Market failure&govern policy
Market Failures
and Government
Policy
Market Failures: Externalities and Public Goods
• Society's microeconomic objectives
– equity
– social efficiency
• marginal social benefits and costs
• production where MSB = MSC
Market Failures: Externalities and Public Goods
• Externalities
• External costs of production
– MSC > MC
External costs in production
Costs and benefits
MC = S
P
D
O
Q1
Quantity
External costs in production
Costs and benefits
MSC
P
MC = S
D
External cost
O
Q2
Social optimum
Quantity
Q1
Market Failures: Externalities and Public Goods
• Externalities
– External costs of production
• MSC > MC
– External benefits of production
• MSC < MC
External benefits in production
Costs and benefits
MC = S
P
O
D
Q1
Quantity
External benefits in production
Costs and benefits
MC = S MSC
External benefit
P
O
D
Q1
Quantity
Q2
Social optimum
External costs and benefits in production
D
P
External cost
O
Q2
Q1
Quantity
(a ) External costs
MC = S MSC
Costs and benefits (£)
Costs and benefits (£)
MSC MC = S
External benefit
P
O
D
Q1
Q2
Quantity
(b) External benefits
Market Failures: Externalities and Public Goods
• Externalities
– External costs of production
• MSC > MC
– External benefits of production
• MSC < MC
– External costs of consumption
Market Failures: Externalities and Public Goods
• Externalities
– External costs of production
• MSC > MC
– External benefits of production
• MSC < MC
– External costs of consumption
• MSB < MB
Costs and benefits
External costs in consumption
P
D
(MB)
MU = D
O
Q1
Quantity
Costs and benefits
External costs in consumption
External cost
P
D
(MB)
MU = D
MSB
O
Social optimum
Q2
Q1
Quantity
Market Failures: Externalities and Public Goods
• Externalities
– External costs of production
• MSC > MC
– External benefits of production
• MSC < MC
– External costs of consumption
• MSB < MB
– External benefits of consumption
Market Failures: Externalities and Public Goods
• Externalities
– External costs of production
• MSC > MC
– External benefits of production
• MSC < MC
– External costs of consumption
• MSB < MB
– External benefits of consumption
• MSB > MB
Costs and benefits
External benefits in consumption
P
D
(MB)
MU = D
O
Q1
Quantity
External benefits in consumption
Costs and benefits
External benefit
P
D
MSB
(MB)
MU = D
O
Q1
Quantity
Q2
Social optimum
External cost
P
P
Costs and benefits (£)
Costs and benefits (£)
External costs and benefits in consumption
External benefit
P
P
MSB
MB
MB
MSB
O
Q2
Q1
Car miles
(a ) External costs
O
Q1
Q2
Rail miles
(b) External benefits
Market Failures: Externalities and Public Goods
• Externalities
– External costs of production
• MSC > MC
– External benefits of production
• MSC < MC
– External costs of consumption
• MSB < MB
– External benefits of consumption
• MSB > MB
• Public goods
Market Failures: Externalities and Public Goods
• Externalities
– External costs of production
• MSC > MC
– External benefits of production
• MSC < MC
– External costs of consumption
• MSB < MB
– External benefits of consumption
• MSB > MB
• Public goods
– non rivalry
Market Failures: Externalities and Public Goods
• Externalities
– External costs of production
• MSC > MC
– External benefits of production
• MSC < MC
– External costs of consumption
• MSB < MB
– External benefits of consumption
• MSB > MB
• Public goods
– non rivalry
– non-excludability
Market Failures: Monopoly Power
• The demand curve under monopoly
– production at less than the social optimum
A monopolist producing less than the social optimum
£
MC
P1
MC1
MR
O
Monopoly output
Q1
AR
Q
A monopolist producing less than the social optimum
£
MC = MSC
P1
P2 = MSB
= MSC
MC1
MR
O
Monopoly output
Q1
Q2
AR = MSB
Q
Perfectly competitive output
Market Failures: Monopoly Power
• The demand curve under monopoly
– production at less than the social optimum
• Deadweight loss under monopoly
– consumer and producer surplus
• consumer surplus
Market Failures: Monopoly Power
• The demand curve under monopoly
– production at less than the social optimum
• Deadweight loss under monopoly
– consumer and producer surplus
• consumer surplus
• producer surplus
Market Failures: Monopoly Power
• The demand curve under monopoly
– production at less than the social optimum
• Deadweight loss under monopoly
– consumer and producer surplus
• consumer surplus
• producer surplus
• total surplus
Deadweight loss under monopoly
MC
£
(= S under perfect competition)
Consumer
surplus
Ppc
a
Producer
surplus
AR = D
O
Qpc
Q
(a) Industry equilibrium under perfect competition
Market Failures: Monopoly Power
• The demand curve under monopoly
– production at less than the social optimum
• Deadweight loss under monopoly
– consumer and producer surplus
• consumer surplus
• producer surplus
• total surplus
– the effect of monopoly on total surplus
Deadweight loss under monopoly
MC
£
(= S under perfect competition)
Pm
Ppc
O
Consumer
surplus
Deadweight
welfare loss
b
a
Producer
surplus
AR = D
MR
Qpc
Qpc
(b) Industry equilibrium under monopoly
Q
Deadweight loss under monopoly
MC
£
(= S under perfect competition)
Perfect
competition
Consumer
surplus
Ppc
a
Producer
surplus
AR = D
O
Qpc
Q
(a) Industry equilibrium under perfect competition
Deadweight loss under monopoly
MC
£
(= S under perfect competition)
Monopoly
Pm
Ppc
O
Consumer
surplus
Deadweight
welfare loss
b
a
Producer
surplus
AR = D
MR
Qpc
Qpc
(b) Industry equilibrium under monopoly
Q
Market Failures: Monopoly Power
• The demand curve under monopoly
– production at less than the social optimum
• Deadweight loss under monopoly
– consumer and producer surplus
• consumer surplus
• producer surplus
• total surplus
– the effect of monopoly on total surplus
• Other problems with monopoly
Market Failures: Monopoly Power
• The demand curve under monopoly
– production at less than the social optimum
• Deadweight loss under monopoly
– consumer and producer surplus
• consumer surplus
• producer surplus
• total surplus
– the effect of monopoly on total surplus
• Other problems with monopoly
• Possible advantages from monopoly
Other Market Failures
• Ignorance and uncertainty
• Immobility of factors and time lags
• Protecting people's interests
– dependants
– the principal–agent problem
• the problem of asymmetric information
• the need for monitoring
– poor economic decision making by people
• merit goods
• Macroeconomic goals
• Economists and policy advice
Government Intervention: Taxes and Subsidies
• The use of taxes and subsidies to
correct externalities
– the optimum size of a tax
Using taxes to correct a market distortion
Costs and benefits
MC = S
P
D
O
Q1
Quantity
Using taxes to correct a market distortion
Costs and benefits
MSC
P
MC = S
D
External cost
O
Q2
Social optimum
Quantity
Q1
Using taxes to correct a market distortion
Costs and benefits
MSC
MC = S
Optimum tax = MSC – MC
P
D
MC
O
Q2
Quantity
Q1
Government Intervention: Taxes and Subsidies
• The use of taxes and subsidies to
correct externalities
– the optimum size of a tax
– the optimum size of a subsidy
Using subsidies to correct a market distortion
Costs and benefits
MC = S
P
O
D
Q1
Quantity
Using subsidies to correct a market distortion
Costs and benefits
MC = S MSC
External benefit
P
O
D
Q1
Quantity
Q2
Social optimum
Using subsidies to correct a market distortion
MC = S MSC
Costs and benefits
MC
Optimum subsidy
= MC – MSC
P
O
D
Q1
Quantity
Q2
Government Intervention: Taxes and Subsidies
• The use of taxes and subsidies to
correct for monopoly
– use of lump-sum taxes
• Advantages of taxes and subsidies
• Disadvantages of taxes and subsidies
– infeasible to use different tax and subsidy
rates
– lack of knowledge
Government Intervention: Laws and Regulation
• The use of laws and regulation
• Advantages of legal restrictions
– simple to understand
– safer when size of problem is potentially great
– quick to implement
– a good way of dealing with imperfect
information
• Disadvantages of legal restrictions
– a 'blunt weapon'
Government Intervention: Laws and Regulation
• Types of regulation
• The system of regulation in the UK
– UK regulatory bodies
– price-cap regulation
• the RPI–X formula
• Advantages of the UK system
– discretionary
– flexible
– incentive for firms to reduce costs
• Disadvantages of the UK system
Other Forms of Government Intervention
• Changes in property rights
– the problem of limited property rights
– extending property rights
– limitations of this solution
• impractical in many situations
• problems of litigation
• questions of equity
• Provision of information
– consumer information
– information on jobs
– information to firms
Other Forms of Government Intervention
• Direct provision of goods and services
– the provision of public goods
– the need to evaluate costs and benefits of
publicly provided goods
– the provision of other goods and services
by the government
• social justice
• large positive externalities
• dependants
• ignorance
More or Less Intervention?
• Drawbacks of government intervention
– shortages and surpluses
– poor information
– bureaucracy and inefficiency
– lack of market incentives
– shifts in government policy
– lack of freedom for the individual
More or Less Intervention?
• Advantages of the free market
– automatic adjustments
– dynamic advantages of capitalism
– possibly high degree of competition even under
monopoly/oligopoly
– Judging the arguments
• Should there be more or less intervention in
the market?
– important to consider both costs and benefits of
intervention
– moral issues
– problem of predicting effects of intervention
The Environment: a Case Study
• The environmental problem
– global and local environmental problems
– causes of the problems
• Market failures
– environment as a common resource
– externalities
– ignorance
– inter-generational problems
The Environment: a Case Study
• Policy alternatives
– charging for use of the environment
• emissions charges
An emissions charge
Costs and benefits (£)
MSC
P2
MB = MSB
P1 = 0
L2
Level of emission
L1
The Environment: a Case Study
• Policy alternatives
– charging for use of the environment
• emissions charges
• user charges
The Environment: a Case Study
• Policy alternatives
– charging for use of the environment
•
•
•
emissions charges
user charges
optimum charge = external cost
The Environment: a Case Study
• Policy alternatives
– charging for use of the environment
•
•
•
emissions charges
user charges
optimum charge = external cost
– green taxes and subsidies
The Environment: a Case Study
• Policy alternatives
– charging for use of the environment
•
•
•
emissions charges
user charges
optimum charge = external cost
– green taxes and subsidies
• use of such taxes around the world
Green tax revenues as a % of GDP
Green tax revenues as a % of GDP
The Environment: a Case Study
• Policy alternatives
– charging for use of the environment
• emissions charges
• user charges
• optimum charge = external cost
– green taxes and subsidies
• use of such taxes around the world
– laws and regulations
The Environment: a Case Study
• Policy alternatives
– charging for use of the environment
• emissions charges
• user charges
• optimum charge = external cost
– green taxes and subsidies
• use of such taxes around the world
– laws and regulations
• advantages and disadvantages
The Environment: a Case Study
• Policy alternatives
– charging for use of the environment
• emissions charges
• user charges
• optimum charge = external cost
– green taxes and subsidies
• use of such taxes around the world
– laws and regulations
• advantages and disadvantages
– education
The Environment: a Case Study
• Policy alternatives
– charging for use of the environment
• emissions charges
• user charges
• optimum charge = external cost
– green taxes and subsidies
• use of such taxes around the world
– laws and regulations
• advantages and disadvantages
– education
– tradable permits
The Environment: a Case Study
• Policy alternatives
– charging for use of the environment
• emissions charges
• user charges
• optimum charge = external cost
– green taxes and subsidies
• use of such taxes around the world
– laws and regulations
• advantages and disadvantages
– education
– tradable permits
• advantages and disadvantages
The Environment: a Case Study
• How much can we rely on governments?
– governments must have the will to protect
the environment
• depends on attitudes of various interest groups
– must be able to identify problems and
appropriates solutions
– when problems are global:
• may require international agreements
• governments are likely to be more concerned
with their own national interests
and Government
Policy
Market Failures: Externalities and Public Goods
• Society's microeconomic objectives
– equity
– social efficiency
• marginal social benefits and costs
• production where MSB = MSC
Market Failures: Externalities and Public Goods
• Externalities
• External costs of production
– MSC > MC
External costs in production
Costs and benefits
MC = S
P
D
O
Q1
Quantity
External costs in production
Costs and benefits
MSC
P
MC = S
D
External cost
O
Q2
Social optimum
Quantity
Q1
Market Failures: Externalities and Public Goods
• Externalities
– External costs of production
• MSC > MC
– External benefits of production
• MSC < MC
External benefits in production
Costs and benefits
MC = S
P
O
D
Q1
Quantity
External benefits in production
Costs and benefits
MC = S MSC
External benefit
P
O
D
Q1
Quantity
Q2
Social optimum
External costs and benefits in production
D
P
External cost
O
Q2
Q1
Quantity
(a ) External costs
MC = S MSC
Costs and benefits (£)
Costs and benefits (£)
MSC MC = S
External benefit
P
O
D
Q1
Q2
Quantity
(b) External benefits
Market Failures: Externalities and Public Goods
• Externalities
– External costs of production
• MSC > MC
– External benefits of production
• MSC < MC
– External costs of consumption
Market Failures: Externalities and Public Goods
• Externalities
– External costs of production
• MSC > MC
– External benefits of production
• MSC < MC
– External costs of consumption
• MSB < MB
Costs and benefits
External costs in consumption
P
D
(MB)
MU = D
O
Q1
Quantity
Costs and benefits
External costs in consumption
External cost
P
D
(MB)
MU = D
MSB
O
Social optimum
Q2
Q1
Quantity
Market Failures: Externalities and Public Goods
• Externalities
– External costs of production
• MSC > MC
– External benefits of production
• MSC < MC
– External costs of consumption
• MSB < MB
– External benefits of consumption
Market Failures: Externalities and Public Goods
• Externalities
– External costs of production
• MSC > MC
– External benefits of production
• MSC < MC
– External costs of consumption
• MSB < MB
– External benefits of consumption
• MSB > MB
Costs and benefits
External benefits in consumption
P
D
(MB)
MU = D
O
Q1
Quantity
External benefits in consumption
Costs and benefits
External benefit
P
D
MSB
(MB)
MU = D
O
Q1
Quantity
Q2
Social optimum
External cost
P
P
Costs and benefits (£)
Costs and benefits (£)
External costs and benefits in consumption
External benefit
P
P
MSB
MB
MB
MSB
O
Q2
Q1
Car miles
(a ) External costs
O
Q1
Q2
Rail miles
(b) External benefits
Market Failures: Externalities and Public Goods
• Externalities
– External costs of production
• MSC > MC
– External benefits of production
• MSC < MC
– External costs of consumption
• MSB < MB
– External benefits of consumption
• MSB > MB
• Public goods
Market Failures: Externalities and Public Goods
• Externalities
– External costs of production
• MSC > MC
– External benefits of production
• MSC < MC
– External costs of consumption
• MSB < MB
– External benefits of consumption
• MSB > MB
• Public goods
– non rivalry
Market Failures: Externalities and Public Goods
• Externalities
– External costs of production
• MSC > MC
– External benefits of production
• MSC < MC
– External costs of consumption
• MSB < MB
– External benefits of consumption
• MSB > MB
• Public goods
– non rivalry
– non-excludability
Market Failures: Monopoly Power
• The demand curve under monopoly
– production at less than the social optimum
A monopolist producing less than the social optimum
£
MC
P1
MC1
MR
O
Monopoly output
Q1
AR
Q
A monopolist producing less than the social optimum
£
MC = MSC
P1
P2 = MSB
= MSC
MC1
MR
O
Monopoly output
Q1
Q2
AR = MSB
Q
Perfectly competitive output
Market Failures: Monopoly Power
• The demand curve under monopoly
– production at less than the social optimum
• Deadweight loss under monopoly
– consumer and producer surplus
• consumer surplus
Market Failures: Monopoly Power
• The demand curve under monopoly
– production at less than the social optimum
• Deadweight loss under monopoly
– consumer and producer surplus
• consumer surplus
• producer surplus
Market Failures: Monopoly Power
• The demand curve under monopoly
– production at less than the social optimum
• Deadweight loss under monopoly
– consumer and producer surplus
• consumer surplus
• producer surplus
• total surplus
Deadweight loss under monopoly
MC
£
(= S under perfect competition)
Consumer
surplus
Ppc
a
Producer
surplus
AR = D
O
Qpc
Q
(a) Industry equilibrium under perfect competition
Market Failures: Monopoly Power
• The demand curve under monopoly
– production at less than the social optimum
• Deadweight loss under monopoly
– consumer and producer surplus
• consumer surplus
• producer surplus
• total surplus
– the effect of monopoly on total surplus
Deadweight loss under monopoly
MC
£
(= S under perfect competition)
Pm
Ppc
O
Consumer
surplus
Deadweight
welfare loss
b
a
Producer
surplus
AR = D
MR
Qpc
Qpc
(b) Industry equilibrium under monopoly
Q
Deadweight loss under monopoly
MC
£
(= S under perfect competition)
Perfect
competition
Consumer
surplus
Ppc
a
Producer
surplus
AR = D
O
Qpc
Q
(a) Industry equilibrium under perfect competition
Deadweight loss under monopoly
MC
£
(= S under perfect competition)
Monopoly
Pm
Ppc
O
Consumer
surplus
Deadweight
welfare loss
b
a
Producer
surplus
AR = D
MR
Qpc
Qpc
(b) Industry equilibrium under monopoly
Q
Market Failures: Monopoly Power
• The demand curve under monopoly
– production at less than the social optimum
• Deadweight loss under monopoly
– consumer and producer surplus
• consumer surplus
• producer surplus
• total surplus
– the effect of monopoly on total surplus
• Other problems with monopoly
Market Failures: Monopoly Power
• The demand curve under monopoly
– production at less than the social optimum
• Deadweight loss under monopoly
– consumer and producer surplus
• consumer surplus
• producer surplus
• total surplus
– the effect of monopoly on total surplus
• Other problems with monopoly
• Possible advantages from monopoly
Other Market Failures
• Ignorance and uncertainty
• Immobility of factors and time lags
• Protecting people's interests
– dependants
– the principal–agent problem
• the problem of asymmetric information
• the need for monitoring
– poor economic decision making by people
• merit goods
• Macroeconomic goals
• Economists and policy advice
Government Intervention: Taxes and Subsidies
• The use of taxes and subsidies to
correct externalities
– the optimum size of a tax
Using taxes to correct a market distortion
Costs and benefits
MC = S
P
D
O
Q1
Quantity
Using taxes to correct a market distortion
Costs and benefits
MSC
P
MC = S
D
External cost
O
Q2
Social optimum
Quantity
Q1
Using taxes to correct a market distortion
Costs and benefits
MSC
MC = S
Optimum tax = MSC – MC
P
D
MC
O
Q2
Quantity
Q1
Government Intervention: Taxes and Subsidies
• The use of taxes and subsidies to
correct externalities
– the optimum size of a tax
– the optimum size of a subsidy
Using subsidies to correct a market distortion
Costs and benefits
MC = S
P
O
D
Q1
Quantity
Using subsidies to correct a market distortion
Costs and benefits
MC = S MSC
External benefit
P
O
D
Q1
Quantity
Q2
Social optimum
Using subsidies to correct a market distortion
MC = S MSC
Costs and benefits
MC
Optimum subsidy
= MC – MSC
P
O
D
Q1
Quantity
Q2
Government Intervention: Taxes and Subsidies
• The use of taxes and subsidies to
correct for monopoly
– use of lump-sum taxes
• Advantages of taxes and subsidies
• Disadvantages of taxes and subsidies
– infeasible to use different tax and subsidy
rates
– lack of knowledge
Government Intervention: Laws and Regulation
• The use of laws and regulation
• Advantages of legal restrictions
– simple to understand
– safer when size of problem is potentially great
– quick to implement
– a good way of dealing with imperfect
information
• Disadvantages of legal restrictions
– a 'blunt weapon'
Government Intervention: Laws and Regulation
• Types of regulation
• The system of regulation in the UK
– UK regulatory bodies
– price-cap regulation
• the RPI–X formula
• Advantages of the UK system
– discretionary
– flexible
– incentive for firms to reduce costs
• Disadvantages of the UK system
Other Forms of Government Intervention
• Changes in property rights
– the problem of limited property rights
– extending property rights
– limitations of this solution
• impractical in many situations
• problems of litigation
• questions of equity
• Provision of information
– consumer information
– information on jobs
– information to firms
Other Forms of Government Intervention
• Direct provision of goods and services
– the provision of public goods
– the need to evaluate costs and benefits of
publicly provided goods
– the provision of other goods and services
by the government
• social justice
• large positive externalities
• dependants
• ignorance
More or Less Intervention?
• Drawbacks of government intervention
– shortages and surpluses
– poor information
– bureaucracy and inefficiency
– lack of market incentives
– shifts in government policy
– lack of freedom for the individual
More or Less Intervention?
• Advantages of the free market
– automatic adjustments
– dynamic advantages of capitalism
– possibly high degree of competition even under
monopoly/oligopoly
– Judging the arguments
• Should there be more or less intervention in
the market?
– important to consider both costs and benefits of
intervention
– moral issues
– problem of predicting effects of intervention
The Environment: a Case Study
• The environmental problem
– global and local environmental problems
– causes of the problems
• Market failures
– environment as a common resource
– externalities
– ignorance
– inter-generational problems
The Environment: a Case Study
• Policy alternatives
– charging for use of the environment
• emissions charges
An emissions charge
Costs and benefits (£)
MSC
P2
MB = MSB
P1 = 0
L2
Level of emission
L1
The Environment: a Case Study
• Policy alternatives
– charging for use of the environment
• emissions charges
• user charges
The Environment: a Case Study
• Policy alternatives
– charging for use of the environment
•
•
•
emissions charges
user charges
optimum charge = external cost
The Environment: a Case Study
• Policy alternatives
– charging for use of the environment
•
•
•
emissions charges
user charges
optimum charge = external cost
– green taxes and subsidies
The Environment: a Case Study
• Policy alternatives
– charging for use of the environment
•
•
•
emissions charges
user charges
optimum charge = external cost
– green taxes and subsidies
• use of such taxes around the world
Green tax revenues as a % of GDP
Green tax revenues as a % of GDP
The Environment: a Case Study
• Policy alternatives
– charging for use of the environment
• emissions charges
• user charges
• optimum charge = external cost
– green taxes and subsidies
• use of such taxes around the world
– laws and regulations
The Environment: a Case Study
• Policy alternatives
– charging for use of the environment
• emissions charges
• user charges
• optimum charge = external cost
– green taxes and subsidies
• use of such taxes around the world
– laws and regulations
• advantages and disadvantages
The Environment: a Case Study
• Policy alternatives
– charging for use of the environment
• emissions charges
• user charges
• optimum charge = external cost
– green taxes and subsidies
• use of such taxes around the world
– laws and regulations
• advantages and disadvantages
– education
The Environment: a Case Study
• Policy alternatives
– charging for use of the environment
• emissions charges
• user charges
• optimum charge = external cost
– green taxes and subsidies
• use of such taxes around the world
– laws and regulations
• advantages and disadvantages
– education
– tradable permits
The Environment: a Case Study
• Policy alternatives
– charging for use of the environment
• emissions charges
• user charges
• optimum charge = external cost
– green taxes and subsidies
• use of such taxes around the world
– laws and regulations
• advantages and disadvantages
– education
– tradable permits
• advantages and disadvantages
The Environment: a Case Study
• How much can we rely on governments?
– governments must have the will to protect
the environment
• depends on attitudes of various interest groups
– must be able to identify problems and
appropriates solutions
– when problems are global:
• may require international agreements
• governments are likely to be more concerned
with their own national interests