Download Understanding Market Failure

Understanding Market Failure
PPA 670
Policy Issue Analysis
Dr. Butz
Economic Freedom
• Economic freedom (from an economic efficiency
standpoint) refers to the degree to which private
individuals are able to carry out voluntary exchange
without government involvement.
• Free exchange in the marketplace arguably leads to
efficient outcomes for individuals, firms, and society
– Pareto efficiency
– No better or more optimal use of society’s limited resources
Allocative Efficiency
• Allocative or pareto efficiency occurs when firms produce
those goods and services most valued by society
– This means scarce resources are allocated to the production of the
goods and services so that consumer wants and needs are met in the
best way possible.
• In a market system, resources are allocated
according to the interaction of supply and demand.
• Through the price mechanism, markets ration scarce
resources to their most highly valued uses
Consumer and Producer Surplus
• Consumer surplus is the difference between the
amount a consumer would be willing to pay and
the actual price.
– Someone who receives consumer surplus
might feel that he or she found “a bargain.”
• Producer surplus is the difference between the
actual price and the minimum price the firm
requires in order to supply the good.
– A firm receiving producer surplus might consider
themselves to be selling “at a market premium.”
Consumer and Producer Surplus
• In ideally competitive markets of buyers and sellers, the
invisible hand of the marketplace maximizes both
producer and consumer surplus and ultimately the
amount of net benefit to society (social surplus)
created by a market.
• This determination usually rests on considerations of
efficiency, rather than fairness or human dignity.
– We assume that adequate consumer participation in the
marketplace is feasible… But that might not always be the
case!
– We will explore social equity, dignity and distributional
concerns beyond resource efficiency next week.
Efficient Markets
• Requirements for an efficient market (assumptions
of the idealized pure market model):
– Private (not public) goods
– Marketplace competition among firms/producers/sellers
– Accurate and ample information is available
– No external (social) costs or benefits
– Property rights are identifiable and protected
– Contract obligations are enforced
Market Failures
• Market failure – The invisible hand pushes in such a
way that individual decisions do not lead to socially
efficient outcomes.
– Fail to achieve the “best” possible outcome in terms of
resource allocation, from an economic perspective
• Market failure occurs when private markets fail,
thus providing a potential role for the government
to intervene and improve efficiency.
Market Failure
• Market failure can arise in cases of:
– Public goods and common property resources
– Monopoly
– Oligopoly
– Externalities
– Asymmetric information
Public Goods
• Public goods have two key properties:
• Non-rivalry in consumption
– Simultaneous consumption - If I consume more, others
do not need to consume less
– Contrasted with private goods and rivalrous
consumption
• Non-excludability
– Difficult to prevent or exclude people from consuming
the good once it is provided
Public Goods
• Public Goods Examples
– National defense
– Street lights; Lighthouse
– Roads and infrastructure
– Parks
– Libraries
– Environment
– Common pooled resources (waterways, etc.)
• Issues of congestion and declining marginal
benefits from additional consumption?
Public Good Solutions
• Often we let the government provide public
goods because they can force people to pay for it
via taxation
– Government collects taxes from citizens and then
directly provides military services, roads and mass
transit systems, parks, libraries, etc.
• Can also find ways to exclude people in relatively
congested public goods (tolls, congestion pricing,
time limit on library computers, etc.)
Natural Monopoly
• Monopoly: Only one producer/seller exists in the
marketplace
– Extremely high fixed, up-front costs of initializing
production
– Low marginal costs of producing an additional unit
– Utility companies
• Inefficient to run multiple competing water, electric and gas
lines --- creates wasteful duplication!
• Building large-scale power generators and running thousands
of miles of pipe/lines has enormous fixed costs
– Extremley high barriers to marketplace entry of competitors!
Natural Monopoly
• Monopoly firm is price-maker not a price-taker
– Violates assumptions of pure market model in which prices are set
by the dynamic interplay of suppliers and buyers
– Does not face rival competitors and minimal competitive pressure
to reduce prices for consumers
• Monopolistic pricing arrangements
– Increased “artificial” pricing and profit maximization motives
– Basic necessary utility services and inelastic demand
– Lack of product substitutes
– Electric company can double rates and most consumers would continue to pay for
the service to keep the lights on!
– Reallocation of wealth from consumers to monopoly producer
• Leads to sizable “deadweight loss” to consumers
Remedies: Antitrust Laws
Laws against monopolies in the United States:
• Sherman Antitrust Act of 1890
– First legislation that deals with monopoly power and
anticompetitive arrangements
– U.S. v. Microsoft (2000)
• Clayton and Federal Trade Commission Acts of 1914
– Deals with acquisitions and mergers
• State and local governments are able to regulate
pricing schemes of natural monopolies
Oligopoly
• An oligopoly is a market dominated by a small
number firms/producers/sellers
– Exhibits potential for market failure similar to
monopolistic competition
• Ability to influence prices (not passive price takers)
• High barriers to entry for potential competitors
– Firms have incentives to coordinate or “collude” with
each other (create a “cartel”) to charge artificially
inflated prices in pursuit of profit maximization
• Exploit consumers and reduce consumer surplus
• Can yield inefficient allocation of scarce resources
Oligopoly Examples
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Automobile makers
Airline industry
Pharmaceutical companies
Health insurance providers
Oil and gas companies
Cellular phone companies
• Rationale for government intervention?
– Regulatory watchdog – Current DOJ investigation into
airline collusion and price inflation!
– Review (and potentially deny) mergers and acquisitions
among powerful corporate firms
Externalities
• Externality refers to a cost or benefit that accrues to someone
who is not the immediate buyer or the seller in the transaction.
– Social costs and social benefits are costs and benefits that
are borne by uninvolved third-parties.
– “Spillover effects”
• Externalities arise when actors in the marketplace are not
considering ALL of the costs and benefits to society when
making their market decisions.
– Leads to inefficient resource allocation/societal outcomes
• Externalities take two forms
– Negative externality
– Positive externality
Negative Externalities
• Negative externalities may result when some of the
costs of an activity are not borne directly by
consumers or firms involved in transaction.
– Costs are felt by uninvolved third-parties
• Hence the term “social costs” (private cost + externality cost)
• When there is a negative externality, marginal social
cost is greater than the marginal private cost of
producing an additional unit.
Negative Externalities
• When there are negative externalities, the “full”
costs are not accounted for.
– Thus, the competitive price is set too low and the
quantity produced and consumed is too high to
maximize social welfare.
• Resources are not being used in their highestvalued, most efficient activity and market failure
occurs.
A Negative Externality: Pollution
Negative Externality Example
– A steel plant’s operations benefit both the owner of the
plant and the buyers of steel.
– However, the plant’s neighbors are made worse off by
the pollution caused by the plant.
– Thus, some of the production costs are “paid for” by
society, not the polluting firm directly
– Thus, too much of the “harmful” good is produced and
resources are allocated inefficiently
Negative Externalities
• Demerit Goods
– Private consumption goods that oftentimes have
negative externalities
• Examples: Alcohol, tobacco, junk food (sugar?), plastic bags,
cars, etc.
– Without government intervention, the market has a
tendency to overproduce many of these goods
• Government intervention?:
– Tax the consumption of the goods (excise taxes reduce demand)
– Tax the production of the good (reduce supply)
– Outlaw the good or severely restrict usage
Positive Externality
• Positive externalities may result when some of the
benefits of an activity are received by third-parties
not directly involved in the transaction.
– The full benefits of market actions to society are not
taken into consideration
• Thus, too little of the good is produced and
consumed, and thus resource allocation is not
maximized (not efficient)
Positive Externalities
• Education
• Innovative ideas
– Research and development
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Public art, beautification and parks
Vaccinations
Public health facilities
Hybrid cars
Positive Externalities
• Merit Goods
– Private goods that has beneficial effects and oftentimes have
positive externalities on others
• Examples: Healthcare, education, vaccinations
– Markets do not always provide merit goods in large enough
quantities because marginal social benefits (private benefit plus
positive spillover to others) are unaccounted for
• Government intervention?
– Subsidize and increase consumption demand for merit
goods
– Subsidize its production and increase the supply of merit
goods
Potential Remedies for Externalities?
• Private Remedies
– Let the individuals work it out themselves
– Could be more efficient remedy than direct
government involvement
– But high transaction costs and costs of coordination
might prevent the private remedy
• Difficult to just “work it out” among each other when there
are more than just a few parties involved!
• Public education campaigns
– Highlighting the benefits of certain actions or reminding
people of costs of certain actions
Taxes and Subsidies
• Internalize costs and benefits
– Make them “feel the pain”
• Pollution tax on polluting firms
– Internalize the “true” cost of production that includes external social
costs of pollution
– Reduces quantity supplied to the marketplace
– Make them “feel the gain”
• Subsidy for families to get inoculated
• Subsidy for higher education
• Subsidies and grants for R&D and innovative technology
advancement
Command and Control
• Another approach is command and control—
rather than imposing a tax or offering a subsidy,
the government simply requires, wills or
commands the activity.
– For a negative externality the government simply
requires the company to stop polluting.
• A common form of “social regulation” used by EPA
– For a positive externality, like inoculation or education,
the government requires certain classes of citizens to
be inoculated or educated.
Marketable Pollution Permits
• Another approach to pollution is the introduction of
marketable pollution permits.
– The government sells the permits, which in total allow the
amount of pollution that the government experts believe to be
acceptable for public health.
– Polluting firms purchase the permits, allowing them to pollute up
to the amount specified by the permits they own.
– If a firm is able to employ a cleaner technology and pollute less,
then it can enjoy additional revenues by selling its pollution
rights to someone else.
• Firms that are better at reducing emissions sell permits to firms that are
worse at it!
Problems in Measuring Externalities
• Subjectivity of externalities
– Merit/demerit good to one person could not be to another
– The degree of merit or demerit is debatable
• Source of externalities and regulation
– international environmental degradation across borders
• Estimation of values of externalities
– Use of social cost-benefit analysis attempts to price on
externalities --- “pricing the priceless?”
– Not clear when you should ban something outright or merely
allowed it to exist in a more controlled fashion
Information Asymmetry
• Asymmetric information occurs when one party to a
transaction knows more than does the other.
• In general, producers have more information about the
quality of goods/services than consumers
• Consumers oftentimes do not have adequate technical
knowledge about a product – especially complex products
• Consumers oftentimes cannot judge the quality of good/service
until after paying and consuming
– “Experience” goods
• Some otherwise efficient trades between buyers and
sellers may be prevented as a result of information
asymmetry.
Informational Asymmetry
• Perfectly competitive markets assume perfect (or
near perfect) information.
• Unfortunately, real-world markets and profit
motives often involve deception, cheating, and
inaccurate information.
• When there is a lack of information, buyers and
sellers do not have equal information, markets may
not behave efficiently.
Information Asymmetry
• If consumer’s demand is faulty due to imperfect
information (lack of knowledge of product attributes or
deceptive marketing practices) then “true” willingness to
pay may deviate substantially from actual priced paid.
• In this case, demand is “wrong” and the competitive
market fails to achieve allocational efficiency.
• Volkswagen deception
• Created faulty or false demand because of information
asymmetries and deceptive advertising
• Leads to allocational inefficiencies
• If consumers had full information they would have bought
“better” automobile options
Information Asymmetry
• Search goods
– Features and quality easily evaluated before purchase
• Experience goods
– Product characteristics and quality are difficult to
observe in advance, but can be ascertained upon
consumption
• Post-experience goods
– Quality is difficult to ascertain even after consumption
• Guiding question: How can we make experience
goods and post-experience goods take on the
characteristics of search goods?
Remedies to Deal with Informational
Problems
• One policy alternative to deal with information
market failures is to regulate the market and see
that individuals provide the correct information.
– Labeling and disclosure requirements
– Safety regulations
• Ensure product/service safety
– Licensing or certifying individuals in the market
Example: Licensing of Physicians
• Licensing of doctors is a debate that is motivated by
information problems.
• Currently all doctors practicing medicine are
required to be licensed – this was not always so!
– Creates barriers to competitive marketplace entry
• Licensing of doctors is justified by informational
problems.
A Market in Information
• A market in information is one solution to the
information problem.
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Consumer reports
Carfax reports
Angie’s list
Amazon reviews
Ebay ratings
Uber ratings
Yelp
Higher education rankings
Rate my professor
Healthcare and market failure
• The health care industry arguable violates conditions of the pure
market model and yields inefficiencies for society
– Information Asymmetry:
Health care service providers have specialized knowledge that can
potentially be used to exploit consumers.
Consumers lack information about the quality and necessity of drugs
and procedures
Emergencies mean that one cannot search and shop for “bargains”
– Externalities:
There are external social benefits to an individual having access to
health care and maintaining good health
– Imperfect competition:
Insurers, hospitals, and pharmaceuticals exhibit characteristics of
oligopoly and all have power to influence prices
Affordable Care Act:
Correcting Market Failure?
• Healthcare.gov helps foster a more competitive
landscape among a few major sellers of health
insurance
• Subsidies help assist in the purchase of health
insurance
– Correcting for positive externalities and under-consumption
of health insurance!
• Forcing insurance companies to cover those with preexisting conditions?
– Concerns with adverse-selection issues?
– Require younger, healthier people to carry insurance!
Martin Shkreli Raises Drug Price 1000%!
• Market failure in drug pricing?
– In other industrialized democracies the central
government uses single-buyer market power to
negotiate lower drug prices
• U.S. lacks monopoly buying power and thus individual
consumers are beholden to more powerful pharma companies
Questions