Market Failure Flashcards
What types of distortions cause market failure?
Market power
Externalities
Public goods
What is market power?
Any industrial structure in which firms have ability to inluence prices
Existence of market power leads to lower output and higher price than in competitive markets, resulting in pareto inefficiency P>MC
“Dead-weight” loss can be thought of as a measure of inefficiency
Explain consumer surplus
The consumers’ surplus associated with the provision of a particular good is defined as the total value that consumers attach to all of the units of the good that they consume, minus what they pay to enjoy this consumption. It is therefore a measure of the net benefit that consumers gain from consumption of that good.
Explain Producer Surplus
Producers’ surplus is analogous to consumers’ surplus, but applied to the supply side of an industry. The producers’ surplus associated with provision of a good is defined as the total revenue that firms receive from their sales of that good, minus their total costs of production. It is therefore a measure of the net benefit that firms gain from the production of a given quantity of a good.
What is the dead weight loss of a monopoly?
The deadweight loss can be regarded as a measure of the social cost of the units Qm to Qc not being traded under monopoly
What is competition policy?
Rules concerned with the conduct of firms and the structure of industries in relation to market power
– Firms are prevented from abusing their market power
• Prohibit price-fixing (collusion), market sharing, entry deterrence, etc.
– Industries are prevented (where possible) from becoming monopolistic
- Prohibit exclusive dealing, tying arrangements or mergers, where effect would be to reduce competition
- In the case of natural monopolies, where competition is not possible, state ownership or direct price regulation are options
What is an Externality?
A situation in which the actions takes by one agent, affect welfare of another without this impact reflected in market prices
Consumption and production externalities
Positive and negative externalities
Externalities arise because of the absence of well-defined Property Rights for certain things (e.g. the river water) – Property rights are the power of residual control over an economic good
• Ill-defined property rights result in ‘missing markets’ – the absence of a market, and so price, for things that matter to firms or individuals. Without complete markets, externality problems can arise
Explain negative externality
Q is the competitive market equilibrium output without intervention (AR=MC)
Q’ is the Pareto efficient output (notice this doesn’t require zero pollution)
Hence overproduction of steel
What is coase theorem?
The Coase Theorem states that provided property rights are well defined and that there are no transactions costs, bargaining over externalities will achieve an efficient outcome
What policy solutions are there to externalities?
Our analysis of externalities suggests a number of possible policy solutions:
– Direct Regulation
- Government forces firms and individuals to engage in the efficient level of the relevant activity (e.g. steel production)
- The difficulty of knowing exactly what the efficient level is makes the imposition of ‘standards’ more practical
– moving things towards (rather than to) the efficient level
– ‘Pigouvian’ taxes and subsidies
- Discourage (encourage) activities that generate negative (positive) externalities by taxing (subsidising) those activities
- How does the government know the ‘right’ rates to set?
- E.g. So-called ‘green taxes’ on activities that pollute –
Establish the ‘missing markets’
- By establishing and enforcing all relevant property rights, trade between affected parties will generate efficient outcome
- Equity issues (who should be given the rights in the first place?) and the problem of transactions costs (will market trade actually occur?)
- E.g. EU Emission Trading Scheme - CO2 emission permits
What is a public good?
a good that in non-rival and non-excludable
What is a non rival good?
A good when consumed by one person does not reduce amount available for consumption by any other person
What is a non-excludable good?
A good which is impossible to exclude any person from consuming once it has been provided for one person
Why do public goods cause market failure?
One reason why public goods generate market failure is that individuals have little incentive to purchase them privately because of their non-rival and non-excludable nature. Instead the dominant strategy is to free-ride, which if pursued by all must lead to under-provision of the public good
• A second reason is that the market provides no mechanism for ‘aggregating’ individuals’ preferences.
What are policy implications on public goods?
The key to resolving market failure is the government (rather than the market) deciding the level of provision; production itself may be via the public sector (e.g. national defence) or the private sector (e.g. street cleaning)
- If it knows individual’s preferences, the government can determine the efficient level of provision of the public good – However the government is likely to face a ‘preference revelation problem’, whereby individuals lie about their preferences in order to reduce their own contributions to the cost of provision
- Elections and the democratic process provide a much cruder way of eliciting preferences, with different parties offering different levels of provision of national defence, clean air etc
. – With a small number of parties and many different policy issues, elections are rarely mainly (if at all) about public good provision – The efficient level of provision is not guaranteed
