efficiency loss, etc.)
Externalities (congestions, pollution, …)
Public goods (‘free rider’ problem)
Information asymmetries (insurance, banking, taxis, health)
Profit maximisation dictates that firms in the market system
are motivated to discover, exploit and ruthlessly protect a
monopoly niche.
MONOPOLY vs. COMPETITION
R
S
D
V
Costs under monopoly
MC = AC
Cost under competition
MC = AC
QuantityQcQxQm0
A
B
Higher costs under monopolyPrice
MONOPOLY PRICE DISCRIMINATION
Quantity Quantity Quantity
Q1 Q(1+2)Q2
Price PricePrice
MR1 MR2 CMR
CMC
C
P1
C
P2
E
FOUR REASONS FOR A MONOPOLY
Economies of scale
Government policies
Ownership know-how
Ownership of natural resources
SUSTAINING MARKET POWER
Distinctive capability
Architecture
Reputation
Innovation
Strategic entry-deterrent measures
Setting price deliberately below profit-maximising level in order to reduce attractiveness of the industry to the outsiders
Conceasing profit figures for monopolised parts of business Below cost selling, predatory pricing and dumping Deliberate over-investment in capacity and extension of
product range
MARKET POWER WITH A FEW FIRMS
The case of cartel
Price leadership
Kinked oligopoly model
Non-price competition
CONCLUSIONS
Large section of modern industrial economies can be described as ‘effectively competitive’
Yet monopolies influence and market power are important realities in the business world
Hence need for competition policy
MARKET STRUCTURE IS DETERMINED BY
Numbers and size-distribution of sellers and buyers
Characteristics of the product and degree of market segmentation
Barriers to entry into the industry
Barriers to exit from the industry
MARKET STRUCTURE AND FIRMS PERFORMANCE
Contestability – firms may be few in number and yet competition can be intense
Innovation – thrives more in competitive conditions than under monopoly
COMPETITION – ADVANTAGES OVER MONOPOLY
It makes organisations internally more efficient
It allows the more efficient organisations to prosper at the expense of the inefficient (selection process)
It improves dynamic efficiency by stimulating innovation
EXTERNALITIES
Primary education
Training employees in general skills
Aesthetic company headquarter buildings
Vaccine against contagious disease
Neighbour’s well-kept garden
Air, water and noise pollution
Ugly factory buildings
Congestion
Radio noise
Production Consumption
EFFECT
ORIGIN
NEGATIVE PRODUCTION EXTERNALITY
SMC
PMC
Demand
Output of chemical plant
Q1Q2
£
P
ŒE
Chemical Plant Polluting River
Q 1- private profit maximum output level
Q2 - social optimum level
DEFINITION OF A PUBLIC GOOD
Non-Rivalrous the marginal cost of an additional individual consuming the good is zero, at least up to a certain level
Non-Excludablethe cost of excluding an individual from consuming it is prohibitively high
Note: Public goods are not the same as merit goods
PUBLIC GOODS
Marginal cost of consumption (rivalry)
Ease of excludability
Clean Air
Innovation –basic research
National Defence
Monetary stability
TV Programme
National Parks
Motorways Bridges
Art Galleries
City Parks
Cinemas
Fire service
Apples
Cars
Private Goods and Public Goods
Examples of Information Asymmetries
• Medical bills – inflated demand
• Fake antiques
• Gasoline
• Bank deposits
COMPETITION POLICY IN ACTION– THE EXAMPLE OF EU
Prohibited agreements
Abuse of dominant position
Control of mergers
State aids
COMPETITION POLICY IN ACTION
Horizontal restraints
restraints in markets for close substitutes
(e.g. price fixing, market sharing)
presumption of illegality
Vertical restraints
restraints between producers of complementary goods and services
presumption of legality unless interest of consumers, existing competitors, potential entrants are shown to be damaged
COMPETITION LAW WITH TEETH Breaches of competition law can carry severe penalties. In 1999, two top European companies were fined a record $725 million in the US for their part in a worldwide conspiracy to control the market in vitamins. According to US investigators, the executives met once a year to fix the annual “budget” of a fictitious company Vitamins Inc. In practice this involved setting prices, sharing geographic markets and setting sales volume. The annual summit was followed by meetings, quarterly reviews and frequent correspondence. The cartel controlled the most popular vitamins including vitamins A, C and vitamin premixes. A former executive of Roche agreed to serve a four-month prison sentence; he was the first European national to submit to such a sentence for anti-trust offences. The European Commission said it was investigating the same matter. Practices that once would have been tolerated if not condoned in the past are now being subjected to the full rigour of the law. Source: Financial Times 24 May 1999
COMPETITION AND GLOBALISATION
A more open market is more competitive
A need for ‘level playing field’
Monopoly power by giant multinationals
COMPETITION POLICY DOES NOT SOLVE ALL PROBLEMS …
Natural monopolies – the core activities where economies of scale dominate
Can be controlled by
1. Regulation
2. Outcontracting and franchising
3. Privatisation
REASONS FOR PRIVATISATION
new managerial ‘culture’
source of funds for government
disposes of loss making
weaken trade unions
encourage efficiency (access to capital, avoid policy confusion)
develop and expand domestic capital market
engender competition
METHODS OF PRIVATISATION
Share flotation (British Telecom 1984)
Direct sale to existing private sector business or institutional buyers (Rover cars to British Aerospace)
Management buy-outs (National Freight corporation 1982)
Contracting out (competitive tender)
EFFECTS OF PRIVATISATION
Efficiency
Government revenue
Income distribution
Privatsation not necessarily superior to state ownership (Railways, London underground)
DEREGULATION – THE CASE OF NATURAL MONOPOLY
Isolate the core natural monopoly element in the industry
Deal with the natural monopoly element: Pricing: P = MC;
break-even or average return on K; RPI minus X
Access
Quality
REGULATION
Costs of direct regulation can be high
Incentive regulation can also be problematic- RPI minus X (UK)- ‘Fair’ return on capital (US)
Competition the best solution- Break up into separate competing firms- Competitive tendering for provision of services- Encourage new entrants (including foreign)- Separate ‘natural’ monopoly (network) and regulate that only
COASE THEOREM
Externalities do not necessarily require government intervention.
Market system can correct externalities, provided property rights are defined and transactions costs are
low.
REGULATION
Regulation is costly …
High administrative costs
Insufficient flexibility in implementation
Stultifying effects of standardisation on industrial innovation
… but necessary …
Natural monopolies
Asymmetric information
When risks of catastrophic failure exists
When the pollution generated by the polluter cannot be measured
When major health risks are involved
GOVERNMENT FAILURE
Government failure arises when the cost of attempting to ‘correct’ free market distortions turn out to be greater than the cost of the original distortion itself.
CAUSES OF GOVERNMENT FAILURE
Absence of ‘invisible hand’
Absence of full information
Theory of public choice
‘political parties formulate policies in order to win elections, rather than win elections in order to formulate policies’ Prof. Anthony Down
Distortions created by taxes and subsidies
(rent-seeking society and the ‘grantepreneurs’)
RESPONSE TO GOVERNMENT FAILURE
Reduce direct public provision (1)
privatisation
out-contracting
Standards
regulation
Response (2)
Use market incentives instead of regulation where possible
Reform public sector – learning from the private sector
Management by objectives
Incentives
Example: The Polluter Pays Principle
Tax the polluter, get as near to the source of the problem as possible, use market incentive instead of regulation
The Polluter Pays Principle
• Gives firm incentive to reduce pollution
• Cuts down on compliance and monitoring costs
• Incentive to innovation with pollution costs integrated into market signals
• Pollution may not be costly or impossible to measure accurately
• Lessens government control over amount of pollution created
FUNCTIONS OF THE STATE
Source: The State in a Changing World, World Development Report 1977, Jun, p. 27.
Improving equity
Protecting the poor:
Antipoverty progrems, disaster relier
Addressing externalities:
Regulating monopoly:
Overcoming imperfect
information: Providing social
insurance:
Intermediate functions
Basic education, environmental protection
Utility regulation, aniitrust policy
Insurance, financial regulation, consumer protection
Redistributive pensions, family allowances, unemployment insurance
Redistribution:
Activist functions
Progressive income taxes, wealth taxes, biasing expenditure towards lower
Addressing market failure
Fostering markets, cluster initiatives, regional development
Co-ordinating private acivity:
Defence, property rights, law and order, public health, macroeconomic management
Minimal functions
Providing pure public goods: