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The Government and the Market
Chapter 13
LIPSEY & CHRYSTAL
ECONOMICS 12e
Learning Outcomes
• A perfectly competitive economy is allocatively efficient
since it operates where price equals marginal cost.
• Free markets can fail to achieve an efficient outcome for
one of several possible causes of ‘market failure’.
• Private markets will tend to overexploit common property
resources.
• Goods that are jointly consumed by more than one person
are called public goods and cannot be provided efficiently
by the market.
Learning Outcomes
• The costs and benefits of production that are external to
the producer cause the level of production that is achieved
by the free market to deviate from the socially optimal
level.
• Government policy towards competition is designed to
encourage competitive practices and to discourage
monopoly.
INTRODUCTION - MARKET FAILURE
Basic Functions of Government
• Effective governments have a monopoly of violence.
They also define and protect the rights and obligations
of property owned by individuals and institutions.
• Key characteristics of market economies are [a] their
ability to co-ordinate decentralized decisions without
conscious control, [b] their determination of the
distribution of income, and [c] compared with the
alternatives, their minimization of arbitrary economic
power.
INTRODUCTION - MARKET FAILURE
Market Efficiency
• A perfectly competitive economy is allocatively efficient
because it produces where price, which measures the
value consumers place on the last unit produced, equals
marginal cost, which measures the value to consumers
that the resources used to produce the marginal unit
could produce in other uses.
INTRODUCTION - MARKET FAILURE
Market Efficiency
• Equating price to marginal cost maximises the sum of
producers’ and consumers’ surpluses.
• Free markets can fail to achieve efficiency because of
inefficient exclusion of users from facilities with excess
capacity, common property resources, public goods,
externalities, asymmetric information, missing markets,
and market power.
INTRODUCTION - MARKET FAILURE
Non-Rivalrous and Non-Excludable Goods
• The optimal price for the service of a facility with
excess capacity is zero.
• Since private owners will charge a positive price,
their facility will be inefficiently underused.
INTRODUCTION - MARKET FAILURE
Non-Rivalrous and Non-Excludable Goods
• The private market will exploit a common property
resource to the point where the average revenue
per producer equals the production cost of a new
entrant instead of to the socially optimal level,
where the marginal addition to total product
caused by a new entrant equals its production
cost.
INTRODUCTION - MARKET FAILURE
• The optimal quantity of a public good is provided
when the marginal cost of production is equal to
the sum of the prices that all its consumers will be
willing to pay for the marginal unit produced.
• This is difficult to attain because of the free rider
problem – the incentive for individuals to
understate the true value that they place on a
public good.
INTRODUCTION - MARKET FAILURE
Externalities
• The Coase theorem shows that if those parties that
create an externality and those that are affected by
it can bargain together with minimal transaction
costs, all inefficiencies can be removed.
• Where private bargaining is impossible, the
government can alleviate externalities by imposing
rules and regulations or, more efficiently, by
internalizing externalities through such measures as
taxes and tradable permits to pollute.
INTRODUCTION - MARKET FAILURE
Public Policy Towards Monopoly and Competition
• Government policy with respect to market power is
designed to encourage competitive practices and
discourage monopolistic ones.
• Direct control of pricing and entry conditions of some
key oligopolistic industries has been common in the
past, but deregulation is reducing such control.
INTRODUCTION - MARKET FAILURE
Public Policy Towards Monopoly and Competition
• An important issue concerns the effect of market
structure on economic growth.
• The productively ineffective resource allocation that
results whenever firms have market power may be
more conducive to the technological change than is
the productively efficient allocation that results from
perfect competition.
Four Types of Goods
Rivalrous
Excludable
Non - Excludable
Normal goods
Common property
Apples
Dresses
TV sets
Computers
A seat on an aeroplane
Fisheries
Common land
Air
Streams
Public goods
Non-rivalrous
(up to capacity)
Art galleries
Museums
Fences
Roads
Bridges
Defence
Police
Public information
Some navigation aids
Broadcast signals
Four Types of Goods
 If one person consumes some of a rivalrous good or service, that
reduces the amount available for consumption by others.
 If one person consumes some of a non-rivalrous good or service,
the amount available for consumption by others is not reduced.
 Producers of an excludable good or service can prevent people
from consuming it and hence can charge for providing it.
 Producers of a non-excludable good cannot prevent anyone form
consuming it and hence cannot charge for providing it.
 Normal goods, shown in the top left segment, are rivalrous and
excludable.
Four Types of Goods
 Many goods are non-rivalrous (up to the capacity of the producing
unit) but are excludable (bottom left hand segment). Examples are
listed in the bottom left segment.
 These goods can be provided to an additional consumer (up to
capacity) at a zero marginal cost.
 Common property resources are rivalrous but non-excludable (top
right hand segment). They will tend to be over used in free market
conditions because additional users cannot be excluded.
 Public goods are non-excludable and non rivalrous. They will not
be provided by the free market.
Over-fishing of a Common Property Fishery
Total cost: old technology
1080
Total cost: new technology
1000
T
800
500
350
0
Value of total catch
35
100
140
200
Number of Boats
Over-fishing of a Common Property Fishery
 Adding boats to the fleet adds to the total catch but at a
diminishing rate up to 140 boats.
 After 140, additional boats lower the total catch.
 With the old technology, the cost (capital and current) of running
each boat is £10,000, giving the steeper of the two total cost
curves.
 The socially optimal level is 35 boats.
 Here the addition to total catch, as shown by the slope of the
tangent to the total catch curve, just equals the addition to the total
cost of running one more boat, as shown by the slope of the total
cost curve.
 At that point there is a surplus of revenue over total cost of
£150,000.
Over-fishing of a Common Property Fishery
 However, at that fleet size, a new boat expects to catch about
£14,300 (i e. £500,000/35) worth of fish, so entry is profitable from
the private point of view.
 With free entry the fleet will grow to 100 boats.
 At 100 boats a new boat expects to catch £10,000 worth of fish,
which just matches its cost.
 Now let the technology change so that each boat costs only £4,000 to
run.
 Under free entry the fleet will expand to 200 boats.
 It will catch £800,000 worth of fish.
 This yields revenue of £4,000 per boat, which just matches cost.
 Once again, production has been pushed beyond the point of
negative marginal returns and hence well beyond the social optimum.
A Public Good
MC
p2
p1
Dm
Db
p0
Da
q0
Quantity
A Public Good
 The society’s demand curve for a public good is the vertical sum of
all the individuals’ demand curves.
 The demand curves Da and Db refer to two individuals.
 Their collective demand is shown by Dm which is the vertical
summation of Da and Db.
 For example:
 individual a would pay p0 for quantity q0.
 individual b would pay p1 for the same quantity.
 together they are willing to pay the sum of p0 and p1,
which is p2.
A Public Good
 The optimal quantity of the good to produce is q0, where the
marginal cost curve MC cuts the collective demand curve.
 At this point the marginal cost of another unit is just equal to the
sum of the values that each person places on that unit.
Private and Social Cost
D
Marginal
external
cost
MCs
MCp
p1
p0
Market price
Full
marginal
social
cost
Marginal
private
cost
q* q0
Production
Private and Social Cost
 Negative externalities cause marginal social cost to exceed price
in competitive equilibrium.
 Marginal social cost, MCs, exceeds marginal private cost, MCp, by
the amount of the external cost imposed on others.
 At the competitive output, q0, marginal private cost equals price,
but marginal social cost exceeds it.
 The socially optimal output is q*, where MCs = market price.
 For every unit between q* and q0, marginal social cost exceeds
price and hence its production involves a social loss.
Pollution Abatement
Firm A
Firm B
100
80
50
0
60
90
120
Tons of pollution eliminated
Pollution Abatement
 Efficient methods of abating pollution take account of differences in
costs of abatement among firms.
 For any given amount of abatement, firm A has a higher cost of a
further unit of abatement than has B.
 (1) Let each be ordered to reduce pollution by 90 units.
 A’s marginal cost of £100 exceeds B’s marginal cost of £50.
 This is inefficient.
 A could cut its abatement by one unit, saving £100, while B
increased its abatement by one unit, adding £50 to its costs.
 Total abatement would then be unchanged but costs would fall by
£50.
Pollution Abatement
 (2) Now let an emissions tax of £80 per tonne of pollution be imposed.
 Low-cost firm B now abates pollution by 120 tonnes.
 High-cost firm A abates by 60 tonnes.
 This is the efficient way of producing 180 tonnes of abatement
since the two firms have the same abatement costs at the margin,
thus minimizing the total cost of reducing pollution by 180 tonnes.
Tradable Pollution Abatement
Firm A
Firm B
120
80
50
0
30
60 90
Tons of pollution generated
120
Tradable pollution permits
 Tradable permits achieve the same results as the most efficient tax.
 Each firm produces 150 tonnes of pollution when no abatement
procedures are followed.
 Abatement reduces the amount of pollution but at a rising marginal
cost.
 Each firm is originally given an endowment of permits to emit 60
tonnes of pollution.
Tradable pollution permits
 If no trading is allowed, the marginal costs of abatement are then
£120 for A and £50 for B.
 With trading, B sells 30 tonnes worth of permits to A.
 Firm A then pollutes by 90 tonnes and firm B by 30 tonnes.
 The price of a permit is £80.
 This is the same as both firms’ marginal cost of abatement at their
new levels of pollution.
[i] Pricing Policies for Natural Monopolies
D1
MC
ATC
p2
c1
[i]. Losses in a falling-cost industry
p1
0
q1
q1
Output
Pricing policies for natural monopolies (i) falling cost
 Marginal cost pricing leads to losses:
 The output at which marginal cost equals price is q1.
 The associated price is p1.
 Average costs are falling at output q1 so marginal costs are
less than the average cost of c1.
 There is a loss of c1 – p1 on each unit making a total loss equal
to the dark blue area.
 Average cost pricing is inefficient:
 The output at which average cost equals price is q2.
 The associated price is p2.
 Marginal cost is less than price at q2, so output is less than the
socially optimal level.
[ii] Pricing Policies for Natural Monopolies
MC
D2
[i]. Profits in a rising-cost industry
ATC
p1
c1
p2
0
q1
q2
Output
Pricing policies for natural monopolies (ii) rising cost
 Marginal cost pricing leads to profits:
 The output at which marginal cost equals price is q1.
 The associated price is p1.
 Average cost of c1 is less than price at output q1.
 There is a profit of p1 - c1 on each unit sold, making a total
profit equal to the blue area.
 Average cost pricing is inefficient:
 The output at which average cost equals price is q2.
 The associated price is p2.
 Marginal cost exceeds price at q2, so output is greater than the
socially optimal level.