Market Failure & Role of

Regulation
RRS I – What is a Regulation

 Emergence of Broad Framework of Study

 Are we regulating or de-regulating?

 Feedback – Market failures -> Regulation

Framework
Competitive Market
Free Market
Forces Efficiency

Market
Regulation
Failure

Regulation Equitable
Distribution

Objective of Regulation – Market Efficiency and Equitable Distribution

 Competitive Market
Free Market
Forces Efficiency

Types of Market
 Perfectly Competitive Market
 Goods/services offered are all same
 Numerous buyers and sellers and no single buyer or seller can
influence the market price - price takers

 Oligopoly
 Few sellers
 Each participant is aware of the actions of the others

 Monopolistic
 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
 Competitive Market
Free Market
Forces Efficiency

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

 Free market produces the

quantity of goods that maximizes
the sum of consumer and
producer surplus

 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)
 Competitive Market
Free Market
Forces Efficiency

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

 The competitive market guides and controls the

self seeking activities of each individual to
maximize the wealth of the nation.

 Laissez faire – “Allow them to do” opposes state

economic interventionism (George Whatley,
Principles of Trade, 1774)
 Market
Regulation
Failure

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

 Therefore economic and social welfare

may not be maximized

 This leads to a loss of economic efficiency

 Market
Regulation
Failure

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

 John Stuart Mill, Henry Sidgwick mark a turning point in the literature of
market failure

(Steven G. Medema, 2004)

 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

 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)
 Market
Regulation
Failure

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

 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

 “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”
 Market
Regulation
Failure

Main causes of Market Failure

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

 Public goods and Common Resources

 Market dominance and abuse of monopoly power

 Imperfect Asymmetry
 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
Regulation
Failure

Market Failure due to Externalities

 Externalities create divergence between private
and social costs and benefits

 Individual consumers and producers may fail to

take externalities into account when making
consumption and production decisions

 Consumers and suppliers are assumed to

consider their own private costs and benefits
Market Failure due to
Market
Regulation
Failure

Externalities
 Negative Externalities
 Over production of goods where the social costs >
private cost
 Over consumption of demerit goods where social benefit
< private benefit

 Positive Externalities
 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
Regulation
Failure

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
Regulation
Failure

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
Regulation
Failure

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

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

 Common resources – non excludable but rival – example

fishing etc

 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

Market Failure due to Market

Regulation
Failure

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

 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
 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
Regulation
Failure

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

 Monopolist charges a higher price therefore

earning a higher profit

 Also there is a deadweight loss implying that

the monopolist produces less than the socially
efficient quantity of output.

 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.

 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
Regulation
Failure

Market Failure due to Natural

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

 The marginal cost of producing one

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

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

(Mankiw, 2007)
 Market
Regulation
Failure

Market Failure due to Oligopoly

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

 Oligopoly is a market with only a few sellers:

 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 co-operate.
 Market
Regulation
Failure

Market Failure due to Information Asymmetry -

(Principal Agent problem)
 Buyers and Sellers will have
different information about
the product’s attributes

 In one instance when the

consumer is less informed –
there will be a producer
surplus but also a net loss to
society

 Adverse Selection, Moral

hazards are a result of
information asymmetry
Wiemer and Vining (1999)
 Market
Regulation
Failure

Adverse Selection – The Market for Lemons

 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)
 Market
Regulation
Failure

Moral Hazards – Shirking of Workers

 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)
 Market
Regulation
Failure

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

 Several forms of government intervention are possible to correct for

perceived market failure

 To employ the diagnostic approach, analysts attempt to identify both

the precise type of problem that gives rise to the market failure

 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).

 Sufficiency is established when the gains from government

intervention outwieghs the dangers of government intervention
 Market
Regulation
Failure

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
Zero provision of Direct provision of public goods
public goods
Negative Financial intervention: taxes (equal to the
externalities monetary value of the MEC) are imposed on
individuals or a firm, internalizing ECs
Legislation: laws and administrative rules are
passed to prohibit or regulate behaviour that
imposes an EC, e.g. pollution permits
Education, campaigns and advertisements solve
the problem of imperfect information by
allowing the external costs to be made known to
the consumer, discouraging demand
Market
Regulation
Failure
Evaluation
Advantages
Leaves space for market forces to interact
Provision of revenue for the government
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
Enforcement is difficult and expensive
Benefits must outweigh the costs of implementation.
A lot of time may be needed for effects to be felt
 Market
Regulation
Failure

Government Intervention to Correct Market Failure

Positive Financial intervention: subsidies made to the Advantages

Externalities producer or consumer Considered the most effective way of 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, Enforcement requires constant checking which may
compulsory education etc. translate to high costs.
 Market
Regulation
Failure

Government Intervention to Correct Market Failure

Non provision of There is a need to produce merit goods (which are naturally underconsumed) at low prices or for free
merit goods 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 Imposition of a lump-sum tax on a monopolist (shifts AC upwards), and supernormal profits are taken as
markets 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)
 Market
Regulation
Failure

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)
 Market
Regulation
Failure

Some regulating act in India

Sectors Type of Market Regulator Type of Regulation Relevant Statutes
Failure

Utilities Natural Monopoly, CERC, SERCs Licensing, Tariff Electricity Act 2003
Externalities, Public fixation, QoS
Good, standards, Dispute
Resolution

Oil & Gas Natural Monopoly, Petroleum and Natural Licensing, Tariff Petroleum and Natural
Externalities Gas Regulatory Board fixation, QoS Gas Regulatory Board
standards, Dispute Act 2006
Resolution Petroleum Act 1934
Petroleum and Minerals
Pipelines Act, 1962

Tele Communications Monopolistic, TRAI Licensing, Tariff TRAI Act 1997

Oligopoly fixation, QoS
standards,
Interconnection,
Spectrum Management
(Advisory)

Banking Information RBI Monetary policy Banking Act 1959

Asymmetry, Supervision &
Regulation

Consultation paper on Approach to Regulation Issues and Options, Planning Commission India
Regulation - Summary
 The possibility of market failure underpin the economic
rationale for state regulation of market economies.

 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

 Economic regulation of public utilities can be explained by

economies of scale and scope and need to protect the consumers
from monopoly exploitation

 Aspects of fiscal policy can be rationalized on the basis in terms of

wealth and income redistribution

 Regulatory intervention for universal service obligations etc.

Regulation - Summary
 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)
 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.
 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