Market Failures and Government Intervention

MARKET FAILURES AND GOVERNMENT INTERVENTION Inna Ushcatz and Ieta Shams Market Failure The difference between a socially optimum level of production and the market level production is a market failure. In a free market economy it is sometimes possible for individual parties to work out a solution, but government intervention is needed when: Property rights are unclear The number of people concerned is large Bargaining costs are high Market fails because it does not allocate resources efficiently. Types of Inefficiency • The resulting inefficiency of market failures: Productive inefficiency: businesses are not maximizing their outputs. More output, could have satisfied more wants and needs. Costs are higher; productivity is lower than could have been. Allocative inefficiency: businesses misallocate resources and produce goods and services that are not wanted by the consumers. Resources could have been used more efficiently. Government Intervention In a market failure the unrestrained market creates more harm than good. In a market failure the government has a role to play in correcting or internalizing the market failure. Government intervention aims to achieve economic efficiencу. Roots Causes of Market Failures Externalities in production and consumption Public Goods (missing market) Lack of Competition (Monopoly) Poverty and Inequality in an Economy Externalities -Marginal BenefitMarginal analysis is used to study externalities. Marginal Private Benefit (MPB): belongs to the producer or consumer of the good. Marginal External Benefit (MEB): the spillover. MPB + MEB = Marginal Social Benefit (MSB) Price QMARKET QOPTIMUM Supply (private cost) Social value Demand (private value) Quantity Externalities -Marginal CostMarginal Private Cost (MPC): the cost incurred by the producer or Price consumer. Marginal External Cost (MEC): is the spillover or the externality. MPC + MEC = Marginal Social Cost (MSC) Market prices generally reflect only private costs and benefits. Optimum Equilibrium Social cost Supply (private cost) Demand (private value) 0 QOPTIMUM QMARKET Quantity Externalities -Common Government ApproachesProblem Spillover costs (negative externalities) Spillover Benefits (positive externalities) Resource Allocation of Outcome Ways to Correct Over allocation of resources Under allocation of resources 1. Individual bargaining 2. Liability rules and lawsuits 3. Tax on producers 4. Quantity controls 5. Market for externality rights 1. Individual bargaining 2. Subsidy to consumers 3. Subsidy to producers 4. Government provision • Externalities -Quantity ControlThe most common form of government regulation is setting a quantity control on the production of good or service. A direct control sets absolute levels. The total amount of the good which can be produced under the quantity control is called the quota limit. The government limits quantity in a market by issuing licenses for production. Quantity controls typically create undesirable side-effects: Inefficiencies, or missed opportunities, in the form of mutually beneficial transactions that don't occur. Incentives for illegal activities a Externalities -Subsidies- •Where there are spillover benefits, government often uses subsidies to correct the under allocation that the free market would produce. •Subsidies can be paid either to the buyers or the sellers. Subsidy to the Buyer Shift of the demand curve to the right, raising the output level closer to the socially optimum level. Subsidy to the Seller Shift of the supply curve to the right, again correcting the under allocation. Price S=MC (S) D2= MSB D1= MPB QE QO Underallocation Quantity Price ($) 51=MPS S2=MSC D=MB Underallocation QE QO Quantity •Subsidies create undesirable side-effec. ■Inefficient producers remain in business ■Serves as a burden for the taxpayers Externalities -Tax on Producers- • A way to solve negative externalities is through issuing excise taxes. Excise taxes on producers will raise the marginal cost, and decrease supply. Sellers pass as much of the added cost on to buyers as possible, by increasing selling price, This will maintain the same profit margin, and allow the consumer to cover the producers purchase costs. Taxes on producers create the following undesirable side-effects: inefficiency as a result of the excess burden or deadweight loss caused by the tax. They also encourage illegal activity in attempts to avoid the tax. Externalities -Effects of a TaхA tax places a wedge between the price buyers pay and the price sellers receive. Because of this tax wedge, the quantity sold falls below the level that would bе sold without a tax. The size of the market for that goop shrinks. A deadweight loss is the fall in total surplus that results from a market distortion, such as a taх. -The Price Price buyers pay Price without tax Price sellers receive Externalities Effects of a TaxSupply Size of tax Demand Quantity with tax Quantity without tax Quantity • Externalities -Public Provision of Goods and ServicesGovernment provides previously decided upon public goods with tax money collected from all citizens. Government cannot use price as a signal of value in the way that a market would, because price does not fully reflect the value of most public goods. Government must use other methods, such as: 0 Public surveys Market research Voting for certain political candidates Monopolies -Market FailuresIncreased competition in a market means that a market is more likely to provide allocative efficiency by providing the socially optimum amount of a good. Some markets will organize themselves to hinder competition, essentially creating a monopoly. The government aims to make industry more competitive. Monopolies -Government ResponsesAntitrust Policies: Laws that aim to curb monopoly power. Antitrust laws make the following practices illegal: • Collusive price fixing • Separation of markets Tying contracts ⚫ Interlocking directorates • Price discrimination when it reduces competition Antitrust laws strengthen government powers to promote competition. Inequality -Disparities in the Distribution of Economic ResourcesQuestions to ask when measuring inequality: How much people are in our society? How many people live in poverty? - How often do people move amongst income classes? Failure to properly distribute income leads to a inequality (a form of market failure) Change in technology and outsourcing, has decreased demand for unskilled labour and made their incomes extremely low. It is believed that everyone has an equal opportunity to succeed, but the misallocation of résources proves this wrong. Inequality -SolutionsPolicies that are imposed in order to decrease Inequality: Minimum wages: If labour is inelastic, this policy is effective at reducing inequality. If labour is elastic, not so much. Welfare: government programs that supplement the income of the needy Negative Income Tax: High income families pay tax, low income families receive the "negative tax" In-kind Transfers: Things given to the poor in the form of goods and services Interest 5.4% Compensation of employees 70.4% Distribution of Income US 2007 Corporate profits 14.3% Rent 0.6% Proprietors' income 9.3% Lorenz Curve The Lorenz Curve: A curve that shows the degree of inequality. Illustrates how income is distributed unequally in a society. The pink shaded area labelled A represents ineguality present in a society. The Gini Coefficient finds the area of inequality, divides it by the total area to find the percentage of inequality. 100% A Lorenz curve cumulative percent of income perfect equality reference line area of inequality B A cumulative percent of population 100% Factor Distribution & the Gini Coefficient Gini coefficient: An number between zero and one that is used to measure inequality as it relates one variable to another. For perfect equality the Gini coefficient is 0. However, absolute inequality yields a coefficient of 1. The Gini Coefficient can be found from the Lorenz Curve by dividing area A by the combination of area A and В Thus, A/(A+B) Factor Distribution of Income: is the division of total income among labor, land and capital. Video http://www.youtube.com/watch?v=8 DuWQVDi9bQ&list=PL71234D006E68 2C13&index=1&feature=plpp_video 1. Practice Multiple Choice Question In the case of a market in which a negative externality is produced, which of the following is true of marginal social cost? a) MSC=MPC b) MSC=MPB c) Government can intervene to cause MSC=MEC d) Marginal social cost is not reflected in the supply curve e) Bystanders are bearing the marginal social cost 1. Practice Multiple Choice Question At the socially efficient output and price for a good whose production causes pollution, we can expect that a) The offending pollution will be eliminated b) The marginal social cost of production will exceed the marginal social benefit of production c) The private cost of production will equal the private benefit of production d) The marginal social benefit of production will equal the marginal social cost of production e) Too little of the good will be produced 1. Practice Free- Response Assume that product X is produced in a perfectly competitive market and yields costs that are borne by third party individuals. Using a correctly labeled graph, show the market output and price if the market ignores the externality. a) Identify the problem in this market. b) Identify and explain a remedy to the problem of misallocation of resources. c) Amend the graph to show how your remedy has changed the output to the socially optimum amount. To be Marked Free Response Question to be marked: http://www.diigo.com/bookmark/http%3A% 2F%2Ftw.neisd.net%2Fwebpages%2Fdmaye r%2Ffiles%2Fap_micro_frq.htm?tab=people &uname=mscuttle