Download Market Failure - Antitrust, positive and negative externalities, public

Market Failure - Antitrust, positive and negative externalities,
public goods, rent seeking, tariffs, Government Failure
Introduction to Market Failure
A market failure results when the price of goods and services do not reflect the true costs of
producing and consuming those goods and services. In other words, the term describes a market
whereby the quantity of a product demanded by consumers does not equate to the quantity
supplied by suppliers. This is a direct result of a lack of certain economically ideal factors,
which prevents equilibrium.
Antitrust
Antitrust policies are government policies designed to keep firms from monopolizing their
markets.
Antitrust policy attempts to eliminate the deadweight loss of monopoly by making it illegal for
managers to engage in activities that foster monopoly power, such as price fixing agreements and
other collusive practices. The cornerstone of U.S. antitrust policy is contained in Sections 1 and
2 of the Sherman Antitrust Act of 1890:
Section 1.
Every contract, combination in the form of trust or otherwise, or conspiracy, in restraint
of trade or commerce among the several states, or with foreign nations, is hereby declared
to be illegal. Every person who shall make any such contract or engage in any such
combination or conspiracy shall be deemed guilty of a felony.
Section 2.
Every person who shall monopolize, or attempt to monopolize, or combine or conspire
with any person or persons, to monopolize any part of the trade or commerce among the
several States, or with foreign nations, shall bee deemed guilty of a felony.
The penalty for conviction of either section of the Antitrust Act consists of a fine not exceeding
five thousand dollars (one million dollars if a corporation) or by imprisonment not exceeding one
(three) years, or by both said punishments, in the discretion of the court. Among other things,
the Sherman Act makes it illegal for managers of U.S. firms to collude with other domestic or
foreign firms. Thus, even though OPEC is not bound by U.S. law (because it is composed of
foreign nations), the manager of a U.S. oil company cannot legally participate in the OPEC oil
cartel.
One of the most prominent cases in which the Sherman Antitrust act was used to help prevent a
merger which would have resulted in a monopoly in the market, was the United States vs.
Standard Oil of New Jersey. In fact, the full power of the Sherman Antitrust Act was not
realized until its conclusion in 1911. In this landmark case, Standard Oil was charged with
attempting to fix the prices of petroleum products and the prices at which those products would
be shipped. It was accused of numerous unlawful activities designed to enhance its monopoly
power, including using physical threats to shippers and producers, setting up illegitimate
companies, using espionage and bribing employees of other companies, engaging in restraint of
trade, and making several attempts to monopolize the oil industry. As a result of the case, the
courts dissolved Standard Oil into 33 subsidiaries, many of which survive today under the names
Exxon, Mobil, Chevron, Amoco, and BP.
Negative Externalities
Negative Externalities are costs born by parties who are not involved in the production or
consumption of a good.
One of the most common examples of a negative externality is pollution. During the course of
producing a good, when a firm creates wastes that either do not biodegrade or that have
potentially harmful effects on the environment, or on other resources, it does not pay the full cost
of production. For example, if a manufacturing company were to dump its toxic byproducts in
the river outside of the plant, the company would theoretically be saving costs because it was
disposing of its wastes at a very low cost, rather than incurring the costs of proper transportation,
processing, or disposal of the byproduct. However, the real cost of this action to society is much
higher, as the toxic waste would poison fish and aquatic life downstream, and contaminate local
drinking water. These results negatively affect people who were not directly involved in the
production or consumption process.
This graph shows the effect of a negative externality. The red line represents society's supply
curve/marginal cost curve while the blue line represents the marginal cost curve that the firm or
industry with the negative externality faces. The optimal production quantity is Q', but the
negative externality results in production of Q*. The deadweight welfare loss is shown in gray.
Notice that the overall marginal cost to society is higher than the marginal cost to the firm
P
Negative Externality
S=MC Society
S=MC Indiv.
DWL
D=MB
Q’
Q*
Q
Positive Externalities
Positive Externalities are benefits that are incurred by parties other than the direct producer or
consumer, as a result of producing or consuming a good.
A positive externality exists when an individual or firm making a decision does not receive the
full benefit of the decision. The benefit to the individual or firm is less than the benefit to society.
Thus when a positive externality exists in an unregulated market, the marginal benefit curve (the
demand curve) of the individual making the decision is less than the marginal benefit curve to
society. With positive externalities, less is produced and consumed than the socially optimal
level.
A classic example of a positive externality occurrence is when an individual improves their
house, through some external means, such as landscaping. While the individual incurred the
actual cost of the landscaping, and he benefits marginally, the neighbors benefit as well, as
beautification of his house has the potential to raise the property values of everyone on the street.
Another example of a positive externality can be observed by looking at bee keepers. The bee
keeper incurs costs of raising the bees, and his return on investment (or marginal benefit) is
tangible, in the honey he collects. But a positive externality exists for nearby farmers, as the
presences of bees will help to cross pollinate plants, thereby improving their crops.
Consider the following graph, for further clarification. When a positive externality exists in an
unregulated market, consumers pay a lower price and consume less quantity than the socially
efficient outcome. This can be seen on the graph. Consumers pay price P' and consume quantity
Q', but at that quantity society would have them pay more. At P' Q' the marginal benefit to
society is much higher than marginal cost, resulting in a deadweight welfare loss. The socially
efficient outcome is to pay price P* and consume quantity Q*. At this price and quantity the
marginal benefit to society is equal to the marginal cost.
P
Positive Externality
MC Indiv.
P’
DWL
MB Society
P*
MB Individual
Q*
Q’
Q
Public Goods
A public good is a good that is nonrival and nonexclusionary in consumption.
Another source of market failure is the provision of public goods—goods that are nonrival and
nonexclusionary in nature, and therefore benefit people other than those who buy the goods. A
public good differs from most goods that you consume. When we consider most goods, they are
often rivalrous goods, that is, once they are consumed by an individual, they can no longer be
consumed by someone else. For example, when you purchase a pair of shoes to wear, that pair
of shoes can no longer be purchased and worn by someone else—thus you have prevented
someone else from wearing that same pair of shoes, hence the good is rivalrous in nature. A
non-rival good is a good does not share these properties. More specifically, a non-rival good
whose consumption by an individual, does not prevent consumption of that good by others. The
classic example of a non-rival good is a radio signal. By tuning into that radio signal with your
radio, you have not prevented others from listening to their radio and consuming the radio signal
good.
The second aspect of a public good, is that it must be nonexclusionary. A good is said to be nonexclusionary if the cost of keeping nonpayers from enjoying the benefits of the good or service is
prohibitive. For instance, if an entrepreneur stages a fireworks show, for example, people can
watch the show from their windows or backyards. Because the entrepreneur cannot charge a fee
for consumption, the fireworks show may go unproduced, even if demand for the show is strong.
Clean air is another example of a nonexclusive good, because when the air is clean, everyone get
to consume the clean air—in cannot be allocated to a single person.
The aspect of public goods that leads to market failure, is that because everyone gets to consume
the good once it is available, individuals have little incentive to purchase the good—rather, they
prefer to let someone else pay for it. Once the good is available, they can “free ride” on the
efforts of others to provide the good. But if everyone were to seek the “free ride,” by allowing
others to pay, no one will buy the good, and it will not be available. If the “free rider” problem
cannot be solved, valuable goods and services will remain unproduced.
Rent Seeking
Rent seeking is defined as selfishly motivated efforts to influence another party’s decision.
Rent-seeking can be thought of as the selfish act of trying to cut oneself a bigger piece of the pie,
rather than actually making the pie bigger. In other words, when someone tries to make more
money, without actually producing more for consumers, he is engaging in rent-seeking.
Some classic examples of rent-seeking activity include a mafia protection racket, in which the
gang takes a cut of the shopkeeper’s profit in exchange for allowing them to operate. Another
real world example of rent-seeking activity might be seen in a laborer’s union. The union might
demand higher wages for everyone, without actually offering any increase in productivity.
Lobbyists are also frequent purveyors of rent-seeking activity, because their sole goal is to lobby
the government for tax, spending or regulatory policies that benefit their organization, at the
expense of taxpayers, consumers, or some other rival.
Tariffs
A tariff is a tax on a good produced abroad, imposed by the government of the country to which
they are exported.
Tariffs are designed to limit foreign competition in the domestic market to benefit domestic
producers. The benefits to domestic producers accrue at the expense of the domestic consumers
and foreign producers. Essentially, the tariff raises the price of foreign goods, allowing the
domestic good to be priced lower, and thus, more attractive to the consumer. For this reason,
many countries have reduced such tariffs as part of the process of freeing up world trade.
A lump-sum tariff is a fixed fee that foreign firms must pay the domestic government to be able
to sell in the domestic market. A lump sum tariff does not affect the marginal cost curve. This is
because the importer must pay the same amount of tariff regardless of how much product it
brings into the country. Since the lump-sum tariff raises average costs, an importer is unwilling
to pay the tariff to enter the domestic market unless his price in the domestic market can
overcome his average costs. The net effect t of this policy often removes foreign competitors
from the domestic market. Furthermore, the lump-sum tariff increases the profits of domestic
producers if demand is low, but has no effect on their profits if demand is high, which renders
the tariff a failure in high demand markets.
In contrast, a per-unit or excise tariff requires the importing firms to pay the domestic
government a fee on each unit they bring into the country. When this type of tariff is imposed,
the marginal cost curve will increase by the amount of the tariff, which in turn decreases the
supply of all foreign firms. The per-unit tariff raises the price that domestic consumers must pay
for the product, which raises the profits of domestic firms at the expense of domestic consumers
and foreign producers.
Government Failure
Government Failure refers to situations where allocative efficiency may have been reduced
following government intervention in markets designed to correct market failure.
Government failure is the public sector analogy to market failure and occurs when a government
intervention causes a more inefficient allocation of goods and resources than would occur
without that intervention. The preceding examples of market failure illustrate situations and
instances where free markets do not always result in socially efficient quantities and/or prices.
Often, the government deems it necessary to step in and intervene to bring the market back to a
socially efficient level, where supply and the demand are in efficient equilibrium. Government
intervention often results in less efficient resources allocation, and a lower overall social benefit,
because the government lacks perfect knowledge of prices, values, costs, and benefits.
There are various reasons why a government might choose to intervene. Situations of shortage
or surplus often are remedied by government intervention. The government might intervene to
provide goods when the market does not or cannot. It often intervenes to protect individuals and
groups in society and to provide a safety net for those unable to help themselves. Such is the
case with recent discussion of government protected mortgages, to prevent foreclosure.
The government has many ways of intervening, including taxation, subsidies, regulation, and
direct provision of goods and services. Government failure often manifests itself in the form of
distorted markets. When the government steps in to impose a price ceiling, as it has in the past
for fuel prices, the socially efficient supply and demand equilibrium is prevented, leading to
overall market dead-weight loss. Welfare support also is a form of government failure, as
welfare is supported by taxation, which erodes consumer and producer surplus, leading to an
inefficient market.
The Concise Encyclopedia of Economics. Public Goods. Tyler Cowen
http://www.econlib.org/library/Enc/PublicGoods.html
A Glossary of Political Economy Terms—Dr. Paul M. Johnson
http://www.auburn.edu/~johnspm/gloss/externality
Fundamental Finance.com
http://economics.fundamentalfinance.com/positive-externality.php
Economist.com: Economics A-Z
http://www.economist.com/research/Economics/alphabetic.cfm?letter=T
BizEd.co.UK: Government Failure, Market Failure, Economics Learning Materials
http://www.bized.co.uk/learn/economics/marketfail/govtfailure/index.htm