Chapter 5 Flashcards
Important sources of “market failure” (3)
Externalities
Imperfect information
Market power
Free riding problem
An agent’s decision does not take into account the costs imposed on other agents (splitting the bill)
Types of externalities (3)
Tragedy of commons: a situation where a common resource is overused with respect to the socially optimal level
Congestion: excessive congestion results from an externality
Public goods: positive externalities (parks, defence, health, education)
Why social cost and Pigou taxes?
In markets with externalities, the fundamental theorem fails to hold: market price is no longer the right guide for consumers and producers –> apply Pigou tax.
The Coase Theorem
If property rights are properly assigned and negotiations are costless, then all externalities will be internalized so that the market solutions (cum negotiations) leads to an efficient solution.
Adverse selection + cost lines & equilibrium
A market situation where buyers and sellers have different information. The result is that participants with key information might participate selectively in trades at the expense of other parties who do not have this information (Lemon problem)
qe is lower than at social optimal where (p=mc)
Advantageous selection + cost lines & equilibrium
Opposite of adverse selection. MC > AC (so AC increasing)
equilibrium output is greater than social optimal (qe > q*)
Moral Hazard
Occurs when an entity has an incentive to increase exposure to risk because it does not bear the full costs of that risk.
Why do monopolies exist?
Patents/copyright
Network effects
Leading the industry in terms of quality and efficiency (economies of scale)
Monopoly and efficiency
Harberger triangle (excess burden) = loss of surplus due to missing efficient trades
allocative inefficiency
productive inefficiency because an inefficient firm manages to survive
Rent seeking
Dominant firms
industry where one of the firms command a market share of 50% or more and the smaller firms divide the rest
Residual demand
Market demand - the total capacity of (small) competitors –> optimal pricing MR=MC (behave as a monopoly)
Monopoly power and elasticity
The degree of monopoly power is inversely related to the demand elasticity faced by the seller
Types of regulation (4)
“Government intervention in economic activity using commands, controls and incentives”
Market regulation
Entry regulation
firm regulation
social regulation
Normative theory of regulation
consumers faced with the negative effects of market failures demand regulation from political leaders
Capture theory of regulation
market regulation is a tool employed by firms to better serve their interest –>
regulation demanded by firms rather than by consumers
Benefits from regulations are highly concentrated in few agents, whereas the costs are spread through a large number of consume
revolving-doors problem: the personnel turnover between regulatory agencies and regulated firms
Regulatory Capture
Situation whereby firms invest resources into influencing the regulator’s decisions, to the point that regulation reflects the objective of profit maximization rather than that of welfare maximization
Average cost pricing
Forces the firm to set the lowest price consistent with making non-negative profits
Natural monopoly
When the cost structure is such that costs are minimized with one supplier only
Rate-of-return regulation
A mechanism whereby prices are set to allow the firm a fair return on the capital it invests
Major issue: little incentive to reduce costs, as fixed rate of return
Regulatory lag
A gap between when the firm reduces cost and the time when the new regulated prices take effect, provide transitory gains
Low-power incentive mechanism
price varies in the same measure as cost, which minimizes the incentives for cost reduction
High-power incentive mechanism
Price is set beforehand and does not change at all even if cost changes, providing maximal incentives to reduce costs.
Little incentive to focus on quality
Could allow for allocative inefficiency if the gap between p and mc becomes substantial
The efficient component pricing rule (ECPR)
the wholesale price offered to an independent downstream firm cannot be higher than the difference between p, the final price set by the integrated firm, and the marginal
cost of the integrated firm at the downstream stage.
If ECPR is applied than production efficiency is maximized
