Market Failures And Government Policy
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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
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
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