Chapter 5 - Market Failure and Public Policy Flashcards
free riding problem
when an agent’s decision does not take into account the costs imposed on other agents
externality
when a agent’s actions have an effect on other agents that goes beyond the market transaction per se
positive or negative
tragedy of the commons
the situation where a common resource is overused with respect to the socially optimal level (negative)
congestion
when many agents are in the same situation, not only harming themselves but others as well (negative)
example: traffic
public goods
actions of an agent that benefit themselves but also the rest (positive)
externality-correcting taxes
to correct these externalities, economists propose applying this
in markets with externalities, the fundamental theorem fails to hold
market price is no longer the right guide for consumers and producers, something else is required to establish social efficiency
-> Pigou tax
pigou tax
an output tax should be imposed if there is a negative externality and an output subsidy if it is positive
is intended to correct a specific market outcome
social costs should be included, shifting the supply curve upwards/downwards by the tax
alternative solutions to the externality problem
direct regulation on externality-creating activity
social norms may already regulate externalities
coase theorem
in the face of market inefficiencies resulting from externalities, entities are able to negotiate a mutually beneficial, socially desirable solution as long as there are no costs associated with the negotiation process.
market externalities imply market failure. Pigou taxes and other mechanisms may reestablish equilibrium efficiency
imperfect information
asymmetric information -> Adverse selection advantageous selection, moral hazard
reasons for the creation of a monopoly
- government granted monopoly such as patent or copyrights
- network effects where firms beat in market cap
- frequently mixture of things: product quality and efficient production, high entry and set-up costs,…
Differences between competitive markets and monopolies
residual demand curve
An individual firm faces a residual demand curve. This is the market demand not met by other sellers. It is equal to the market demand minus the supply of all other firms.
the monopoly model provides a good approximation to the behaviour of dominant firms
monopoly power
the ability to sell at a price substantially above cost
the degree of monopoly power is … related to the demand elasticity faced by the seller
inversely
regulation
government intervention in an economic activity using commands, controls and incentives
different types of regulation
market regulation (price mechanism) entry regulation firm regulation social regulation (apply to everyone)
normative theory of regulation
consumers faced with negative effects of market failure demand regulation from the government
capture theory
defends that market regulation is a tool employed by firms to better serve their own interest
price fixing
firms collude to set a price acting as a monopoly together, they have market power, these collusions are called horizontal agreements
merger policy
focuses on preventing firms to merge or acquire others resulting in an excessive concentration of market shares
abuse of dominant position
monopolies are not per se illegal, but an abuse of such monopoly or a dominant position is
natural monopoly
if fixed costs are very large or scale economies are very significant the competition might not exist
cost structures are such that costs are minimized with one supplier only
-> direct firm regulation
social welfare will be maximized but firms may leave as they cannot take on that price
regulatory capture
situation whereby firms invest resources into influencing the regulator’s decisions, to the point that regulation reflects the objective of profit maximisation rather than that of welfare maximisation
average cost pricing
firm is forced to set the lowest price consistent with making a non-negative profit; that is price equal to marginal cost
this solution is intermediate between those of marginal cost pricing and unregulated monopoly
rate-of-return regulation
is a mechanism whereby prices are set so as to allow the firm a fair rate of return on the capital it invests (similar to average cost pricing)
gives the firm little incentive for cost reduction
regulatory lag
the gap between the time when the firm reduces its cost and the time when the new regulated prices take effect
low-power incentive mechanism
price varies in the same measure as cost, which minimises the incentives for cost reduction
high-power incentive mechanism
price is set beforehand and does not change at all even if cost changes
a high-power regulation mechanism provides strong incentives for the cost reduction but little incentives for quality provision. In addition it implies a high degree of risk for the regulated firm and requires strong commitment on the part of the regulator
efficient component pricing rule (ECPR)
allows the independent downstream firms to survive if and only if they are competitive with respect to the vertically integrated firm
if ECPR is applied, production efficiency is maximised
