M03EFA: Economic Environment of Business Government, Market Failure & Market Regulation: Aims: a)Evaluate the causes of government intervention b)Focus on externalities & public goods power c)Assess policy solutions including taxation

THE CASE FOR GOVERNMENT INTERVENTION Immobility of factors and time lags Protecting people’s interests –Dependants –Merit goods

THE CASE FOR GOVERNMENT INTERVENTION Externalities –External costs of production MSC > MC

External costs in production O MC = S DP Q1Q1 Costs and benefits Quantity

O MC = S DP Q1Q1 MSC External cost Costs and benefits Quantity External costs in production

O MC = S DP Q1Q1 MSC Q2Q2 Social optimum Costs and benefits Quantity External costs in production

Beneficial Consumption Externality (training) Quantity (training) Price MSC, MPC DD Q private MSB Q soc Net Social Benefits

Defining Public Goods: No singular agreed definition Often welfare economists focus upon two characteristics…… * Non- excludability * Non-rivalry in consumption

Pay -offs from Public Goods: Voluntary Contribution versus free - riding: (Buchanan, 1968) Outcomes StrategiesOthers contributeOthers free - ride (good provided)(good not provided) Don contributes(£10-£5) = £5- £5 Don free£10£0 -rides

One solution to the free - rider: is the Clarke Tax: This involves making a large group case appear a small group case The Mechanics of the Clarke Tax 1. Ask willingness to pay 2. Sum total for each option 3. Select option with greatest willingness 4. Apply Clarke Tax, i.e. absolute difference between options

Voter High SpendingLow Spending Total8070 A. High level wins B. Voter 1 pays Clarke Tax of 40 C. If Voter 1 free rides, Voter 2 is 70 better off and Voter 3 is 30 worse off D. Voter 3 pays Clarke Tax of 20 E. Voter 2 has Clarke Tax of 0 (free - riding = 0 effect)

THE CASE FOR GOVERNMENT INTERVENTION Market power –Deadweight loss under monopoly

O £ Q P pc Q pc MC (= S under perfect competition) AR = D (a) Industry equilibrium under perfect competition Consumersurplus Producersurplus a

O £ Q P pc Q pc MC (= S under perfect competition) AR = D a PmPm Q pc MR b (b) Industry equilibrium under monopoly Consumersurplus

O £ Q P pc Q pc MC (= S under perfect competition) AR = D a PmPm Q pc MR b (b) Industry equilibrium under monopoly Consumersurplus Producersurplus

O £ Q P pc Q pc MC (= S under perfect competition) AR = D a PmPm Q pc MR b (b) Industry equilibrium under monopoly Consumersurplus Producersurplus Deadweight welfare loss

Monopoly power O P1P1 MC Q1Q1 MR D = MSB £ Q Monopoly price and output

O MC Q1Q1 MR AR = MSB £ Q AC P =AR Profit (no tax) Using a lump-sum tax to reduce monopoly profits

O P1P1 MC Q1Q1 MR AR = MSB £ Q AC AC + lump-sum tax AC AC + tax Acceptable profit 2. Lump sum tax necessary to achieve acceptable profit

Readings: Begg, D. et al, (2008), Economics, Chpt. 15 Boyes, W., (2004), The New Managerial Economics, Chpt. 15 Cook, M. & Farquarson, C., (1998) Business Economics, Chpt. 20 Griffiths, A. & Wall, S. (2005), Economics for Business & Management, Chapter 8 Hanley, N., et al, (1997), Environmental Economics, Chpts. 2, 4 & 5