Introduction to Economics - LEC 9 (Government Intervention in the Market and Market Failure) PDF

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Introduction to EconomicsLecture 9Government Intervention in the Market and Market Failure:Free markets do not always operate in a socially efficient way. For example, some industries may lack competition, leading to high prices, economic profits and inefficient resource use. Or, a company may creat...

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Introduction to Economics Lecture 9

Government Intervention in the Market and Market Failure: Free markets do not always operate in a socially efficient way. For example, some industries may lack competition, leading to high prices, economic profits and inefficient resource use. Or, a company may create pollution as a consequence of a production process. Alternatively, the free market may simply not find it profitable to produce some goods and services that society wants or needs. Markets may also fail in terms of consumer decision making. For example, a person’s decision to smoke cigarettes in a restaurant may not be a socially preferred outcome. This topic examines the main forms of free market failure. It then analyses the role of the government in attempting to correct for market failure. Learning Objectives:

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Understand why market failure can occur Discuss and illustrate positive and negative externalities in production and consumption Understand the nature of public goods Discuss the issues associated with common property resources Evaluate government policies used to correct for market failure Understand the difficulties and limitations facing governments in the correction of market failure, that is, ‘government failure’

What’s Good about Markets and Why does the Government Intervene?: • •

Equilibrium in a competitive market results in the economically efficient level of output, where marginal benefit equals marginal cost. Also, equilibrium in a competitive market results in the greatest amount of economic surplus, or total net benefit to society, from the production of a good or service.

The economic bases for government intervention •

Although markets often lead to economic efficiency, the majority of economists acknowledge the necessity of some government intervention. E.g. • Market Failure • The market fails to produce the efficient level of output - too many or too few goods and services consumed or produced [i.e. allocative inefficiency] • LACK OF EFFICIENCY DEVELOPS MARKET FAILURE

Reason for Government Intervention include: 1) Legal System & Rule of Law: a. The ability of a government to enforce the laws of a country, particularly with respect to protecting private property and enforcing contracts 2) Maintaining or Enforcing Competition: a. A lack of competition in the market is a form of market failure, as it leads to allocative inefficiency - too little is produced at a price greater than marginal cost b. Measures to increase Competition: i. Deregulation ii. ACCC enforcement of the Trade Practices Act iii. Trade reform iv. Making markets contestable: 1. A contestable market is one in which the potential for competition exists due to minimal entry and exit costs a. Even monopoly markets may have the potential to be competitive with government intervention 3) Regulating a Natural Monopoly: a. Natural Monopoly (Under produces and over charges) i. A situation in which economies of scale are so large that one firm can supply the entire market at a lower average cost that can two or more firms 1. Regulated Prices 2. Third Party Access 4) Externalities: a. Is a benefit or cost that affects someone who is not directly involved in the production or consumption of a good or service i. Negative Externality: 1. Occurs when a production or consumption activity imposes costs on others who are not directly associated with that activity, and no compensation is paid ii. Positive Externality: 1. Occurs when a production or consumption activity benefits others who are not directly involved with that activity and who do not pay for it

Negative Externalities Examples: 

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Negative Externality in Consumption: a. Cigarette smoking b. Wild parties (When your neighbours are trying to sleep) Negative Externality in Production: a. Noise, Air and/or Water Pollution b. Land degradation and/or contamination c. Global Warming

Positive Externality Examples: 

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Positive Externality in Consumption: a. Education b. Parents vaccinating their children Positive Externality in Production: a. Research and Development (R&D) b. Displaying beautiful garden (Visual satisfaction by others) c. Provision of public transport (Less congestion on roads)

Externalities and Efficiency: 

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Economic efficiency is reduced as externalities lea to a divergence between: a. Private benefits and Social benefits b. Private costs and Social Costs Private Benefit: a. The benefit received by the consumer of a good or service Social Benefit: a. The total benefit from consuming a good or service, including both the private benefit and any external benefit Private Cost: a. The cost borne by the producer of a good or service Social Costs (third-party costs): a. The total cost of producing a good or service, including both the private cost and any external cost. b. E.g. pollution

Negative Externality in Production: • Negative externality in production reduces economic efficiency

• The social cost of the production activity is greater than the private cost of production

• Production occurs at a level that is higher than the socially efficient level, and price is lower than the socially efficient price

• A deadweight loss occurs > Leads to market failure

Positive Externality in Production: • The social cost of the production activity is less than the private cost of production

• Production occurs at a level that is lower than the socially efficient level, and price is higher than the socially efficient price

• Deadweight loss occurs > Leads to market Failure

Negative Externality in Consumption: • The social benefit from the consumption activity is less than the private benefit from the activity

• Consumption occurs at a level that is higher than the socially efficient level, and price is higher than the socially efficient price

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A deadweight loss occurs > Leads to market failure

Positive Externality in Consumption: • The social benefit from the consumption activity is greater than the private benefit from the activity

• Consumption and production occurs at a level that is lower than the socially efficient level, and price is lower than the socially efficient price

• Deadweight loss occurs > Leads to market failure

What causes Externalities?:  

Externalities and market failures result from incomplete property rights or from the difficulty of enforcing property rights in certain situations Property Rights: a. The rights individuals or firms have the exclusive use of their property, including to buy or sell it

Government Policies to Deal with Externalities: 

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Pigovian Taxes and Subsidies: a. Government taxes and subsidies intended to bring about an efficient level of output in the presence of externalities For a negative externality in production, a tax could be imposed on production equal to the cost of the externality In practice, it is administratively more practical to place the tax on producers

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Command and Control Approach:

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a. Government-imposed quantitative limits or regulations on the amount or type of activity that firms, or individuals are allowed to engage in Tradeable Emissions Allowances: a. The government can issue a fixed quantity of emission allowances, which can then be bought and sold in the market i. Rewards firms who reduce emissions, as they can sell their allowances. Penalises firms with high emissions, as they must buy more emission allowances

Common Resources: -

An extreme case of externalities where no one can be denied access to the resource but one person’s use of the resource of the resource reduces the possible use by others Examples: 1. Tuna in the ocean 2. Public Park 3. Clean Air 4. Wildlife

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Without government intervention, such as regulations, people will use too much of a common resource because: -

It is free to use No one pays for its upkeep There are no incentives to conserve it

Tragedy of the commons:

Rivalry and Excludability: 

All goods differ on the basis of whether their consumption is rival and/or excludable

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Rivalry: The situation that occurs when one person consuming a unit of a good or service means no one else can consume it.

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Excludability: The situation in which anyone who does not pay for a good or service cannot consume it. Tragedy of the commons: The tendency for a common resource to be overused. Market failure

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Government Policy towards Common Resources: Is there a way out of the tragedy of the commons? •

Legal restrictions on access to the common resource. Taxes. Tradeable permits. Quotas.

Public Goods: •

A good or service which an additional consumer does not ‘use up’ or prevent another’s use of it, and non can be excluded from consuming the good or service. It is both non-rival and nonexcludable in consumption

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Examples include national defence and street lighting

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The marginal cost of providing for one extra person is zero

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A price cannot be charged (non-excludable). This leads to the problem of the free-rider. Free riding: Benefiting from a good without paying for it

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No incentive for the private sector to provide such goods

Merit Goods: •

A good which is beneficial to society irrespective of the preferences of consumers

Examples include art galleries and museums Asymmetric Information: •

The situation in which one party to an economic transaction has less information than the other party.

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Adverse selection: The situation in which one party to a transaction takes advantage of knowing more than the other party to the transaction.

Reducing adverse selection in the car market: •

Buyers in the used car market fall victim to adverse selection: the market for ‘lemons’.

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Regulations requiring minimum warranties (free repairs on the car for a specified time period after purchase) help to address the problem of adverse selection in the used car market.

Other Roles for Government: -

Income distribution Macroeconomic Stabilisation...