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Lecture 13: Market Failure and Government Action Readings: Chapters 13 (pp.313-315), 16, 17 Copyright © 2000 Pearson Education Canada Inc. Slide 17-1 Market Failures • Markets can fail to be efficient: • Insufficient Competition • Externalities • Public goods • And Markets can be unfair: • Inequality • Poverty Copyright © 2000 Pearson Education Canada Inc. Slide 17-2 Insufficient Competition • Q: How do governments intervene in markets which have insufficient competition? • A: The main policy instruments are: • Regulation • Public ownership • Anti-combine law Copyright © 2000 Pearson Education Canada Inc. Slide 17-3 Insufficient Competition • Q: How does government supply regulation? • A: Regulatory agencies vary in size and scope. But there are certain features common to all agencies. • Government appoints the senior bureaucrats who are the key decision makers. • Each agency adopts a set of practices or operating rules for controlling prices, product standards, and other aspects of economic performance. • Agency certifies firms to serve a particular market. Copyright © 2000 Pearson Education Canada Inc. Slide 17-4 Insufficient Competition • Q: What determines government provision of regulation? • A: It is a product of the political process, and hence will reflect a political equilibrium. • In recent years, the equilibrium has shifted towards de-regulation (a reduction in the provision of regulation) Copyright © 2000 Pearson Education Canada Inc. Slide 17-5 Insufficient Competition • Q: Why has there been a move towards de-regulation? • A: There has been growing evidence that regulation to protect the public frequently only succeeds in protecting the regulated firms from competition. 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 Insufficient Competition • 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. Copyright © 2000 Pearson Education Canada Inc. Slide 17-7 Price and cost (dollars per household per month) Natural Monopoly: Profit Maximization 30 Consumer surplus 25 20 18 15 Deadweight loss Economic profit ATC MC 10 MR 0 2 4 6 D 8 10 Quantity (millions of households) Copyright © 2000 Pearson Education Canada Inc. Slide 17-8 Price and cost (dollars per household per month) Natural Monopoly: Marginal Cost Pricing 30 25 20 15 Loss per household Total surplus ATC MC 10 D 0 2 4 6 8 10 Quantity (millions of households) Copyright © 2000 Pearson Education Canada Inc. Slide 17-9 Price and cost (dollars per household per month) Natural Monopoly: Average Cost Pricing 30 25 20 15 Consumer surplus ATC Producer surplus MC 10 Deadweight loss 0 Copyright © 2000 Pearson Education Canada Inc. 2 4 D 6 8 10 Quantity (millions of households) Slide 17-10 Insufficient Competition • 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. Copyright © 2000 Pearson Education Canada Inc. Slide 17-11 Price and cost (dollars per household per month) Natural Monopoly: Inflating 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 17-12 Insufficient Competition • Q: Is regulatory capture a real problem? • A: A test of whether natural monopoly 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) Copyright © 2000 Pearson Education Canada Inc. Slide 17-13 Insufficient Competition • Q: What is the alternative to regulation? • A: Formation of crown corporations: • Canada Post, Ontario Hydro, etc. • Q: Are crown corporations efficient? • 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 Price and cost (dollars per tonne) Crown Corporation: Efficient Outcome 10 8 6 Consumer surplus 4 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 Insufficient Competition • Q: Have Crown Corporations served the public interest? • A: Over time, a different sort of capture may set in. Managers will tend inflate costs, and make themselves the residual claimants. Copyright © 2000 Pearson Education Canada Inc. Slide 17-16 Price and cost (dollars per tonne) Crown Corporation: Budget Maximization 10 8 6 4 2 ATC (inflated) Subsidy per tonne: efficient output but maximizing budget ATC MC D 0 Copyright © 2000 Pearson Education Canada Inc. 2 8 10 4 6 Quantity (billions of tonnes per year) Slide 17-17 Insufficient Competition • Q: Are crown corporations inefficient? • A: Case study: • CN had costs 14% higher than CP. • Ontario Hydro routinely pays its workers wages above the market rate. • In recent years, there has been a move to privatize publicly owned corporations. • Petro-Canada (1991) , Ontario Hydro (2002) Copyright © 2000 Pearson Education Canada Inc. Slide 17-18 Externalities • Q: What are externalities? • A: Externalities are costs or benefits that 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. Copyright © 2000 Pearson Education Canada Inc. Slide 17-19 Externalities There are two types of Externalities: • A negative externality occurs whenever a 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. Copyright © 2000 Pearson Education Canada Inc. Slide 17-20 Externalities • Q: How do negative externalities affect social outcomes? • A: Negative externalities include: • • • • • • Copyright © 2000 Pearson Education Canada Inc. 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. Slide 17-21 Externalities • Q: Has economic growth doomed the environment? • A: It has put tremendous pressure on it, but at the same time higher incomes has lead to the increased demands for a clean environment. Copyright © 2000 Pearson Education Canada Inc. Slide 17-22 Externalities: Air Pollution Copyright © 2000 Pearson Education Canada Inc. Slide 17-23 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 17-24 Externalities • 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. Copyright © 2000 Pearson Education Canada Inc. Slide 17-25 Cost and benefit of waste (dollars per tonne) Externality Impact 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) Copyright © 2000 Pearson Education Canada Inc. Slide 17-26 Externalities • Q: What can the government do to correct market failures? • A: The government has two options: • 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 Copyright © 2000 Pearson Education Canada Inc. Slide 17-27 Externalities • Q: Do standards work? • A: Economists have been concerned that standards have largely failed to be implemented effectively. Political equilibrium is susceptible to special interest group manipulation. • Even when they have been implemented, they are not usually the most efficient method for reducing pollution. Copyright © 2000 Pearson Education Canada Inc. Slide 17-28 Externalities • Q: What’s the problem with standards? • 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 Externalities • Q: Can government policy force firms to 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 MSC 15 At $7/tonne, MSC > MB 10 7 Efficient price per tonne 0 5 10 MB 15 20 Emissions (millions of tonnes per year) Copyright © 2000 Pearson Education Canada Inc. Slide 17-31 Externalities • Q: What if emission charges cannot be assessed (ie noise pollution). • A: The government could introduce a Pigouvian Tax which discourages the activity that has the negative externality associated with it. • Q: What is the correct Pigouvian tax? • A: If the tax is set equal to the external marginal cost, then efficient outcome will be achieved. Copyright © 2000 Pearson Education Canada Inc. Slide 17-32 Cost, price, and benefit (dollars per kilometre) Competitive markets oversupply if there is pollution MSC = PMC + EMC EMC SC0 Point of allocative efficiency S = PMC P1 Competitive equilibrium P0 C1 D = MB 0 Q1 Q0 Quantity (kilometres) Copyright © 2000 Pearson Education Canada Inc. Slide 17-33 Cost, price, and benefit (dollars per kilometre) External Cost at Competitive Equilibrium MSC SC0 External cost S = MC P1 Competitive equilibrium P0 C1 D = MB 0 Q1 Q0 Quantity (kilometres) Copyright © 2000 Pearson Education Canada Inc. Slide 17-34 Cost, price, and benefit (dollars per kilometre) Pigouvian Tax MSC S+T SC0 Point of allocative efficiency S = MC P1 C1 D = MB 0 Q1 Q0 Quantity (kilometres) Copyright © 2000 Pearson Education Canada Inc. Slide 17-35 Externalities • Q: What are the problems with government asserting ownership over the commons? • A: There are several: • Political equilibrium may not be efficient. • Business will resist the huge transfer to government implied by the government solution. (ie carbon tax resistance) Copyright © 2000 Pearson Education Canada Inc. Slide 17-36 Externalities • Q: What are the private property solutions to pollution? • A: The government can clarify and extend common law rights, or it can establish and distribute marketable emission permits. Copyright © 2000 Pearson Education Canada Inc. Slide 17-37 Externalities • Q: How does extending common law property rights solve the externality problem? • A: Many problems occur because when 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. Copyright © 2000 Pearson Education Canada Inc. Slide 17-38 Externalities • Q: If common law property rights are extended, does it matter who gets them? • A: According to the Coase theorem: • 1. If transaction costs are low, the (common law) assignment of property rights will solve the externality. • 2. It will not matter who receives the property right. Copyright © 2000 Pearson Education Canada Inc. Slide 17-39 Externalities • Q: How does this work: • A: It will depend on who receives the property right: • If the polluted party is given control of the environment, they can force the polluter to reduce pollution. • If the polluter is given control of the environment, the polluted party may choose to pay the polluter to reduce pollution. Copyright © 2000 Pearson Education Canada Inc. Slide 17-40 Cost and benefit of waste (dollars per tonne) The Coase Theorem MSC 200 150 100 Efficient level of waste 50 MB 0 2 4 6 8 Quantity of waste (tonnes per week) Copyright © 2000 Pearson Education Canada Inc. Slide 17-41 Externalities • Q: Can we rely on Coasian bargains to resolve all negative externalities? • A: No! Transaction costs are frequently high because: • 1) There are many affected parties • 2) people bargain strategically, and fail to agree on a price. Copyright © 2000 Pearson Education Canada Inc. Slide 17-42 Externalities • Q: How does a system of marketable emission permits work? • 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 the amount of the permits held. • A firm can either buy or sell its permits. Copyright © 2000 Pearson Education Canada Inc. Slide 17-43 Externalities • Q: Why is this system efficient? • A: It will be expected that firms that 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. Copyright © 2000 Pearson Education Canada Inc. Slide 17-44 Externalities • Q: What sorts of positive externalities are there? • A: There are many, among which include: • Landscaping • Inoculations • Education Copyright © 2000 Pearson Education Canada Inc. Slide 17-45 Externalities • Q: In what way does education have a positive externality associated with it? • A: External benefits: • Citizens who can better communicate and interact • Good ideas/inventions can be copied Copyright © 2000 Pearson Education Canada Inc. Slide 17-46 Externalities • Q: Does this create a 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 17-47 Externalities • Q: How does the government solve this market failure? • 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 Externalities 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. Copyright © 2000 Pearson Education Canada Inc. Slide 17-49 Cost, price, and benefit (thousands of dollars per student per year) The Efficient Quantity of Education Copyright © 2000 Pearson Education Canada Inc. Competitive equilibrium 25 Efficient allocation 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. Copyright © 2000 Pearson Education Canada Inc. Slide 17-51 Externalities • 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. Copyright © 2000 Pearson Education Canada Inc. Slide 17-52 Externalities Patents or copyrights are 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. Slide 17-53 Externalities The economic cost of patent protection is the deadweight loss of monopoly. 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 • Q: What are public goods? • A: Public goods are goods or services that are consumed simultaneously by everyone and from which no one can be excluded. Copyright © 2000 Pearson Education Canada Inc. Slide 17-55 Public Goods 1) Nonrivalry The consumption by one person does not decrease the consumption by another. • Television show 2) Nonexcludable It is impossible, or extremely costly, to prevent someone from benefiting from a good. • National defence Copyright © 2000 Pearson Education Canada Inc. Slide 17-56 Public Goods and Private Goods Pure private goods Food Car House Excludable & nonrival Cable television Bridge Highway Nonexcludable & rival Pure public goods Fish in the ocean Lighthouse Air National defence Copyright © 2000 Pearson Education Canada Inc. Slide 17-57 Public Goods and The Free-Rider Problem A free rider is a person who consumes a good without paying for it. 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? Copyright © 2000 Pearson Education Canada Inc. Slide 17-58 Public Goods • Q: What is the social value of another unit of a public good ? • 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. • Social Marginal Benefit = sum of each individual’s marginal willingness to pay. • The social marginal benefit at each provision level can be derived by vertically summing each individual’s demand for the public good. Copyright © 2000 Pearson Education Canada Inc. Slide 17-59 Benefits of a Public Good Marginal benefit (dollars per acid-rain check) Marginal benefit (dollars per acid-rain check) Lisa's Marginal Benefit 80 60 40 80 60 40 20 0 Max's Marginal Benefit MBL 1 2 3 4 5 Quantity (number of acid-rain checks) Copyright © 2000 Pearson Education Canada Inc. 20 0 MBM 1 2 3 4 5 Quantity (number of acid-rain checks) Slide 17-60 Marginal benefit (dollars per acid-rain check) Benefits of a Public Good 140 120 Economy's Marginal Benefit 100 80 60 40 20 0 Copyright © 2000 Pearson Education Canada Inc. MB 1 2 3 4 5 Quantity (number of acid-rain checks) Slide 17-61 Public Goods • Contrast this with a private good. Only one 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. • By a little bit of thought you will be able to 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). Copyright © 2000 Pearson Education Canada Inc. Slide 17-62 Public Goods • 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: • increase provision if SMB > MC • reduce provision if SMB < MC • hold provision constant if SMB = MC Copyright © 2000 Pearson Education Canada Inc. Slide 17-63 Total Benefit & Total Cost 7.5 Marginal Benefit & Marginal Cost TC Marginal benefit (billions of dollars per acid-rain check) Total benefit and total cost (billions of dollars) The Efficient Provision of a Public Good MC 2.0 5.0 TB 3.5 M 1.0 1.5 Net benefit $2.0 billion 0 1 2 3 4 5 Quantity (number of acid-rain checks) Copyright © 2000 Pearson Education Canada Inc. Efficient use of resources MB 0 1 2 3 4 5 Quantity (number of acid-rain checks) Slide 17-64 Public Goods • Q: Is private market provision efficient? • A: No! Because of the free rider 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 Public Goods • Q: Is government provision efficient? • A: To answer this we have to examine 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 Provision Q: How does political competition between parties influence the platforms on offer? 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. The principle of minimum differentiation is the tendency for competitors to make themselves identical to appeal to the maximum number of clients or voters. Copyright © 2000 Pearson Education Canada Inc. Slide 17-67 Public Goods • Q: Will the winning platform be efficient? • A: The winning platform on public good 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. Copyright © 2000 Pearson Education Canada Inc. Slide 17-68 Public Goods • Q: Is there anything that might complicate the political equilibrium? • 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. Copyright © 2000 Pearson Education Canada Inc. Slide 17-69 Public Goods • Q: How do bureaucratic interests alter the political equilibrium? • A: There are a number of theories. The 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. Copyright © 2000 Pearson Education Canada Inc. Slide 17-70 Bureaucratic Overprovision TC Total benefit and total cost (billions of dollars) 7.5 5.0 Goal of bureaucracy 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 Public Goods • Q: How do bureaucrats influence the political equilibrium? • A: Bureaucrats controls information about 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. • Example: Missile Defense Copyright © 2000 Pearson Education Canada Inc. Slide 17-72 Bureaucratic Exaggeration TC Total benefit and total cost (billions of dollars) 7.5 5.0 TB 3.5 1.5 0 1 2 3 4 5 Quantity (number of acid-rain checks) Copyright © 2000 Pearson Education Canada Inc. Slide 17-73 Public Goods • Q: Are bureaucrats the only group who wish to manipulate the political equilibrium? • A: No special interests who have a private stake in public good provision are very active in attempting to manipulate political outcomes. Copyright © 2000 Pearson Education Canada Inc. Slide 17-74 Public Goods • Q: How do special interest groups manipulate the political equilibrium? • A: By manipulating information. 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. • Example: Softwood lumber dispute. Copyright © 2000 Pearson Education Canada Inc. Slide 17-75 Public Goods • Q: Why might democracy be easily manipulated by special interests? • A: Rational ignorance. Rational ignorance is the decision not to acquire information because the cost of doing so exceeds the expected benefit. Copyright © 2000 Pearson Education Canada Inc. Slide 17-76 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. • 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 END Copyright © 2000 Pearson Education Canada Inc. Slide 17-78