Market Failure and Government Failure

Market Failure: In the wealthy countries of OECD governments take in and spend an average of 40% of GDP. How is such a widespread interference in the market economy explained. The two main answers include (i) The correction of known instances of market failure (ii) the redistribution of the social product toward disadvantaged, primarily economically inactive groups.

Sources of Market Failure

Sources of Market Failure I. Market Power/Monopolies (1)Unnatural or Artificial Monopoly: (i) dominant firm gathers market share and then erects barriers to entry (ii) demand curve facing monopolist slopes downward (iii) firm is price setter (iv) Firm restricts production (v) increases prices (vi) Generates economic profits (vii) Drives a wedge between P and MC (viii) Loss of consumer surplus (ix) Deadweight loss (xi) Barriers to entry prevent supernormal profits from serving their important economic function to attract new investment that would return the profit rate to normal. (xii) Antitrust policy (ISCC (1887, Sherman act 1890, Clayton Act 1914)

Un-Natural or Artificial Monopoly

Natural Monopoly
2. Natural Monopoly: (i) High fixed costs resulting from extensive initial capital investment (ii) Long run average cost curve falling (iii) MC<AC, MC constant or falling (iv) Competition can be created at the cost of extensive and wasteful replication of facilities (v)Monopoly price, pm, at MC=MR too high (vi) Efficiency point of view price PE, and Q, QE (MR=MC). But here TR<TC (losses) (vii) Common compromise solution is a government regulatory commission to fix price, PR=ATC. This will allow utility to cover all fixed and variable costs including a normal rate of return on capital.

Natural Monopoly

Labor Unions
3. Labor Unions: (i) Labor organizations represent the attempt to monopolize a factor of production, generally with a view to restrict supply and raise its price. (ii) The consequences are usually higher wages and better benefits for workers, and a higher level of unemployment than would exist otherwise. (iii) The decline of heavy industry and the growing surplus of labor as indicated by historically high rates of unemployment, weakened the power of the union movement (iv) The Japanese miracle of the 1960s through 1980s were assisted by the repression of the labor movement in late 1950s.

Lack of Information
II. Lack of Information (i) In case of simple commodities and frequent purchases government help is not needed to protect consumers. Reputation is an important asset (ii) In case of complex goods and infrequent purchases, government is needed to protect consumers (iii) Standards, what info sellers must offer to the buyer and what recourse available to buyer in case of disappointment (iv) Government creates barriers to entry by limiting access to the industry to those who demonstrate appropriate qualification (v) Regulation and licensing an effective way of minimizing consumers needs for expensive info (vi) Performing surgery w/o such qualifications is forbidden (vii) No restrictions on who can offer to shave people or cut hair. (viii) One bad hair cut does not kill but one poor surgery can kill and licensing reduces the risk to the public.

Public Goods
III. Public Goods (i)Quality of private goods is that they are excludable (producers/sellers charge a price and deny access to those who fail to pay the price) and diminishable (implies that one persons consumption of a good or service reduces the supply available to others) (ii) Public goods are neither excludable nor diminishable (iii) Free rider problem if private sector produces public goods (iv) Only the government with its ability to coerce payments through taxation holds the potential to supply the good at the optimal level (v) Pure public goods national defense, administration of justice, public health (vi) Motivation to provided social/merit goods involve distributional/ egalitarian concerns.

Externalities As a Market Failure

IV. Externalities (i) Imperfections created by presence of externalities (ii) Both consumers and producers make decisions by considering private benefits and costs (iii) Appropriate consideration should be social benefits and social costs (iv) Existence of externalities due to ability of producers to emit smoke into the atmosphere w/o paying pollution fee or compensation to those affected cause a divergence between the private MC and social MC (v) The market system with the imperfections of uncompensated externalities tends to overproduce the good to the level of QP rather than the socially optimal position of QS.

Externalities: Social Versus Private Benefits/ Costs

Government Regulatory Activity to Counter Pollution

1. Ban pollution process entirely. (banning production totally will result in undersupply of polluting good. Loss of consumer welfare from absolute non-availability may outweigh the gains of completely clean air or water) 2. Establish minimum compliance standards. ( Establishing minimum standards leaves no incentives for manufacturers to press for further reduction below the standard even though an additional cut may be socially beneficial) 3. Offer subsidies to manufacturers to reduce pollution: (Economically efficient outcome. But the policy grants the right to pollute to manufacturer and bribes them to stop) 4. Charge manufacturer a fee per unit of pollution emitted. (Economically efficient outcome. Gives manufacturers no right but forces them to purchase the ability to pollute from the state).

Government Failure: Info, Capture of Regulators, Collective Action

II. Government Failure
1.Availability of Information: (i) Market system economizes on information as the economy works in a decentralized way. (ii) No participant needing to see the whole picture (iii) Government action requires all relevant info to be centralized. (iii) Government will only outperform even an imperfect market if it has access to all appropriate information. This task is at best expensive and at worst impossible when participants see an incentive to provide misleading information. (iv) Groups that benefit from provision of publicly supplied goods find it in their interest to overstate their demand.

2. The Capture of Regulators: (i) Main device for control of monopoly power lies with regulatory agencies established to supervise pricing and output. (ii) Over time regulatory agencies tend to capture the regulatory body set to oversee it. Regulators often identify more with those of the industry that they, in theory, control than with public at large. (iii) Guaranteed profit margins set by agency (iv) grow cautious about innovation. (v) Too little attention to cost control.
3. Collective Action: (i) Small interest groups can organize much more easily and forcefully than large ones. (ii) Small groups with intense preferences, through their collective action, will lobby hard for types of expenditures, even if total costs will exceed benefits (iii) Costs spread among large numbers, benefits more compactly distributed (iv) members of beneficiary groups try to free ride on the broadest tax paying population (v) Consequence some public goods oversupplied (Defense, health).

Government Failure: Log rolling, Rent Seeking, Pork Barreling

4. Log Rolling: (i)Through this process , pressure groups band together to form coalitions. (ii) Receive the support of all other small groups for their cause in return for reciprocal support (iii) Result of this process is a general over supply of public goods. (iv) an industry and its workers benefit from imposition of protective tariff and may lobby hard for it (v) They will frequently prevail though impact on overall consumers welfare might be strongly negative. (vi) It is because they are easily organized and highly focused while losers are dispersed and disorganized. 5. Rent Seeking Behavior: (i) expenditure of real resources in an attempt to appropriate a surplus in the form of rent. (ii) In the above example, auto co. executives employed lobbyists (which represent real resources) to convince the government to restrict competition from abroad. (iii) A common form of government intervention denies access to specific industries or professions to those not appropriately qualified. (iv)S down in such activities and enables successful entrants to earn a monopoly rent. 6. Pork Barreling: (i) Politicians prone to use government expenditure to bolster their own position (ii) Representatives of a particular district will lobby hard for specific expenditure that will benefit their own electorate. This is pork barreling. (iii) Projects may take form of public expenditure on infrastructure or government facilities that benefit the locality but the costs spread over the tax paying population of entire economy. (iv) 3 implication is those voter groups care great deal about a specific issue are rewarded and where politicians rely on contributions to finance their election campaign, campaign contributors are rewarded.

Government Failure: Agency Inertia, Deadweight Loss

7. Agency Inertia: (i)Once created bureaucracies tend to take on a life of their own. They will seek to perpetuate their existence by finding work to do. (ii) FDR administration 1936 founded rural electrification authority (REA) (iii) All HH in USA have power, its task finished but managed to stay in business, named rural utilities service (RUS) to help ski areas, golf courses. (iv) with arrival of web a new role to ensure that rural schools obtain high speed internet access. 8. Deadweight loss and Taxes: (DWL is fall in economic welfare that accrues to no one (ii) a change of behavior occasioned solely by the imposition of tax is an example of deadweight loss. (iii) All taxes influence economic choice. Taxes on income distort the choice between labor and leisure (iv)increase in government borrowing increases interest rates, and distorts choice between Saving and Consumption, also leading o crowding out private investment (v) Printing money increases inflation and distorts choice between present and future consumption.