Market Failure

04/08/23 Microeconomics (EIM3232) 1

Microeconomics

Failure to Achieve Pareto Efficiency

What is Market Failure?· Market failure exists when one or

more of the efficiency conditions is not satisfied

· Points B & C indicate market failure· Distributional failure may also occur· Causes are monopoly, externalities

(incl. public goods), uncertainty, & imperfect information

MRTMSCMRSMSB

CIC1

Units of BreadU

nits

o f

Win

e

Units of Bread

Units of Wine given up

MSB(MRS)

MSC(MRT)

A

CIC2

C

BMarket Failure

Increasing Returns/Monopoly

· Increasing returns to scale imply declining LRAC

· This can lead to natural monopoly· Barriers to entry can also create

and maintain monopoly power· Monopoly generates allocative

inefficiency

Externalities· DirectDirect effects on utility or output

by consumption/production activities of others for which no price is paid

· Positive (benefits) & negative (costs) externalities

· Examples: pollution, environmental degradation, education & training

Why do externalities arise?

· Jointness in consumption and production

· Lack of clearly defined property rights· e.g. “common property”

· Property rights not enforceable

How do they cause market failure?

· Divergence between private and social costs and benefits

· Rational agents act only on private costs/benefits

· Hence market outcome is not Pareto optimal

Externalities

D(MSB)

S(MPC)

MSC

S(MSC)

D(MPB)

MSB

QQ* Q Q*

PP*

P

P*

Private Market Solution· Private bargaining/negotiation can remove

inefficiency by “internalising” the externality· Most likely when

· potential gains, well defined property rights, few agents affected, low transaction costs

· Coase’s Theorem· Whoever is assigned the property rights does not matter, as

long as property rights are clearly defined and enforced, bargaining between parties ensures an efficient outcome

· Distributional effects – depends on the exact definition of property rights (Example of a farmer)

· Simply assigning property rights will not solve all externality problems (example river – many people to negotiate with)

· Whenever the effects are nonrival over a large group and exclusion is not feasible, the free-rider problem hinders the process of achieving agreement among all concerned

· Negotiation process costly and time consuming – no pollution, but inefficient solution (PIDCO-Caprivi)

· Assigning property rights can solve externality when there are small numbers of parties involved, but not as readily when there are large numbers – due to the free rider problem

Government Policies· Taxation

· to reduce production/consumption· Subsidy

· to increase production/consumption

· Regulation· Public Production

Public Good· Public goods are goods which benefit all

consumers, such as national defense· A public good will be undersupplied by the

market when consumers cannot be excluded from sharing in its benefit

· There is no incentive to pay for its production

· Even a public good is worth more to people than it costs to produce, private markets may fail to provide it

· When public good or externalities lead markets to generate an inefficient allocation of resources, government can intervene· (Note the problems associated with government

intervention – Rent controls)

What are public goods?· Does not necessarily refer to a good

provided by government· Economist define public good by its

characteristics· A good is nonrival in consumption (street

lights) · Simultaneous consumption by many persons

· Public good is non-exclusion· Cannot exclude others from benefiting· A person benefits whether they pay or not

· Free-Rider problem (Dam construction example) · Incentive to understate what the dam is real

worth to them· Free-Rider problem increases with the size of

the group involved

Efficiency in the production of a public good

· What is efficient output of a public good?· Marginal benefits vs. marginal cost

associated with the different levels of output· The opportunity cost of using the resources· The marginal benefit of producing an additional unit of a

burger is the value of the burger to a single person who consumes it (private)

· Public good such as defence, marginal benefit is not the marginal value to any one person alone

People benefit simultaneously from same unit· Therefore we must add the marginal benefits

of every person who values the additional unit of defense

· The resulting sum indicates the combined willingness of the public to pay for more defence –that is its marginal benefit

Deriving social marginal benefitAssume only 2 people benefit

(Ted and Jane)Their demand curve represented by dt and dj from their indifference curvesHeight of demand curve shows benefit of a unitAdd the marginal benefits of the 2 to derive marginal social or combined demand curve (vertical summation)Ted’s N$400 benefit is added to Jane’s N$250 for social benefit of N$650 for the 1st tankOutput level where Ds lies above the marginal cost curve MC (Horizontal for simplicity)Ted and Jane willing to pay more for an additional unit than its marginal costEfficiency require a high outputWhen MC is lies above Ds too much of public good demanded (combined marginal benefit is less than marginal cost

· Vertical summation

N$650

MCN$500

N$400N$325N$250N$175

1 10

Dsdt

dj

N$ per tanks

Tanks

In general, the efficient output of a public good occurs where Ds, obtained by vertical summing the demand curves for all consumers, intersect the marginal cost curve

· There is no presumption that this output will be the actual, or equilibrium output

· The free-rider problem will generally mean that private markets will not produce an efficient output

· Government financing of a public good overcomes one aspect of the free-rider problem (the tendency of people to withhold payment)

· Another aspect of free-rider problem that is not overcome by government financing, is that people have no incentive accurately reveal their demands for the public good especially when they will be taxed commensurate to the benefit they report receiving

· Determining efficient output requires that we know every person’s demand curve

Efficiency in Production and Distribution

· In addition to an efficient level of output· A second condition is that the output is be

produced using the least costly combination of inputs

· Condition implicit in the figure for vertical summation, that N$500 is the minimum cost necessary to produce a tank

· Third condition relates to efficient distribution of the good among consumers

· So, how is public good rationed efficiently?· No rationing problem for public goods· Due to simultaneous benefit· It would be inefficient to exclude anyone even if

we could

Nonrival, but exclusion possible

· Patents –legal monopoly· Knowledge of making an AIDS vaccine

· Nonrival· Its use cannot make someone else worse off· Whether exclusion is possible depends on

type of knowledge· But its use can be prohibited if producing or

selling its tangible embodiment is made illegal · illegal to manufacture and sell vaccine

· Patents encourage a greater, more efficient output of new knowledge, because inventors receive temporary monopoly right, to compensate for their research costs

Questions for thought· What two characteristics define a public

good?· Why will private markets produce an

inefficient output of a public good? Explain how the efficient level of a public good is determined.

· Education is frequently cited as a source of external benefits. In what way, if at all will your receiving university education benefit other people?

· “When public goods or externalities lead to inefficient resource allocation, government intervention is justified” Is it? Why?

· From a public good perspective, critique the use of patents