Market Failures

and Government
Policy
Market Failures: Externalities and
Public Goods
• Society's microeconomic objectives

– equity

– social efficiency

• marginal social benefits and costs

• production where MSB = MSC

Market Failures: Externalities and
Public Goods
• Externalities
• External costs of production
– MSC > MC
 External costs in production

MC = S
Costs and benefits

P D

O Q1

Quantity
 External costs in production
MSC
MC = S
Costs and benefits

P D
External cost

O Q2 Q1
Social optimum
Quantity
Market Failures: Externalities and
Public Goods
• Externalities
– External costs of production
• MSC > MC
– External benefits of production
• MSC < MC
 External benefits in production
MC = S
Costs and benefits

P D

O Q1
Quantity
 External benefits in production
MC = S MSC
Costs and benefits

External benefit

P D

O Q1 Q2
Social optimum
Quantity
 External costs and benefits in production

MSC MC = S MC = S MSC

Costs and benefits (£)

Costs and benefits (£)

External benefit

P D P D
External cost

O Q2 Q1 O Q1 Q2
Quantity Quantity

(a ) External costs (b) External benefits

Market Failures: Externalities and
Public Goods
• Externalities
– External costs of production
• MSC > MC
– External benefits of production
• MSC < MC
– External costs of consumption
Market Failures: Externalities and
Public Goods
• Externalities
– External costs of production
• MSC > MC
– External benefits of production
• MSC < MC
– External costs of consumption
• MSB < MB
Costs and benefits External costs in consumption

P D

(MB)
MU = D

O Q1
Quantity
 External costs in consumption

External cost
Costs and benefits

P D

(MB)
MU = D
MSB

O Q2 Q1
Social optimum
Quantity
Market Failures: Externalities and
Public Goods
• Externalities
– External costs of production
• MSC > MC
– External benefits of production
• MSC < MC
– External costs of consumption
• MSB < MB
– External benefits of consumption
Market Failures: Externalities and
Public Goods
• Externalities
– External costs of production
• MSC > MC
– External benefits of production
• MSC < MC
– External costs of consumption
• MSB < MB
– External benefits of consumption
• MSB > MB
Costs and benefits External benefits in consumption

P D

(MB)
MU = D

O Q1
Quantity
 External benefits in consumption

External benefit
Costs and benefits

P D
MSB

(MB)
MU = D

O Q1 Q2
Social optimum
Quantity
 External costs and benefits in consumption

Costs and benefits (£)

Costs and benefits (£)

External benefit

External cost
P P P P
MSB

MB MB
MSB

O Q2 Q1 O Q1 Q2

Car miles Rail miles

(a ) External costs (b) External benefits

Market Failures: Externalities and
Public Goods
• Externalities
– External costs of production
• MSC > MC
– External benefits of production
• MSC < MC
– External costs of consumption
• MSB < MB
– External benefits of consumption
• MSB > MB
• Public goods
Market Failures: Externalities and
Public Goods
• Externalities
– External costs of production
• MSC > MC
– External benefits of production
• MSC < MC
– External costs of consumption
• MSB < MB
– External benefits of consumption
• MSB > MB
• Public goods
– non rivalry
Market Failures: Externalities and
Public Goods
• Externalities
– External costs of production
• MSC > MC
– External benefits of production
• MSC < MC
– External costs of consumption
• MSB < MB
– External benefits of consumption
• MSB > MB
• Public goods
– non rivalry
– non-excludability
Market Failures: Monopoly Power

• The demand curve under monopoly

– production at less than the social optimum
A monopolist producing less than the social optimum
£
MC

P1

MC1
AR
MR
O Q1 Q
Monopoly output
A monopolist producing less than the social optimum
£
MC = MSC

P1

P2 = MSB
= MSC

MC1
AR = MSB
MR
O Q1 Q2 Q
Monopoly output Perfectly competitive output
Market Failures: Monopoly Power

• The demand curve under monopoly

– production at less than the social optimum
• Deadweight loss under monopoly
– consumer and producer surplus
• consumer surplus
Market Failures: Monopoly Power

• The demand curve under monopoly

– production at less than the social optimum
• Deadweight loss under monopoly
– consumer and producer surplus
• consumer surplus
• producer surplus
Market Failures: Monopoly Power

• The demand curve under monopoly

– production at less than the social optimum
• Deadweight loss under monopoly
– consumer and producer surplus
• consumer surplus
• producer surplus
• total surplus
 Deadweight loss under monopoly
£ MC
(= S under perfect competition)

Consumer
surplus
a
Ppc
Producer
surplus

AR = D
O Qpc Q
(a) Industry equilibrium under perfect competition
Market Failures: Monopoly Power

• The demand curve under monopoly

– production at less than the social optimum
• Deadweight loss under monopoly
– consumer and producer surplus
• consumer surplus
• producer surplus
• total surplus
– the effect of monopoly on total surplus
 Deadweight loss under monopoly
£ MC
(= S under perfect competition)

Deadweight
Consumer welfare loss
surplus b
Pm

Ppc Producer a
surplus

MR AR = D
O Qpc Qpc Q
(b) Industry equilibrium under monopoly
 Deadweight loss under monopoly
£ MC
(= S under perfect competition)
Perfect
competition

Consumer
surplus
a
Ppc
Producer
surplus

AR = D
O Qpc Q
(a) Industry equilibrium under perfect competition
 Deadweight loss under monopoly
£ MC
(= S under perfect competition)
Monopoly

Deadweight
Consumer welfare loss
surplus b
Pm

Ppc Producer a
surplus

MR AR = D
O Qpc Qpc Q
(b) Industry equilibrium under monopoly
Market Failures: Monopoly Power

• The demand curve under monopoly

– production at less than the social optimum
• Deadweight loss under monopoly
– consumer and producer surplus
• consumer surplus
• producer surplus
• total surplus
– the effect of monopoly on total surplus
• Other problems with monopoly
Market Failures: Monopoly Power

• The demand curve under monopoly

– production at less than the social optimum
• Deadweight loss under monopoly
– consumer and producer surplus
• consumer surplus
• producer surplus
• total surplus
– the effect of monopoly on total surplus
• Other problems with monopoly
• Possible advantages from monopoly
 Other Market Failures
• Ignorance and uncertainty
• Immobility of factors and time lags
• Protecting people's interests
– dependants
– the principal–agent problem
• the problem of asymmetric information
• the need for monitoring
– poor economic decision making by people
• merit goods
• Macroeconomic goals
• Economists and policy advice
Government Intervention: Taxes
and Subsidies
• The use of taxes and subsidies to
correct externalities
– the optimum size of a tax
 Using taxes to correct a market distortion

MC = S
Costs and benefits

P D

O Q1

Quantity
 Using taxes to correct a market distortion
MSC
MC = S
Costs and benefits

P D
External cost

O Q2 Q1
Social optimum
Quantity
 Using taxes to correct a market distortion
MSC
MC = S

Optimum tax = MSC – MC

Costs and benefits

P D

MC

O Q2 Q1

Quantity
Government Intervention: Taxes
and Subsidies
• The use of taxes and subsidies to
correct externalities
– the optimum size of a tax
– the optimum size of a subsidy
 Using subsidies to correct a market distortion
MC = S
Costs and benefits

P D

O Q1
Quantity
 Using subsidies to correct a market distortion
MC = S MSC
Costs and benefits

External benefit

P D

O Q1 Q2
Social optimum
Quantity
 Using subsidies to correct a market distortion
MC = S MSC

MC
Costs and benefits

Optimum subsidy
= MC – MSC

P D

O Q1 Q2
Quantity
Government Intervention: Taxes
and Subsidies
• The use of taxes and subsidies to
correct for monopoly
– use of lump-sum taxes

• Advantages of taxes and subsidies

• Disadvantages of taxes and subsidies

– infeasible to use different tax and subsidy
rates
– lack of knowledge
Government Intervention: Laws
and Regulation
• The use of laws and regulation
• Advantages of legal restrictions
– simple to understand
– safer when size of problem is potentially great
– quick to implement
– a good way of dealing with imperfect
information

• Disadvantages of legal restrictions

– a 'blunt weapon'
Government Intervention: Laws
and Regulation
• Types of regulation
• The system of regulation in the UK
– UK regulatory bodies
– price-cap regulation
• the RPI–X formula

• Advantages of the UK system

– discretionary
– flexible
– incentive for firms to reduce costs
• Disadvantages of the UK system
Other Forms of Government Intervention

• Changes in property rights

– the problem of limited property rights
– extending property rights
– limitations of this solution
• impractical in many situations
• problems of litigation
• questions of equity

• Provision of information
– consumer information
– information on jobs
– information to firms
Other Forms of Government Intervention

• Direct provision of goods and services

– the provision of public goods
– the need to evaluate costs and benefits of
publicly provided goods
– the provision of other goods and services
by the government
• social justice
• large positive externalities
• dependants
• ignorance
 More or Less Intervention?

• Drawbacks of government intervention

– shortages and surpluses

– poor information

– bureaucracy and inefficiency

– lack of market incentives

– shifts in government policy

– lack of freedom for the individual

 More or Less Intervention?

• Advantages of the free market

– automatic adjustments
– dynamic advantages of capitalism
– possibly high degree of competition even under
monopoly/oligopoly
– Judging the arguments
• Should there be more or less intervention in
the market?
– important to consider both costs and benefits of
intervention
– moral issues
– problem of predicting effects of intervention
 The Environment: a Case Study

• The environmental problem

– global and local environmental problems
– causes of the problems

• Market failures
– environment as a common resource
– externalities
– ignorance
– inter-generational problems
 The Environment: a Case Study

• Policy alternatives
– charging for use of the environment
• emissions charges
 An emissions charge

MSC
Costs and benefits (£)

P2

MB = MSB
P1 = 0
L2 L1
Level of emission
 The Environment: a Case Study

• Policy alternatives
– charging for use of the environment
• emissions charges
• user charges
 The Environment: a Case Study

• Policy alternatives
– charging for use of the environment
• emissions charges
• user charges
• optimum charge = external cost
 The Environment: a Case Study

• Policy alternatives
– charging for use of the environment
• emissions charges
• user charges
• optimum charge = external cost
– green taxes and subsidies
 The Environment: a Case Study

• Policy alternatives
– charging for use of the environment
• emissions charges
• user charges
• optimum charge = external cost
– green taxes and subsidies
• use of such taxes around the world
Green tax revenues as a % of GDP
Green tax revenues as a % of GDP
 The Environment: a Case Study

• Policy alternatives
– charging for use of the environment
• emissions charges
• user charges
• optimum charge = external cost
– green taxes and subsidies
• use of such taxes around the world
– laws and regulations
 The Environment: a Case Study

• Policy alternatives
– charging for use of the environment
• emissions charges
• user charges
• optimum charge = external cost
– green taxes and subsidies
• use of such taxes around the world
– laws and regulations
• advantages and disadvantages
 The Environment: a Case Study

• Policy alternatives
– charging for use of the environment
• emissions charges
• user charges
• optimum charge = external cost
– green taxes and subsidies
• use of such taxes around the world
– laws and regulations
• advantages and disadvantages
– education
 The Environment: a Case Study

• Policy alternatives
– charging for use of the environment
• emissions charges
• user charges
• optimum charge = external cost
– green taxes and subsidies
• use of such taxes around the world
– laws and regulations
• advantages and disadvantages
– education
– tradable permits
 The Environment: a Case Study

• Policy alternatives
– charging for use of the environment
• emissions charges
• user charges
• optimum charge = external cost
– green taxes and subsidies
• use of such taxes around the world
– laws and regulations
• advantages and disadvantages
– education
– tradable permits
• advantages and disadvantages
 The Environment: a Case Study

• How much can we rely on governments?

– governments must have the will to protect
the environment
• depends on attitudes of various interest groups

– must be able to identify problems and

appropriates solutions
– when problems are global:
• may require international agreements
• governments are likely to be more concerned
with their own national interests