Download Insufficient Competition

Market Failures
Lecture 13: Market Failure
and Government Action
• Markets can fail to be efficient:
• Insufficient Competition
• Externalities
Readings: Chapters 13 (pp.313-315), 16, 17
• Public goods
• And Markets can be unfair:
• Inequality
• Poverty
Copyright © 2000 Pearson Education Canada Inc.
Slide 17-1
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Slide 17-2
Insufficient Competition
Insufficient Competition
• Q: How do governments intervene in
• Q: How does government supply regulation?
• A: Regulatory agencies vary in size and
markets which have insufficient
competition?
scope. But there are certain features
common to all agencies.
• Government appoints the senior bureaucrats who
• A: The main policy instruments are:
are the key decision makers.
• Each agency adopts a set of practices or operating
• Regulation
• Public ownership
• Anti-combine law
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rules for controlling prices, product standards, and
other aspects of economic performance.
• Agency certifies firms to serve a particular market.
Slide 17-3
Insufficient Competition
Slide 17-4
Insufficient Competition
• Q: What determines government
• Q: Why has there been a move towards
provision of regulation?
de-regulation?
• A: It is a product of the political
• A: There has been growing evidence that
process, and hence will reflect a
political equilibrium.
regulation to protect the public
frequently only succeeds in protecting
the regulated firms from competition.
• In recent years, the equilibrium has
shifted towards de-regulation (a reduction
in the provision of regulation)
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Slide 17-5
Capture theory says that regulations are
supplied to satisfy the demand of
producers to maximize economic profit.
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Slide 17-6
Natural Monopoly:
Profit Maximization
• Q: Why have regulation at all?
• A: If a firm has diminishing average
costs, it will be a natural monopoly. With
no competition, there will be severe
under-supply and prices will be
dramatically higher than marginal costs.
• Regulation is one way of forcing output
up and prices down.
Price and cost (dollars per household
per month)
Insufficient Competition
30
Consumer
surplus
25
20
18
15
Deadweight
loss
Economic
profit
ATC
10
MC
MR
0
2
4
6
D
8
10
Quantity (millions of households)
Slide 17-7
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Natural Monopoly:
Average Cost Pricing
30
Price and cost (dollars per household
per month)
Price and cost (dollars per household
per month)
Natural Monopoly:
Marginal Cost Pricing
25
20
15
Loss per
household
Total
surplus
ATC
10
MC
D
0
2
4
6
8
10
Quantity (millions of households)
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Slide 17-8
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Slide 17-9
30
25
20
Consumer
surplus
15
ATC
Producer
surplus
10
MC
Deadweight
loss
0
2
4
D
6
8
10
Quantity (millions of households)
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Slide 17-10
Natural Monopoly:
Inflating Costs
Insufficient Competition
Price and cost (dollars per household
per month)
• Q: Does price regulation reduce the
excess burden from natural
monopoly?
• A: Capture theory predicts that the
producer will get the regulator to set
rules that allow it to charge the same
price and produce the same output as
an unregulated monopoly. Firms can
do this by exaggerating their costs.
30
Profit is
maximized
25
20
18
15
ATC (inflated)
ATC
MC
Economic
profit
10
MR
0
2
4
6
D
8
10
Quantity (millions of households)
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Slide 17-11
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Slide 17-12
Insufficient Competition
Insufficient Competition
• Q: Is regulatory capture a real problem?
• Q: What is the alternative to regulation?
• A: A test of whether natural monopoly
• A: Formation of crown corporations:
regulation is in the public interest or
producer interest by measuring rates of
return in regulated monopolies.
• Many natural monopolies in Canada earn higher
rates of return than the economy average. (i.e.
cable television service; telephone service)
Slide 17-13
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Price and cost (dollars per tonne)
Crown Corporation:
Efficient Outcome
• A: With a public subsidy, a crown
corporation can supply the market at
marginal cost and achieve the efficient
output level.
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Slide 17-14
• Q: Have Crown Corporations served
the public interest?
8
• A: Over time, a different sort of
capture may set in. Managers will
tend inflate costs, and make
themselves the residual claimants.
6
Consumer
surplus
Subsidy per tonne:
efficient output
ATC
2
Tax payment
MC
D
0
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2
4
6
8
10
Quantity (billions of tonnes per year)
Slide 17-15
Crown Corporation:
Budget Maximization
Price and cost (dollars per tonne)
• Q: Are crown corporations efficient?
Insufficient Competition
10
4
• Canada Post, Ontario Hydro, etc.
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Slide 17-16
Insufficient Competition
• Q: Are crown corporations inefficient?
10
• A: Case study:
8
6
• CN had costs 14% higher than CP.
• Ontario Hydro routinely pays its workers wages
ATC (inflated)
above the market rate.
4
2
Subsidy per tonne:
efficient output but
maximizing budget
• In recent years, there has been a move to
ATC
privatize publicly owned corporations.
MC
D
0
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2
• Petro-Canada (1991) , Ontario Hydro (2002)
8
10
4
6
Quantity (billions of tonnes per year)
Slide 17-17
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Slide 17-18
Externalities
Externalities
• Q: What are externalities?
There are two types of Externalities:
• A: Externalities are costs or benefits that
• A negative externality occurs whenever a
arise from economic transactions that fall on
people who do not participate in the
transaction. When externalities exist, the
parties to the transaction consider only their
own costs and benefits, and not those social
costs accruing to third parties.
person’s well being or a firm’s production
capability is directly harmed by the actions of other
consumers or firms.
• A positive externality occurs whenever a
person’s well being or a firm’s production
capability is directly improved by the actions of
other consumers or firms.
Slide 17-19
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Slide 17-20
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Externalities
Externalities
• Q: How do negative externalities affect
social outcomes?
• Q: Has economic growth
doomed the environment?
• A: Negative externalities include:
•
•
•
•
•
•
• A: It has put tremendous
Acid Rain
Ozone layer Depletion
Smog alerts
Global Warming
Bacterial ground water contamination (Walkerton)
heavy metal and persistent toxic chemical
contamination of land and ground-water, etc.
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Slide 17-21
pressure on it, but at the
same time higher incomes
has lead to the increased
demands for a clean
environment.
Slide 17-22
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Externalities: Air Pollution
Externalities
• Q: Why do negative externalities occur?
• A: An absence of property rights.
Property rights are social
arrangements that govern the
ownership, use, and disposal of
productive resources and goods and
services.
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Slide 17-23
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Slide 17-24
• Q: How does an absence of property
rights create environmental problems?
• A: Because no one owns the air, the
rivers, and the oceans, they are
available for free use with no
restriction. Users consider only their
private interest in deciding how to use
the productive resource.
Cost and benefit of waste
(dollars per tonne)
Externality Impact
Externalities
MSC
200
Fishing club
bears large
cost...
150
100
…when factory
maximizes its benefit
by dumping waste
50
0
2
4
6
MB
8
Quantity of waste (tonnes per week)
Slide 17-25
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Externalities
Externalities
• Q: What can the government do to
• Q: Do standards work?
correct market failures?
• A: Economists have been concerned that
• A: The government has two options:
standards have largely failed to be
implemented effectively. Political
equilibrium is susceptible to special
interest group manipulation.
• 1. It can assert sole ownership over the
commons resource and limit use:
• 1.1) pollution controls and standards
• 1.2) emission charges and taxes
• 2. It can distribute private property rights:
• 2.1) Common law rights
• 2.2) Marketable emission permits
Slide 17-27
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Slide 17-26
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• Even when they have been implemented,
they are not usually the most efficient
method for reducing pollution.
Slide 17-28
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Externalities
Externalities
• Q: What’s the problem with standards?
• Q: Can government policy force firms to
• A: Suppose the government decides
that pollution should be reduced by
25% and orders all firms to reduce their
pollution from current levels by 25%.
Some firms may find this extremely
expensive and close. Others could
reduce their pollution by 75% at very
little cost but are only required to
reduce pollution by 25%.
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Slide 17-29
distribute the burden of reduction in the
most efficient manner possible?
• A: Emission charges: The government
regulator sets a charge per unit of
pollution. The efficient emission charge
is set so that the marginal social cost of
pollution is equal to its marginal social
benefit.
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Slide 17-30
Cost and benefit of waste
(dollars per tonne)
Externalities: Emission Charges
• Q: What if emission charges cannot be assessed
MSC
15
(ie noise pollution).
• A: The government could introduce a Pigouvian
At $7/tonne,
MSC > MB
10
Externalities
Tax which discourages the activity that has the
negative externality associated with it.
7
• Q: What is the correct Pigouvian tax?
Efficient price
per tonne
• A: If the tax is set equal to the external marginal
MB
cost, then efficient outcome will be achieved.
0
5
10
15
20
Emissions (millions of tonnes per year)
Slide 17-31
Cost, price, and benefit
(dollars per kilometre)
Competitive markets oversupply
if there is pollution
External Cost at Competitive Equilibrium
MSC = PMC + EMC
EMC
SC0
Point of
allocative
efficiency
S = PMC
P1
Competitive
equilibrium
P0
C1
Q1
MSC
SC0
External
cost
Competitive
equilibrium
C1
Q0
D = MB
0
Quantity (kilometres)
Q1
Q0
Quantity (kilometres)
Slide 17-33
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Slide 17-34
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Pigouvian Tax
Cost, price, and benefit
(dollars per kilometre)
S = MC
P1
P0
D = MB
0
Slide 17-32
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Cost, price, and benefit
(dollars per kilometre)
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Externalities
MSC
• Q: What are the problems with
government asserting ownership over
the commons?
S+T
SC0
Point of
allocative
efficiency
S = MC
P1
• A: There are several:
• Political equilibrium may not be efficient.
• Business will resist the huge transfer to
C1
government implied by the government
solution. (ie carbon tax resistance)
D = MB
0
Q1
Q0
Quantity (kilometres)
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Slide 17-35
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Slide 17-36
Externalities
Externalities
• Q: What are the private property
• Q: How does extending common law
solutions to pollution?
property rights solve the externality
problem?
• A: The government can clarify and
• A: Many problems occur because when
extend common law rights, or it can
establish and distribute marketable
emission permits.
no one owns a resource, everyone
thinks they own it. Extending property
rights would clarify who owns the
resource. The owner could then set
about limiting use of the resource.
Slide 17-37
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Slide 17-38
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Externalities
Externalities
• Q: How does this work:
• A: It will depend on who receives the
• Q: If common law property rights are
extended, does it matter who gets
them?
property right:
• A: According to the Coase theorem:
• If the polluted party is given control of the
environment, they can force the polluter to
reduce pollution.
• 1. If transaction costs are low, the
(common law) assignment of property
rights will solve the externality.
• If the polluter is given control of the
environment, the polluted party may choose
to pay the polluter to reduce pollution.
• 2. It will not matter who receives the
property right.
Slide 17-39
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The Coase Theorem
Cost and benefit of waste
(dollars per tonne)
Slide 17-40
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Externalities
• Q: Can we rely on Coasian bargains to
MSC
200
resolve all negative externalities?
• A: No! Transaction costs are frequently
150
high because:
100
• 1) There are many affected parties
• 2) people bargain strategically, and fail to
Efficient level
of waste
50
agree on a price.
MB
0
2
4
6
8
Quantity of waste (tonnes per week)
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Slide 17-41
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Slide 17-42
Externalities
Externalities
• Q: How does a system of marketable
• Q: Why is this system efficient?
emission permits work?
• A: It will be expected that firms that
• A: A maximum allowable amount of
pollution is determined. Permits which
sum to this total are distributed to
current polluters.
• A firm is permitted to only pollute up to
can easily abate pollution will choose
to sell their permits to firms that find it
expensive to abate. The result is that
the least cost method distribution of
abatement will automatically be found.
the amount of the permits held.
• A firm can either buy or sell its permits.
Slide 17-43
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Externalities
Externalities
• Q: What sorts of positive externalities
• Q: In what way does education
have a positive externality
associated with it?
are there?
• A: There are many, among which
• A: External benefits:
include:
• Citizens who can better
communicate and interact
• Landscaping
• Inoculations
• Education
• Good ideas/inventions can be
copied
Slide 17-45
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Slide 17-46
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Externalities
Externalities
• Q: Does this create a market failure?
• Q: How does the government solve this
market failure?
• A: Education and research and
development decisions are made by
comparing private marginal costs and
private marginal benefits. When
decision-makers neglect external
benefits there will be underinvestment
in education and R&D without
government intervention.
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Slide 17-44
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Slide 17-47
• A: The government has three main
policy instruments to correct the
market failure:
• Subsidies
• Below-cost provision
• Patents and copyrights
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Slide 17-48
A subsidy is a payment made by the
government to producers that depends
on the level of output.
Providing a subsidy to
producers reduces their
private marginal cost.
If a subsidy is provided
equal to the external
benefit, an efficient
outcome will be achieved.
Slide 17-49
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The Efficient Quantity
of Education
Cost, price, and benefit
(thousands of dollars per student per year)
Externalities
20
MC
External
benefit
15
10
MSB
5
D = MPB
0
10
20
30
40
50
Quantity (thousands of students per year)
Slide 17-50
Externalities
Instead of offering subsidies to private
schools, the government can provide its
own schools that provide schooling
below cost.
It may still charge tuition equal to the marginal
private benefit of education.
It can also establish its own research
facilities.
In education, direct provision is larger; in
R&D, subsidies are main tool.
Slide 17-51
• Q: Is there a private property solution?
• A: Since knowledge is productive and
creates external benefits, it is
necessary to use public policies to
ensure that there are incentives to
develop new ideas. Intellectual
property rights provide the creators of
knowledge with property rights to their
discoveries.
Slide 17-52
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Externalities
Externalities
Patents or copyrights are
The economic cost of patent protection
is the deadweight loss of monopoly.
government-sanctioned exclusive
rights granted to the inventor or a
good, service, or productive process.
Obtaining a patent allows the developer of
the new idea to prevent others from
benefiting from the invention for a number
of years.
To obtain the patent, the inventor must make
knowledge of the invention public.
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Efficient allocation
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Externalities
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Competitive
equilibrium
25
Slide 17-53
But without patents, the effort to
develop new goods, services, or
process is diminished, and the flow of
new inventions would slow.
Patent protection trades off the benefits
of more invention against costs of
monopoly over a limited time.
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Slide 17-54
Public Goods
Public Goods
1) Nonrivalry
• Q: What are public goods?
The consumption by one
person does not decrease
the consumption by
another.
• A: Public goods are goods or
services that are consumed
simultaneously by everyone and
from which no one can be
excluded.
• Television show
2) Nonexcludable
It is impossible, or extremely costly, to prevent
someone from benefiting from a good.
• National defence
Slide 17-55
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Public Goods and
The Free-Rider Problem
Public Goods and
Private Goods
Pure private goods
Food
Car
House
A free rider is a person who consumes a
good without paying for it.
Excludable & nonrival
Cable television
Bridge
Public goods create a freerider problem because the
quantity of the good that a
person is able to consume
is not influenced by the
amount the person pays for
the good...so why pay
anything at all?
Highway
Nonexcludable & rival
Pure public goods
Fish in the ocean
Lighthouse
Air
National defence
Slide 17-57
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Slide 17-56
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Slide 17-58
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Benefits of a Public
Good
Public Goods
• Q: What is the social value of another unit
Lisa's Marginal Benefit
• A: As everyone will jointly consume this
additional unit of the public good, its total
social value (its social marginal benefit) is
the sum of every persons maximum
willingness to pay.
Marginal benefit
(dollars per acid-rain check)
Marginal benefit
(dollars per acid-rain check)
of a public good ?
80
60
40
• Social Marginal Benefit = sum of each
individual’s marginal willingness to pay.
20
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0
MBL
1
2
3
4
5
Quantity (number of acid-rain checks)
Slide 17-59
80
60
40
• The social marginal benefit at each provision
level can be derived by vertically summing
each individual’s demand for the public good.
Max's Marginal Benefit
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20
0
MBM
1
2
3
4
5
Quantity (number of acid-rain checks)
Slide 17-60
Public Goods
• Contrast this with a private good. Only one
140
120
person gets to consume a private good, so
the social marginal benefit of one unit of the
private good is the marginal benefit
(maximum willingness to pay) of the person
who gets to consume the good.
Economy's Marginal Benefit
100
80
60
• By a little bit of thought you will be able to
40
20
0
see that the social marginal benefit curve for
a private good is the horizontal summation
of the individual demand curves (maximum
willingness to pay curves).
MB
1
2
3
4
5
Quantity (number of acid-rain checks)
Slide 17-61
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The Efficient Provision
of a Public Good
• Q: What is the efficient provision level of the
public good?
• A: The most efficient provision level is
where the social surplus is maximized. This
occurs where the social marginal benefit
(SMB) equals the marginal cost. A rational
strategy for finding the efficient provision
level is to:
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Total benefit and total cost (billions of dollars)
Public Goods
• increase provision if
SMB > MC
• reduce provision if
SMB < MC
• hold provision constant if SMB = MC
Slide 17-62
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Total Benefit & Total Cost
Marginal Benefit & Marginal Cost
TC
7.5
Marginal benefit
(billions of dollars per acid-rain check)
Marginal benefit
(dollars per acid-rain check)
Benefits of a Public Good
2.0
5.0
TB
3.5
M
1.0
Net benefit
$2.0 billion
1.5
0
2
3
4
5
1
Quantity (number of acid-rain checks)
Slide 17-63
MC
Efficient
use of
resources
MB
0
1
2
3
4
5
Quantity (number of acid-rain checks)
Slide 17-64
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Public Goods
Public Goods
• Q: Is private market provision efficient?
• Q: Is government provision efficient?
• A: No! Because of the free rider
• A: To answer this we have to examine
problem, too little of the public good is
provided.
• A private firm will not deliver the efficient quantity
of a public good. It needs to charge consumers a
price that will cover its costs…but once it is
produced, no one has an incentive to buy.
• Example: Lighthouse signal
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Slide 17-65
what the political equilibrium delivers.
• Political parties do a “what if” analysis before
determining their policy regarding the provision of
public goods.
• They choose the platform that maximizes their
chance of being elected: this means they must
maximize the perceived net benefit of a winning
coalition of voters.
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Slide 17-66
Public Goods
Public Provision
Q: How does political competition between
parties influence the platforms on offer?
• Q: Will the winning platform be efficient?
A: Competition for votes tends to move parties to
the center. It is in the center that the median
voter is found, and hence it is in the center that
winning coalitions can be constructed. The
implication is that all parties tend to advocate
similar provision levels in equilibrium.
• A: The winning platform on public good
The principle of minimum differentiation is
the tendency for competitors to make themselves
identical to appeal to the maximum number of
clients or voters.
Slide 17-67
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provision will tend to appeal to the
median voter’s preferences. Notice that
this equilibrium is unrelated to the
calculation of the efficient provision level.
We therefore cannot expect that the
democratic process will deliver an
efficient amount of the public good.
Public Goods
Public Goods
• Q: How do bureaucratic interests alter the
• Q: Is there anything that might
political equilibrium?
complicate the political equilibrium?
• A: There are a number of theories. The
• A: Politics is the art of the possible.
Politicians rely heavily on the advice of
bureaucrats as to what is possible, and
the costs of these possibilities.
• A bureaucrat’s interests are different
from the interests of vote maximizing
politicians.
Slide 17-69
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Slide 17-68
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simplest suggests that many bureaucrats
may seek to maximize the size of their
bureau so as to increase their pay and
prestige. Such a bureaucrat will thus seek
methods to influence the political
equilibrium in a way that increases the size
of the budget that they control.
Slide 17-70
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Public Goods
Bureaucratic Overprovision
TC
• Q: How do bureaucrats influence the
7.5
Total benefit and total cost
(billions of dollars)
political equilibrium?
5.0
• A: Bureaucrats controls information about
Goal of
bureaucracy
the costs and benefits of proposed public
goods. If they exaggerate the benefits or
underestimate the costs of a public good,
they might be able to get a politician to
adopt and implement a platform that
promotes a larger provision level than is
efficient.
TB
3.5
1.5
0
Efficient
provision
1
2
3
4
5
Quantity (number of acid-rain checks)
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Slide 17-71
• Example: Missile Defense
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Slide 17-72
Public Goods
Bureaucratic Exaggeration
TC
Total benefit and total cost
(billions of dollars)
7.5
• Q: Are bureaucrats the only group who
wish to manipulate the political
equilibrium?
5.0
TB
• A: No special interests who have a
3.5
private stake in public good provision
are very active in attempting to
manipulate political outcomes.
1.5
0
1
2
3
4
5
Quantity (number of acid-rain checks)
Slide 17-73
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Slide 17-74
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Public Goods
Public Goods
• Q: How do special interest groups
• Q: Why might democracy be easily
manipulated by special interests?
manipulate the political equilibrium?
• A: By manipulating information.
• A: Rational ignorance.
Politicians and voters are uninformed
about the costs and benefits of public
goods, and interest groups will use
advertising and political contributions
to influence platforms.
Rational ignorance is the decision not
to acquire information because the cost of
doing so exceeds the expected benefit.
• Example: Softwood lumber dispute.
Slide 17-75
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Slide 17-76
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Public Goods
• Q: What are the most expensive public goods
provided by government in wealthy countries?
• Concern for poor families and poor children has led to desire for the
community to do something to help alleviate suffering.
END
• One response is to create social norms that laud charitable giving.
This is found in virtually all religions of the world.
• A modern response is to get the State to provide a social safety net of
welfare services.
• This is a public good, because the benefit (relief that something is
being done to help the poor) is shared communally, but the cost is
subject to free riding.
• Public provision financed by taxation solves under-supply problem.
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Slide 17-77
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Slide 17-78