Market Failure & Role Of Regulation[1]

Research Review Seminar - II

Market Failure & Role of Regulation Jogendra Behera 8th February, 2008

RRS I – What is a Regulation 

Emergence of Broad Framework of Study

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Are we regulating or de-regulating?

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Feedback – Market failures -> Regulation

Framework Free Market

Competitive Forces

Market Efficiency

Market Failure

Regulation

Regulation

Equitable Distribution

Objective of Regulation – Market Efficiency and Equitable Distribution

Types of Market 

Perfectly Competitive Market  

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Oligopoly  

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Few sellers Each participant is aware of the actions of the others

Monopolistic  

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Goods/services offered are all same Numerous buyers and sellers and no single buyer or seller can influence the market price - price takers

Goods/services are slightly differentiated Numerous sellers – each seller has some ability to influence the price

Monopoly  

No substitute available for the goods/services offered Only one seller and this seller sets the price – price maker

Perfectly Competitive Market 

Free markets allocate  Supply of goods to the buyers who values them most  Demand for goods to the sellers who can produce them at least cost

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Free market produces the quantity of goods that maximizes the sum of consumer and producer surplus

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Competitive forces efficiently allocate the scarce resources (Arrow, Kenneth, and Debreu, Existence of an equilibrium for a competitive economy, 1954 – Formal proof under which the market equilibrium is Pareto efficient)

The Invisible Hand 

Adam Smith stated in 1776, “ …while he intends only his own gain…he is …led by an invisible hand to promote an end which was no part of his intention…” – that is to maximize the wealth of the nation

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The competitive market guides and controls the self seeking activities of each individual to maximize the wealth of the nation.

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Laissez faire – “Allow them to do” opposes state economic interventionism (George Whatley, Principles of Trade, 1774)

What is a Market Failure 

Market failure occurs when freely functioning markets, operating without government intervention, fail to deliver an efficient or optimal allocation of resources

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Therefore economic and social welfare may not be maximized

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This leads to a loss of economic efficiency

Brief History of Market Failure 

Preclassical economics – primarily government regulation; nineteenth century classical economics – harmonization of self interest and social interest; neoclassical economics – presence of market failures and government to act as an efficient coordinating force

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John Stuart Mill, Henry Sidgwick mark a turning point in the literature of market failure (Steven G. Medema, 2004)

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The concept of market failure initially appeared as a means of explaining in economic terms why the need for government expenditures should arise – normative judgement about the role of government

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As it matured the market failure concept on an additional characteristics – diagnostic tool by which policy makers learned how to objectively determine the exact scope and type of intervention (Weimer and Vining, 1992)

Definition of Market Failure 

Market failure when the competitive outcome of markets is not efficient from the point of view of the economy as a whole

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This is usually because the benefits that the market confers on individuals or firms carrying out a particular activity diverge from the benefits as a whole

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“a case in which a market fails to efficiently provide or allocate goods and services” in comparison to some ideal standard, such as the perfect competition model”

Main causes of Market Failure 

Externalities causing private and social costs and/or benefits to diverge

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Public goods and Common Resources

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Market dominance and abuse of monopoly power

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Imperfect Asymmetry  

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Adverse Selection – Ignorant party lacks information while negotiating a transaction (Akerlof – Lemon’s Problem); Moral Hazards – ignorant party lacks information about performance of the of the agreed upon transaction (Peltzman argument on insured driver taking more risks);

Equity issues – Markets can generate an unacceptable distribution of income and social exclusion

Market Failure due to Externalities 

Externalities create divergence between private and social costs and benefits

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Individual consumers and producers may fail to take externalities into account when making consumption and production decisions

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Consumers and suppliers are assumed to consider their own private costs and benefits

Market Failure due to Externalities 

Negative Externalities 

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Over production of goods where the social costs > private cost Over consumption of demerit goods where social benefit < private benefit

Positive Externalities 

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Under consumption/provision of merit goods where the social benefit > private benefit Information failure may lead to under-consumption (individuals not fully aware of the benefits to themselves of consuming a merit good)

Market Failure due to Externalities

Negative Externalities

Positive Externalities

Negative externalities lead markets to produce a larger quantity than socially desirable; Positive externalities lead markets to produce a smaller quantity than is socially desirable

Market Failure due to Public Good

In the case of public goods and common resources, externalities arises because something of value has no price attached to it. “goods which will enjoy in common in the sense that each individual’s consumption of such a good leads to no subtractions from any other individual’s consumption of that good …” (Samuleson, 1954)

Market Failure due to Public Good 

Free market economy will fail to deliver the efficient quantity of public goods because of their characteristics  A problem arising from public goods is the free rider issue 

People take a free ride when they benefit from consuming a good or a service without paying for the costs of provision

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Many goods have a public element but they are not pure public goods – congested motorway

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Common resources – non excludable but rival – example fishing etc

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Because people are not charged for their use of common resources, they tend to use them excessively (The Tragedy of Commons, Garret Hardin 1968)

Market Failure due to Market Power 

Monopoly – A price maker compared to price taker of a firm in competitive market

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A firm is monopoly because of  

It owns a key resources The government provide a single firm an exclusive right to produce some good or service – patents and copyrights given by the government 

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Provide incentive for research and creativity activity offset by the monopoly prices

Natural Monopoly - The costs of production make a single producer more efficient than a larger number of producers

Market Failure due to Market Power - Monopoly 

In a competitive firm – price equals marginal cost while in the case of monopolized market price exceeds marginal cost

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Monopolist charges a higher price therefore earning a higher profit

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Also there is a deadweight loss implying that the monopolist produces less than the socially efficient quantity of output.

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Monopolist chooses to produce and sell the quantity of output at which the marginal revenue and marginal cost curve intersect; while the social planner would choose the quantity at which the demanded marginal cost curves intersect.

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The monopoly may also use some of its profit paying for its monopoly profits paying for these additional costs. Therefore the social loss from monopoly includes both these costs and the deadweight loss resulting from a price above marginal cost

Market Failure due to Natural Monopoly 

High fixed costs of entering an industry which causes long run average costs to decline as output expands

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The marginal cost of producing one more unit is constant – average cost declines as output increases over a much large range of output levels.

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Telecommunications, electricity, water, railways etc. are some natural monopolies

(Mankiw, 2007)

Market Failure due to Oligopoly 

In reality a firm is neither perfectly competitive or monopoly in nature rather somewhere between.

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Oligopoly is a market with only a few sellers:  

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A key feature of oligopoly is the tension between co-operation and self-interest. The group of oligopolists is best off co-operating and acting like a monopolist – producing small quantity of output and charging a price above marginal cost – cartel or collusion However the self interest is hindrance to co-operate (example of two prisoners) – dominant strategy leading to Nash equilibrium which is less than what monopolist would make profit As the number of sellers in an oligopoly grows larger, an oligopolistic market looks more like a competitive market. The price approaches marginal cost, and the quantity produced approaches the socially efficient level

Co-operation between oligopolists is undesirable from the standpoint of society – to move the allocation of resources closer to social optimum, policy makers should try to induce firms in an oligopoly to compete rather than cooperate.

Market Failure due to Information Asymmetry - (Principal Agent problem) 

Buyers and Sellers will have different information about the product’s attributes

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In one instance when the consumer is less informed – there will be a producer surplus but also a net loss to society

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Adverse Selection, Moral hazards are a result of information asymmetry Wiemer and Vining (1999)

Adverse Selection – The Market for Lemons

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Finally the market for poor quality of cars only exist – Good products and good customers are under represented while bad products and bad customers are over represented

(Pindyck and Rubinfeld (2001)

Moral Hazards – Shirking of Workers

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The higher the current rate of unemployment, and the higher the wage paid over the market wage, the more effective will be the threat of dismissal (Pindyck and Rubinfeld (2001)

Government Intervention to Correct Market Failure 

The economic rationale for Government intervention  

(i) Correction for market failure/loss of economic efficiency (ii) Desire for greater degree of equity in the distribution of income and wealth

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Several forms of government intervention are possible to correct for perceived market failure

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To employ the diagnostic approach, analysts attempt to identify both the precise type of problem that gives rise to the market failure

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Policy analysts argue that existence of a market failure provides a necessary, not a sufficient justification for public policy interventions. A double market failure test is required. (Weimer & Vining, 1992).

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Sufficiency is established when the gains from government intervention outwieghs the dangers of government intervention

Government Intervention to Correct Market Failure (1) Command and Control technique (including regulation) (2) Government subsidy and other forms of financial assistance (including research grants and tax allowances/tax exemptions) (3) Taxation (including indirect taxes designed to control pollution) (4) Policies to increase competition and reduce the immobility of factors of production (5) Provision and finance of public and merit goods (6) Introduction/expansion of market based incentives to change both consumer and producer behaviour

Government Intervention to Correct Market Failure Problem

Intervention

Evaluation

Zero provision of Direct provision of public goods public goods Negative externalities

Financial intervention: taxes (equal to the monetary value of the MEC) are imposed on individuals or a firm, internalizing ECs

Advantages Leaves space for market forces to interact Provision of revenue for the government

Legislation: laws and administrative rules are passed to prohibit or regulate behaviour that imposes an EC, e.g. pollution permits

Enforcement is difficult and expensive

Education, campaigns and advertisements solve the problem of imperfect information by allowing the external costs to be made known to the consumer, discouraging demand

Benefits must outweigh the costs of implementation. A lot of time may be needed for effects to be felt

Disadvantages Difficulty in valuating EC Overvaluation means output is below social optimum, as with undervaluation means that output is not sufficiently lowered (ie, society’s welfare is not always maximized) Effectiveness of tax dependent on PED

Government Intervention to Correct Market Failure Positive Externalities

Financial intervention: subsidies made Advantages Considered the most effective way of to the producer or consumer solving underconsumption as it is easily implemented Disadvantages Like taxes, the valuation of EB is difficult High government expenditure is required Okun’s leaky bucket: each dollar transferred from a richer to a poorer individual, results in less than a dollar increase in income for the recipient. Leaks arise as a result of administrative costs, changes in work effort, attitudes etc. arising from the redistribution

Legislation include regulation seatbelt usage, compulsory education etc.

Enforcement requires constant checking which may translate to high costs.

Government Intervention to Correct Market Failure Non provision of There is a need to produce merit goods (which are naturally underconsumed) at low merit goods prices or for free due to four reasons 1.Social justice: they should be provided according to need and not ability to pay 2.Large positive externalities, for example in the provision of free health services helps to contain and combat the spread of disease 3.Dependants are subject to their guardians decision which are not necessarily the best, therefore the provision of services like free education and dental treatment is needed to protect dependants from uninformed or bad decisions 4.Ignorance: The problem of imperfect information makes consumers unaware of the positive externalities and benefits that arise from consumption

Imperfect markets

Imposition of a lump-sum tax on a monopolist (shifts AC upwards), and supernormal profits are taken as tax. Governments may also regulate MC/AC pricing for monopolies.

Government may impose regulations to control a monopolies 1.Forbidding the formation of monopolies (e.g., antitrust laws) 2.Forbidding monopolistic behaviour (like predatory pricing) 3.Ensuring standards of provision. 4.Ensuring competition exists (e.g., deregulation)

Government Intervention to Correct Market Failure Natural Monopolies

In the case of Natural Monopoly the essence of regulation is the explicit replacement of competition with governmental orders with principal institutional device for assuring good performance.

In the case of natural monopoly the primary guarantor of acceptable performance is conceived to be not competition or self restraint but direct governmental prescription of major aspects of their structure and economic

There are four principal components of this regulation that in combination distinguish the public utility from other sectors of the economy: control of entry, price fixing, prescription of quality and conditions of service, and an imposition of an obligation to serve all applicants under reasonable conditions. (The principles of economic regulation, A.E.Kahn)

Some regulating act in India Sectors

Type of Market Failure Regulator

Type of Regulation

Relevant Statutes

Utilities

Natural Monopoly, CERC, SERCs Externalities, Public Good,

Licensing, Tariff fixation, QoS standards, Dispute Resolution

Electricity Act 2003

Oil & Gas

Natural Monopoly, Externalities

Petroleum and Natural Gas Regulatory Board

Licensing, Tariff fixation, QoS standards, Dispute Resolution

Petroleum and Natural Gas Regulatory Board Act 2006 Petroleum Act 1934 Petroleum and Minerals Pipelines Act, 1962

Tele Communications

Monopolistic, Oligopoly

TRAI

Licensing, Tariff fixation, TRAI Act 1997 QoS standards, Interconnection, Spectrum Management (Advisory)

Banking

Information Asymmetry,

RBI

Monetary policy Banking Act 1959 Supervision & Regulation

Consultation paper on Approach to Regulation Issues and Options, Planning Commission India

Theorem of Welfare Economics 

First Theorem 

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If (1) households and firms act perfectly competitively, taking price as parametric, (2) there is a full set of markets, and (3) there is perfect information, then a competitive equilibrium, if it exists, is Pareto efficient

Second Theorem 

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If household indifference maps and firm production sets are convex, if there is a full set of markets, if there is perfect information, and if lump sum transfers and taxes may be carried out costlessly, then and Pareto efficient allocation can be achieved as a competitive equilibrium with appropriate lump sum transfers and taxes (The size of output is not shrunk) Ideally, this would be achieved through measures that did not destroy the efficiency properties, and much of welfare economics is based on the assumption that non-discriminatory taxes and transfers can be carried out

(Albert & Hahnel)

Political Philosophy of redistributing income  Utilitarianism  Liberalism  Libertarianism

Policies to reduce poverty 

Minimum Wage Laws

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Welfare

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Negative Income Tax

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In-kind transfers

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Antipoverty programs and work incentives

Trade-off between equality and efficiency (Mankiw, 2007)

Regulation - Summary 

The possibility of market failure underpin the economic rationale for state regulation of market economies.

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Regulations can take different forms with different roles 

Health, safety regulations and environmental regulations can be rationalized on the basis of imperfect information and externalities

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Economic regulation of public utilities can be explained by economies of scale and scope and need to protect the consumers from monopoly exploitation

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Aspects of fiscal policy can be rationalized on the basis in terms of wealth and income redistribution

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Regulatory intervention for universal service obligations etc.

Regulation - Summary  

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Regulation cannot be limited to economic issues – means to ultimately achieve non-economic ends Intentions and outcomes are therefore defined by a combination of economic, social, political and bureaucratic factors and cannot be attributed to one set of factors alone Involvement of disciplines other than economics (law, political science, sociology etc.) Broad definition – “ the use of public authority to set and apply rules and standards” (Hood et al, 1999)

(Economic Regulation – A Preliminary literature review and summary of research questions – Parker)

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As an effort by the state “to address social risk, market failure or equity concerns through rule based direction of individual and society” (Planning Commission consultation paper on Regulation)

Regulation - Summary 

Regulation is a complex balancing act between advancing the interests of consumers, competitors and investors, while promoting a wider, ‘public interest’ agenda.   

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minimum prices to benefit the consumer (maximize consumer surplus); ensure adequate profits are earned to finance the proper investment needs of the industry (earn at least a normal rate of return on capital employed); provide an environment conducive for new firms to enter the industry and expand competition (police anti-competitive behavior by the dominant supplier); preserve or improve the quality of service (ensure higher profitability is not achieved by cutting services to reduce costs); identify those parts of the business which are naturally monopolistic (statutory monopolies that are not necessarily justified in terms of either economies of scale or scope); take into consideration social and environmental issues (e.g. when removing cross subsidization of services).

(Parker, 2000)

References Books 1. Mankiw, N. Gregory. (2007). Principles of Economics. 3rd Indian Edition, 2. Friedman, D. (1990). Market Failures. Chapter 18. Price Theory. Southwestern Publishing 3. Djolov, G. George. (2008). The Economics of Competition – The Race to Monopoly. Jaico publishing house 4. Michael, A. & Hahnel, R,. A quiet revolution in welfare economics. Online book. Journals 1. Dollery, B. and Worthington, A. (1996). The Evaluation of Public Policy. Normative Economic Theories of Government Failure. Journal of Interdisciplinary Economics 7(1):pp. 27-39. 2. Medema, G. Steven. (2004). Mill, Sidgwick, and the evolution of the theory of market failure. History of Political Economy 3. Stigler, J. George. (1971). The theory of economic regulation. Bell Journal of Economics 2(1), Page 3-21

References 4. Shleifer, Andrei. Understanding Regulation. European School of Management, Vol 11, No. 4, 2005, pp 439 – 451 5. Hammond, J. Peter. (1997).The Efficiency Theorems and Market Failure. Elements of General Equilibrium Analysis, Basil Blackwell 6. Parker, D. (1999). Regulation of privatized public utilities in the UK: performance and governance. International Journal of Public Sector Management. Vol 12, pp 213-236. 7. Dollery, B., & Wallis, J. (2001). The theory of market failure and policy making in contemporary Local Government. Working Paper in Economics 8. Consultation Paper(2006). Approach to Regulation: Issues and Options. Planning Commission, Government of India

Thank You