Market Failure & Role of Regulation

Market Failure

Market Failure
Definition: Where the market mechanism fails to allocate resources efficiently

Social Efficiency Allocative Efficiency Technical Efficiency Productive Efficiency

Market Failure
Social Efficiency = where external costs and benefits are accounted for Allocative Efficiency = where society produces goods and services at minimum cost that are wanted by consumers Technical Efficiency = production of goods and services using the minimum amount of resources Productive Efficiency = production of goods and services at lowest factor cost

Market Failure

Allocative efficiency:

Also referred to as

Pareto Efficient Allocation resources cannot be readjusted to make one consumer better off without making another worse off zero opportunity cost!

Market Failure

Market Failure occurs where:

Knowledge is not perfect - ignorance Goods are differentiated Resource immobility Market power Services/goods would or could not be provided in sufficient quantity by the market Existence of external costs and benefits Inequality exists

Market Failure

Imperfect Knowledge:

Consumers do not have adequate technical knowledge Advertising can mislead or mis-inform Producers unaware of all opportunities Producers cannot accurately measure productivity Decisions often based on past experience rather than future knowledge

Market Failure

Goods/Services are differentiated

Branding Designer labels - they cost three times as much but are they three times the quality? Technology lack of understanding of the impact Labelling and product information

Market Failure

Resource Immobility

Factors are not fully mobile Labour immobility geographical and occupational Capital immobility Not the financial one. Land cannot be moved to where it might be needed!

Market Failure

Market Power:

Existence of monopolies and oligopolies Collusion Price fixing Abnormal profits Rigging of markets Barriers to entry

Market Failure
Inadequate Provision: Merit Goods and Public Goods

Merit Goods Could be provided by the market but consumers may not be able to afford or feel the need to purchase market would not provide them in the quantities society needs Sports facilities?

Market Failure

Merit Goods
Education nurseries, schools, colleges, universities could all be provided by the market but would everyone be able to afford them?

Market Failure

Public Goods

Markets would not provide such goods and services at all!

Non-excludability Person paying for

the benefit cannot prevent anyone else from also benefiting - the free rider problem. Buying house near the main road.

Non-rivalry

Large external benefits relative to cost socially desirable but not profitable to supply! Like govt. libraries

Market Failure
De-Merit Goods Goods and services provided by the market which are not in our best interests!

Tobacco and alcohol Drugs Gambling

Market Failure
External Costs and Benefits External or social costs

The cost of an economic decision to a third party The benefits to a third party as a result of a decision by another party Examples in next pages

External benefits

Market Failure

External Costs
Decision makers do not take into account the cost imposed on society and others as a result of their decision

e.g. pollution, traffic congestion, environmental degradation, depletion of the ozone layer, misuse of alcohol, tobacco, anti-social behaviour, drug abuse, poor housing

The difference between the value of the MSB and the MSC represents the welfare loss to society of 100 units being produced.

Price
Rs12

External Costs

The MPC does not take into account the cost to society of production. At an output level of 100, the private cost to the supplier is Rs 5 per unit but the cost to society is higher than this (Rs 12).

MSC = MPC + External Cost

MPC

The true cost therefore is the MSC (the MPC plus the external cost). Current output levels therefore (100) represent some element of market failure price does not accurately reflect the true cost of production.

Rs 7 Rs 5

Social Cost

Value of the negative externality (Welfare Loss)

Socially efficient output is where MSC = MSB The Marginal Social

MSB 80 100

Quantity Bought and Sold

Benefit curve (MSB) represents the sum of the benefits to consumers in society as a whole the private and social benefits. The Marginal Private Cost (MPC) curve represents the costs to suppliers of producing a given output.

Market Failure

External benefits

by products of production and decision making that raise the welfare of a third party
e.g. education and training, public transport, health education and preventative medicine, refuse collection, investment in housing maintenance, law and order

External Benefits
Price MSC
Rs10 Rs 6.50 Rs 5 Social Benefits

There can be a position where output is less than would be socially desirable (education for example?) In this case, the sum of the benefits to society is greater than the private benefit to the individual.

Value of the positive externality (Welfare Loss) Socially efficient output is where MSC = MSB

MSB MPB
100
140

Quantity Bought and Sold

Market Failure

Inequality:

Poverty absolute and relative Distribution of factor ownership Distribution of income Wealth distribution Discrimination Housing

Market Failure

Measures to correct market failure

State provision Extension of property rights Taxation Subsidies Regulation Prohibition Positive discrimination Redistribution of income

Emergence of Broad Framework of Study

Are we regulating or de-regulating? Feedback Market failures -> Regulation

What is a Regulation
Free Market

Competitive Forces

Market Efficiency

Market Failure

Regulation

Regulation

Equitable Distribution

Objective of Regulation Market Efficiency and Equitable Distribution

Free Market

Competitive Forces

Market 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

Free Market

Competitive Forces

Market 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

Free Market

Competitive Forces

Market Efficiency

The Invisible Hand

Adam Smith stated in 1776, while he intends only his own gainhe 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

Market Failure

Regulation

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 Failure

Regulation

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 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.

Market Failure

Regulation

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 Failure

Regulation

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

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

Market Failure

Regulation

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

Regulation

Market Failure due to 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 Failure

Regulation

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

Regulation

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

Market Failure

Regulation

Market Failure due to Market 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 Failure

Regulation

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 Failure

Regulation

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

Market Failure

Regulation

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 selfinterest. 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 Failure

Regulation

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

Market Failure

Regulation

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

Market Failure

Regulation

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

Market Failure

Regulation

Government Intervention to Correct Market Failure

Problem Zero provision of public goods Negative externalities Intervention Direct provision of public goods 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 Disadvantages Difficulty in valuating EC Overvaluation means output is below social optimum, as with undervaluation means that output is not sufficiently lowered (ie, societys welfare is not always maximized) Effectiveness of tax dependent on PED 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 Enforcement is difficult and expensive Evaluation

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

Market Failure

Regulation

Government Intervention to Correct Market Failure

Positive Externalities Financial intervention: subsidies made to the producer or consumer Advantages 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 Okuns 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.

Market Failure

Regulation

Government Intervention to Correct Market Failure

Non provision of merit goods There is a need to produce merit goods (which are naturally underconsumed) at low 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)

Market Failure

Regulation

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 Failure

Regulation

Some regulating act in India

Sectors Type of Market Failure Regulator Type of Regulation Relevant Statutes Utilities Natural Monopoly, Externalities, Public Good, CERC, SERCs 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 TRAI Act 1997

Tele Communications

Monopolistic, Oligopoly

TRAI

Licensing, Tariff fixation, QoS standards, Interconnection, Spectrum Management (Advisory) Monetary policy Supervision & Regulation

Banking

Information Asymmetry,

RBI

Banking Act 1959

Regulation

Equitable Distribution

Theorem of Welfare Economics

First Theorem

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

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

Regulation

Equitable Distribution

Policies to reduce poverty

Minimum Wage Laws Welfare Negative Income Tax

In-kind transfers
Antipoverty programs and work incentives

Trade-off between equality and efficiency

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) 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).

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