MARKET FAILURES AND GOVERNMENT INTERVENTION Inna Ushcatz and Ieta Shams

Market Failure The difference between a socially optimum level of production and the market level production is a market failure. The difference between a socially optimum level of production and the market level production is a market failure. In a free market economy it is sometimes possible for individual parties to work out a solution, but government intervention is needed when: In a free market economy it is sometimes possible for individual parties to work out a solution, but government intervention is needed when: Property rights are unclear Property rights are unclear The number of people concerned is large The number of people concerned is large Bargaining costs are high Bargaining costs are high Market fails because it does not allocate resources efficiently. Market fails because it does not allocate resources efficiently.

Types of Inefficiency The resulting inefficiency of market failures: The resulting inefficiency of market failures: Productive inefficiency: businesses are not maximizing their outputs. More output, could have satisfied more wants and needs. Costs are higher; productivity is lower than could have been. Productive inefficiency: businesses are not maximizing their outputs. More output, could have satisfied more wants and needs. Costs are higher; productivity is lower than could have been. Allocative inefficiency: businesses misallocate resources and produce goods and services that are not wanted by the consumers. Resources could have been used more efficiently. Allocative inefficiency: businesses misallocate resources and produce goods and services that are not wanted by the consumers. Resources could have been used more efficiently.

Government Intervention  In a market failure the unrestrained market creates more harm than good.  In a market failure the government has a role to play in correcting or internalizing the market failure.  Government intervention aims to achieve economic efficiency.

Roots Causes of Market Failures Externalities in production and consumption Externalities in production and consumption Public Goods (missing market) Public Goods (missing market) Lack of Competition (Monopoly) Lack of Competition (Monopoly) Poverty and Inequality in an Economy Poverty and Inequality in an Economy

Externalities -Marginal Benefit- Marginal analysis is used to study externalities. Marginal analysis is used to study externalities. Marginal Private Benefit (MPB): belongs to the producer or consumer of the good. Marginal Private Benefit (MPB): belongs to the producer or consumer of the good. Marginal External Benefit (MEB): the spillover. Marginal External Benefit (MEB): the spillover. MPB + MEB = Marginal Social Benefit (MSB) Quantity Price Demand (private value) Social value Supply (private cost) Q MARKET Q OPTIMUM

Externalities -Marginal Cost-  Marginal Private Cost (MPC): the cost incurred by the producer or consumer.  Marginal External Cost (MEC): is the spillover or the externality. MPC + MEC = Marginal Social Cost (MSC)  Market prices generally reflect only private costs and benefits. Price Cost of pollution Equilibrium Quantity 0 Demand (private value) Supply (private cost) Social cost Q OPTIMUM Optimum Q MARKET

Externalities -Common Government Approaches- Problem Resource Allocation of Outcome Ways to Correct Spillover costs (negative externalities) Over allocation of resources 1.Individual bargaining 2.Liability rules and lawsuits 3.Tax on producers 4.Quantity controls 5.Market for externality rights Spillover Benefits (positive externalities) Under allocation of resources 1.Individual bargaining 2.Subsidy to consumers 3.Subsidy to producers 4.Government provision

Externalities -Quantity Control- The most common form of government regulation is setting a quantity control on the production of a good or service. The most common form of government regulation is setting a quantity control on the production of a good or service. A direct control sets absolute levels. A direct control sets absolute levels. The total amount of the good which can be produced under the quantity control is called the quota limit. The government limits quantity in a market by issuing licenses for production. The total amount of the good which can be produced under the quantity control is called the quota limit. The government limits quantity in a market by issuing licenses for production. Quantity controls typically create undesirable side-effects: Quantity controls typically create undesirable side-effects: Inefficiencies, or missed opportunities, in the form of mutually beneficial transactions that don’t occur. Inefficiencies, or missed opportunities, in the form of mutually beneficial transactions that don’t occur. Incentives for illegal activities Incentives for illegal activities

Externalities -Subsidies-  Shift of the demand curve to the right, raising the output level closer to the socially optimum level.  Shift of the supply curve to the right, again correcting the under allocation. Subsidy to the Buyer Subsidy to the Seller Where there are spillover benefits, government often uses subsidies to correct the under allocation that the free market would produce. Subsidies can be paid either to the buyers or the sellers. Subsidies create undesirable side-effects:  Inefficient producers remain in business  Serves as a burden for the taxpayers

Externalities -Tax on Producers- A way to solve negative externalities is through issuing excise taxes. Excise taxes on producers will raise the marginal cost, and decrease supply. A way to solve negative externalities is through issuing excise taxes. Excise taxes on producers will raise the marginal cost, and decrease supply. Sellers pass as much of the added cost on to buyers as possible, by increasing selling price. This will maintain the same profit margin, and allow the consumer to cover the producers purchase costs. Sellers pass as much of the added cost on to buyers as possible, by increasing selling price. This will maintain the same profit margin, and allow the consumer to cover the producers purchase costs. Taxes on producers create the following undesirable side-effects: Taxes on producers create the following undesirable side-effects: inefficiency as a result of the excess burden or deadweight loss caused by the tax. inefficiency as a result of the excess burden or deadweight loss caused by the tax. They also encourage illegal activity in attempts to avoid the tax. They also encourage illegal activity in attempts to avoid the tax.

Externalities -Effects of a Tax-  A tax places a wedge between the price buyers pay and the price sellers receive.  Because of this tax wedge, the quantity sold falls below the level that would be sold without a tax.  The size of the market for that good shrinks.  A deadweight loss is the fall in total surplus that results from a market distortion, such as a tax.

Externalities -The Effects of a Tax- Size of tax Quantity Price Price buyers pay Price sellers receive Demand Supply Price without tax Quantity without tax Quantity with tax

Externalities -Public Provision of Goods and Services- Government provides previously decided upon public goods with tax money collected from all citizens. Government provides previously decided upon public goods with tax money collected from all citizens. Government cannot use price as a signal of value in the way that a market would, because price does not fully reflect the value of most public goods. Government cannot use price as a signal of value in the way that a market would, because price does not fully reflect the value of most public goods. Government must use other methods, such as: Government must use other methods, such as: Public surveys Public surveys Market research Market research Voting for certain political candidates Voting for certain political candidates

Monopolies -Market Failures-  Increased competition in a market means that a market is more likely to provide allocative efficiency by providing the socially optimum amount of a good.  Some markets will organize themselves to hinder competition, essentially creating a monopoly.  The government aims to make industry more competitive.

Monopolies -Government Responses- Antitrust Policies: Laws that aim to curb monopoly power. Antitrust Policies: Laws that aim to curb monopoly power. Antitrust laws make the following practices illegal: Antitrust laws make the following practices illegal: Collusive price fixing Collusive price fixing Separation of markets Separation of markets Tying contracts Tying contracts Interlocking directorates Interlocking directorates Price discrimination when it reduces competition Price discrimination when it reduces competition Antitrust laws strengthen government powers to promote competition. Antitrust laws strengthen government powers to promote competition.

Inequality - Disparities in the Distribution of Economic Resources- Inequality - Disparities in the Distribution of Economic Resources-  Questions to ask when measuring inequality: –How much people are in our society? –How many people live in poverty? –How often do people move amongst income classes?  Failure to properly distribute income leads to a inequality (a form of market failure)  Change in technology and outsourcing, has decreased demand for unskilled labour and made their incomes extremely low.  It is believed that everyone has an equal opportunity to succeed, but the misallocation of resources proves this wrong.

Inequality -Solutions-  Policies that are imposed in order to decrease Inequality: –Minimum wages: If labour is inelastic, this policy is effective at reducing inequality. If labour is elastic, not so much. –Welfare: government programs that supplement the income of the needy –Negative Income Tax: High income families pay tax, low income families receive the “negative tax” –In-kind Transfers: Things given to the poor in the form of goods and services Distribution of Income US 2007

Lorenz Curve The Lorenz Curve: A curve that shows the degree of inequality. Illustrates how income is distributed unequally in a society. The Lorenz Curve: A curve that shows the degree of inequality. Illustrates how income is distributed unequally in a society. The pink shaded area labelled A represents inequality present in a society. The pink shaded area labelled A represents inequality present in a society. The Gini Coefficient finds the area of inequality, divides it by the total area to find the percentage of inequality. The Gini Coefficient finds the area of inequality, divides it by the total area to find the percentage of inequality.

Factor Distribution & the Gini Coefficient  Gini coefficient: An number between zero and one that is used to measure inequality as it relates one variable to another. For perfect equality the Gini coefficient is 0. However, absolute inequality yields a coefficient of 1.  The Gini Coefficient can be found from the Lorenz Curve by dividing area A by the combination of area A and B  Thus, A/(A+B)  Factor Distribution of Income: is the division of total income among labor, land and capital.

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Practice Multiple Choice Question 1. In the case of a market in which a negative externality is produced, which of the following is true of marginal social cost? a)MSC=MPC b)MSC=MPB c)Government can intervene to cause MSC=MEC d)Marginal social cost is not reflected in the supply curve e)Bystanders are bearing the marginal social cost

Practice Multiple Choice Question 1. At the socially efficient output and price for a good whose production causes pollution, we can expect that a)The offending pollution will be eliminated b)The marginal social cost of production will exceed the marginal social benefit of production c)The private cost of production will equal the private benefit of production d)The marginal social benefit of production will equal the marginal social cost of production e)Too little of the good will be produced

Practice Free- Response 1. Assume that product X is produced in a perfectly competitive market and yields costs that are borne by third party individuals. Using a correctly labeled graph, show the market output and price if the market ignores the externality. a)Identify the problem in this market. b)Identify and explain a remedy to the problem of misallocation of resources. c)Amend the graph to show how your remedy has changed the output to the socially optimum amount.

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