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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 Copyright © 2000 Pearson Education Canada Inc. 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 Copyright © 2000 Pearson Education Canada Inc. 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) Copyright © 2000 Pearson Education Canada Inc. Copyright © 2000 Pearson Education Canada Inc. Slide 17-5 Capture theory says that regulations are supplied to satisfy the demand of producers to maximize economic profit. Copyright © 2000 Pearson Education Canada Inc. 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 Copyright © 2000 Pearson Education Canada Inc. 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) Copyright © 2000 Pearson Education Canada Inc. Slide 17-8 Copyright © 2000 Pearson Education Canada Inc. 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) Copyright © 2000 Pearson Education Canada Inc. 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) Copyright © 2000 Pearson Education Canada Inc. Slide 17-11 Copyright © 2000 Pearson Education Canada Inc. 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 Copyright © 2000 Pearson Education Canada Inc. 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. Copyright © 2000 Pearson Education Canada Inc. 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 Copyright © 2000 Pearson Education Canada Inc. 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. Copyright © 2000 Pearson Education Canada Inc. 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 Copyright © 2000 Pearson Education Canada Inc. 2 • Petro-Canada (1991) , Ontario Hydro (2002) 8 10 4 6 Quantity (billions of tonnes per year) Slide 17-17 Copyright © 2000 Pearson Education Canada Inc. 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 Copyright © 2000 Pearson Education Canada Inc. Slide 17-20 Copyright © 2000 Pearson Education Canada Inc. 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. Copyright © 2000 Pearson Education Canada Inc. 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 Copyright © 2000 Pearson Education Canada Inc. 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. Copyright © 2000 Pearson Education Canada Inc. Slide 17-23 Copyright © 2000 Pearson Education Canada Inc. 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 Copyright © 2000 Pearson Education Canada Inc. 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 Copyright © 2000 Pearson Education Canada Inc. Slide 17-26 Copyright © 2000 Pearson Education Canada Inc. • Even when they have been implemented, they are not usually the most efficient method for reducing pollution. Slide 17-28 Copyright © 2000 Pearson Education Canada Inc. 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%. Copyright © 2000 Pearson Education Canada Inc. 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. Copyright © 2000 Pearson Education Canada Inc. 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 Copyright © 2000 Pearson Education Canada Inc. Slide 17-34 Copyright © 2000 Pearson Education Canada Inc. Pigouvian Tax Cost, price, and benefit (dollars per kilometre) S = MC P1 P0 D = MB 0 Slide 17-32 Copyright © 2000 Pearson Education Canada Inc. Cost, price, and benefit (dollars per kilometre) Copyright © 2000 Pearson Education Canada Inc. 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) Copyright © 2000 Pearson Education Canada Inc. Slide 17-35 Copyright © 2000 Pearson Education Canada Inc. 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 Copyright © 2000 Pearson Education Canada Inc. Slide 17-38 Copyright © 2000 Pearson Education Canada Inc. 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 Copyright © 2000 Pearson Education Canada Inc. The Coase Theorem Cost and benefit of waste (dollars per tonne) Slide 17-40 Copyright © 2000 Pearson Education Canada Inc. 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) Copyright © 2000 Pearson Education Canada Inc. Slide 17-41 Copyright © 2000 Pearson Education Canada Inc. 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 Copyright © 2000 Pearson Education Canada Inc. 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 Copyright © 2000 Pearson Education Canada Inc. Slide 17-46 Copyright © 2000 Pearson Education Canada Inc. 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. Copyright © 2000 Pearson Education Canada Inc. Slide 17-44 Copyright © 2000 Pearson Education Canada Inc. Slide 17-47 • A: The government has three main policy instruments to correct the market failure: • Subsidies • Below-cost provision • Patents and copyrights Copyright © 2000 Pearson Education Canada Inc. 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 Copyright © 2000 Pearson Education Canada Inc. 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 Copyright © 2000 Pearson Education Canada Inc. 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. Copyright © 2000 Pearson Education Canada Inc. Efficient allocation Copyright © 2000 Pearson Education Canada Inc. Externalities Copyright © 2000 Pearson Education Canada Inc. 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. Copyright © 2000 Pearson Education Canada Inc. 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 Copyright © 2000 Pearson Education Canada Inc. 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 Copyright © 2000 Pearson Education Canada Inc. Slide 17-56 Copyright © 2000 Pearson Education Canada Inc. Slide 17-58 Copyright © 2000 Pearson Education Canada Inc. 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 Copyright © 2000 Pearson Education Canada Inc. 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 Copyright © 2000 Pearson Education Canada Inc. 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 Copyright © 2000 Pearson Education Canada Inc. 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: Copyright © 2000 Pearson Education Canada Inc. 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 Copyright © 2000 Pearson Education Canada Inc. 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 Copyright © 2000 Pearson Education Canada Inc. 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 Copyright © 2000 Pearson Education Canada Inc. 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. Copyright © 2000 Pearson Education Canada Inc. 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 Copyright © 2000 Pearson Education Canada Inc. 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 Copyright © 2000 Pearson Education Canada Inc. Slide 17-68 Copyright © 2000 Pearson Education Canada Inc. 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 Copyright © 2000 Pearson Education Canada Inc. 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) Copyright © 2000 Pearson Education Canada Inc. Slide 17-71 • Example: Missile Defense Copyright © 2000 Pearson Education Canada Inc. 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 Copyright © 2000 Pearson Education Canada Inc. Slide 17-74 Copyright © 2000 Pearson Education Canada Inc. 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 Copyright © 2000 Pearson Education Canada Inc. Slide 17-76 Copyright © 2000 Pearson Education Canada Inc. 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. Copyright © 2000 Pearson Education Canada Inc. Slide 17-77 Copyright © 2000 Pearson Education Canada Inc. Slide 17-78