Chapter 9: Market Power and Market Failure zPurpose of chapter – a detailed examination of how Pareto Optimality can be distorted in a market economy by Market Power and Market Failure. zLeads to Distortions between shares of the Social Endowment and Social Product of members of a society.

Market Power zMarket Power – the process of exploiting an advantage to give an individual some control in the market. -- Distributes a larger share of the social product (production) of the economy to the powerful. -- Makes the economy less efficient, producing less social product than under GCE.

Naturally Occurring Market Power zNaturally Occurring Market Power – market power resulting from either the consumers initial endowment (gifts, talents, attributes), or the natural competitive process of business. zNatural part of an economy.

Naturally Occurring Market Power in the Labor Market zConsider a labor market with a very high demand for a certain attribute. zNow consider individuals who have this attribute more than anyone else (and it doesnt have to be a lot more). zThe result – a large amount of market power for these individuals, and a very wage for them. zE.G. – Michael Jordan, Julia Roberts.

Naturally Occurring Market Power in Industry zTake an industry which undergoes great Economies of Scale – large purchases of physical capital, leading to a large region of downward sloping Average Cost (AC) zSignificant increases in efficiency, lower average costs for high volume of production as a result. zDrives many other businesses out. zCreates Barriers to Entry – difficult for other businesses to enter to grab some of the positive economic profit.

The Extreme Case zMonopoly – industry characterized by one producer. zProducer has driven everyone else out through economies of scale, significant barriers to entry make it very difficult for firms to enter in. zIllegal in US (early 20 th Century).

Naturally Occurring Market Power: Not Permanent zConsumers tend to lose attribute of being #1 in these highly competitive markets. zNew technologies arise and produce superior products, bringing down original firms (e.g. IBM and Microsoft).

Artificially Occurring Market Power zArtificially Occurring Market Power – market power stemming from institutional restrictions or social perceptions. zMost dangerous threat to competitive economy (Adam Smith). zCan be long-term, not eroded naturally.

Rent-Seeking and Rent-Maintenance zRent-Seeking – an attempt to seek market power by achieving an artificially created advantage. zRent-Maintenance – an attempt to maintain market power by maintaining an artificially created advantage. zApplication: Is this occurring through lobbying by special-interest groups in Congress?

Examples of Market Power zKey – protection or benefit of a segment of society at the expense of the competitive economy as a whole. -- patents for inventors -- tariffs and trade restrictions -- laws to keep industries out of villages (e.g. Wal-Mart) -- discrimination (institutional laws and social perceptions)

Discrimination and Gender Pay Inequity zConsider two labor markets, with the same labor demand and requiring roughly equal human capital. zOne is man-sphere jobs (MS). zOther is woman-sphere jobs (WS). zEquilibrium wage in WS jobs (W* WS ) < Equilibrium wage in MS jobs (W* MS ).

Discrimination and Gender Pay Inequity zNo discrimination (institutional or social perception) migration from low-paying WS jobs to high- paying MS jobs. zSupply of labor decreases in WS market W* WS. zSupply of labor increases in MS market W* MS. zContinues until W* WS = W* MS.

Discrimination and Market Power zDiscrimination – either prevents this adjustment from happening by law (institutional), or discourages it from happening (social perception). zRent-Maintenance done by group imposing discrimination.

Market Failure zMarket Failure – a market either doesnt form when needed, or it doesnt work smoothly and quickly to make necessary adjustments.

Market Failure and Public Goods zPublic Good – a good which is non-partitionable (cannot be split up into pieces or degrees), and non-excludable (cannot exclude anyone from using it). zExamples – national defense, fire protection, police protection.

The Free Rider Problem zFree Rider Problem – since public goods are non-excludable, and non-partitionable, people can get full coverage for free. Therefore, everyone waits for someone else to pay for it. As a result, a market doesnt form (market failure).

Market Failure and Externalities zExternality – when the actions of one economic unit (consumer, firm) affect another economic unit. zPositive Externality – affects in a positive way. zNegative Externality – affects in a negative way.

Externalities and (Lack of) Property Rights zUnderlying reason for externalities – actions affect shared community resource where property rights cant be assigned (e.g. air, water, environment). zExample – second-hand smoke from cigarettes.

Externalities – External Costs and Benefits zNegative Externality – imposes an external cost to society, due to spillover harm on other members. zPositive Externality – produces an external benefit to society, due to spillover benefit on other members.

Marginal Private Benefit and Marginal Private Cost zMarginal Private Benefit (MPB) – the benefit to an individual person of doing one more unit of an activity (similar to marginal utility). zMarginal Private Cost (MPC) – the cost to an individual person of doing one more unit of an activity (all economic costs).

Marginal Social Benefit and Marginal Social Cost zMarginal Social Benefit (MSB) – the benefit to society of the person doing one more unit of an activity (similar to marginal utility). zMarginal Social Cost (MSC) – the cost to society of the person doing one more unit of an activity (all economic costs).

Characteristics of MPB, MPC, MSB, and MSC zAll are measured in dollars ($). zMSB = MPB + EB, where EB are External Benefits associated with a positive externality involving the action. zMSC = MPC + EC, where EC are External Costs associated with a negative externality involving the action.

Negative Externality – A Graphical Representation zNegative externality implies that External Costs > 0 and MSC > MPC. zMSC curve represented by an upward shift of the MPC curve. zSocially optimal level of activity (L S ) < Privately optimal level of activity (L P ).

Negative Externality – Conclusion zInefficiency due to Market Failure. zToo much undesirable activity, shifts social costs to bystanders.

Positive Externality – A Graphical Representation zPositive externality implies that External Benefits > 0 and MSB > MPB. zMSB curve represented by an upward shift of the MPB curve. zSocially optimal level of activity (L S ) > Privately optimal level of activity (L P ).

Positive Externality – Conclusion zInefficiency due to Market Failure. zToo little desirable activity.

Negative Externalities and Firms zInherent problem in production. zExamples -- acid rain and the environment. -- dumping chemicals in lakes, contaminating water supply -- noise pollution -- bars, adult places, and crime

Risk Externalities zRisk Externality – externality resulting from creating an unintended risk for innocent bystanders. zExample -- DWI. zTechnology to reduce incidence of risk externality: breathalyzer/starter lock for car.

Market Power and Market Failure: The Next Step zCreates inefficiencies in society, deviation from GCE. zVery realistic and common. zWhat can government do to remedy these problems? zWhen should government not try to remedy these problems? zTopic of next chapter.