Lecture 7: Market Failures and Government Policy

1. Lecture 7: Market Failures and Government Policy

2. Social Efficiency • Society’s microeconomic objectives • equity • problems of defining ‘fairness’ • social efficiency • allocative efficiency • private and social • marginal social benefits and costs • MSB > MSC socially efficient to produce more • MSC > MSB socially efficient to produce less • social efficiency achieved where MSB = MSC • general equilibrium

3. QSocial efficiency is achieved where: resources are allocated in the fairest possible way. people can be made better off with no one being made worse off. losses to the rich will be more than offset by gains to the poor. there is no X inefficiency. it is not possible to make anyone better off without making at least one other person worse off.

4. QIn a perfect market, social efficiency in any activity will be maximised where the activity’s: marginal benefit equals marginal cost. total benefit equals total cost. marginal social benefit exceeds marginal social cost. marginal social benefit equals marginal social cost. total social benefit exceeds total social cost.

5. Externalities: An externalityis aneffectofa decisionby onesetofpartieson otherswho didnot havea choice andwhoseinterestswerenot taken intoaccount. External costs of production MSC > MC Market Failure: Externalities and Public Goods

6. Externalities • Externalities are any costs or benefits that fall on others besides the buyer and sellers of a particular good or service. Externalities are also referred to as spill-over effects. • Can occur in production or consumption. • May be positive or negative externalities. • When the spillover effects are harmful, they are called external costs or negative externalities. • When the spillover effects are beneficial to others, they are called external benefits or positive externalities.

7. External costs in production MC = S P D Q1 Firm is a price taker Costs and benefits O Quantity

8. External costs in production External cost Q2 Social optimum MSC MC = S Costs and benefits P D O Q1 Quantity

9. Externalities External costs of production MSC > MC External benefits of production MSC < MC Market Failure: Externalities and Public Goods

10. External benefits in production MC = S Costs and benefits P D O Q1 Quantity

11. External benefits in production External benefit Q2 Q1 Social optimum MC = S MSC Costs and benefits P D O Quantity

12. External benefit External cost External costs and benefits in production MSC MC = S MSC MC = S Costs and benefits (£) Costs and benefits (£) D P P D O O Q Q Q Q 2 1 2 1 Quantity Quantity (b) External benefits (a) External costs

13. Externalities External costs of production MSC > MC External benefits of production MSC < MC Market Failure: Externalities and Public Goods • External costs of consumption • MSB < MB

14. External costs in consumption (MB) MU = D Q1 Costs and benefits P S O Quantity

15. External costs in consumption External cost (MB) MU = D Q2 Social optimum Costs and benefits P S MSB O Q1 Quantity

16. Externalities External costs of production MSC > MC External benefits of production MSC < MC External costs of consumption MSB < MB Market Failure: Externalities and Public Goods • External benefits of consumption • MSB > MB

17. External benefits in consumption (MB) MU = D Costs and benefits P S O Q1 Quantity

18. External benefits in consumption External benefit (MB) MU = D Q2 Social optimum Costs and benefits P S MSB O Q1 Quantity

19. External benefit External cost Q Q Q Q 2 2 1 1 External costs and benefits in consumption Costs and benefits (£) Costs and benefits (£) P P P P MSB MB MB MSB O O Rail miles Car miles (a) External costs (b) External benefits

20. QWhich of the following creates a net external cost in consumption? Cycling. Smoking. Electricity generation from coal. Electricity generation from nuclear power. Recycling of waste.

21. 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 Market Failure: Externalities and Public Goods • Public goods • Non-rivalry • non-excludability

22. QWhich one of the following is an example of a public good (or service)? Museums. National defence. Motorways. Health care. Secondary education.

23. Market Failures: Monopoly Power The demand curve under monopoly production at less than the social optimum

24. A monopolist producing less than the social optimum MC P1 MC1 AR MR Q1 Monopoly output £ O Q

25. A monopolist producing less than the social optimum Perfectly competitive output Monopoly output £ MC = MSC P1 P2= MSB = MSC MC1 AR = MSB MR O Q Q2 Q1

26. The demand curve under monopoly production at less than the social optimum Market Failures: Monopoly Power • Deadweight loss under monopoly • consumer and producer surplus • consumer surplus • producer surplus • total surplus

27. Deadweight loss under monopoly a Ppc Qpc MC (= S under perfect competition) £ Consumer surplus Producer surplus AR = D O Q (a) Industry equilibrium under perfect competition

28. 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 Market Failures: Monopoly Power

29. Deadweight loss under monopoly Deadweight welfare loss b Pm MR Qpc MC (= S under perfect competition) £ Consumer surplus a Ppc Producer surplus AR = D O Qpc Q (b) Industry equilibrium under monopoly

30. Deadweight loss under monopoly Perfect competition a Ppc Qpc MC (= S under perfect competition) £ Consumer surplus Producer surplus AR = D O Q (a) Industry equilibrium under perfect competition

31. Deadweight loss under monopoly Monopoly Deadweight welfare loss b Pm MR Qpc MC (= S under perfect competition) £ Consumer surplus a Ppc Producer surplus AR = D O Qpc Q (b) Industry equilibrium under monopoly

32. QWhich one of the following is a definition of deadweight welfare loss under monopoly (compared with perfect competition)? The loss in output. The increase in price. The loss of total consumer surplus. The increase in total profit. The loss of total consumer-plus-producer surplus.

33. 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 Market Failures: Monopoly Power • Other problems with monopoly • Possible advantages from monopoly

34. Other Market Failures • Ignorance and uncertainty • The principal–agent problem • the problem of asymmetric information • the need for monitoring and incentives • Immobility of factors and time lags • Protecting people’s interests • dependants • poor economic decision making by people • merit goods • Macroeconomic goals • Economists and policy advice

35. Government Intervention: Taxes and Subsidies The use of taxes and subsidies to correct externalities the optimum size of a tax

36. Using taxes to correct a market distortion MC = S P D Q1 Costs and benefits O Quantity

37. Using taxes to correct a market distortion External cost Q2 Social optimum MSC MC = S Costs and benefits P D O Q1 Quantity

38. Using taxes to correct a market distortion Optimum tax = MSC–MC MC Q2 MSC MC = S Costs and benefits P D O Q1 Quantity

39. The use of taxes and subsidies to correct externalities the optimum size of a tax the optimum size of a subsidy Government Intervention: Taxes and Subsidies

40. Using subsidies to correct a market distortion MC = S Costs and benefits P D O Q1 Quantity

41. Using subsidies to correct a market distortion External benefit Q2 Q1 Social optimum MC = S MSC Costs and benefits P D O Quantity

42. Using subsidies to correct a market distortion MC Optimum subsidy = MC – MSC MC = S MSC Costs and benefits P D O Q2 Q1 Quantity

43. 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: Taxes and Subsidies

44. QThe optimum tax and/or subsidy on a monopoly which produces external benefits would be: A lump-sum tax and a per-unit subsidy. A lump-sum subsidy and a per-unit tax. A lump-sum tax and a per-unit tax. A per-unit tax and a per-unit subsidy related to the externality. A per-unit tax will be sufficient.

45. Government Intervention: Laws and Regulation The use of laws and regulation Advantages of legal restrictions simple to understand safer when size of problem may be great quick to implement a good way of dealing with imperfect information Disadvantages of legal restrictions a ‘blunt weapon’

46. Other Forms of Government Intervention Changes in property rights the problem of limited property rights extending property rights the Coase theorem 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

47. 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

48. QIf walkers are given the right to walk over other people’s land so long as they do not cause damage, this approach to externalities would be called: changing property rights. reducing the free-rider problem. the provision of public goods. the provision of merit goods. a market-based approach.

49. 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

50. More or Less Intervention? • Advantages of the free market • automatic adjustments • dynamic advantages of capitalism • possibly high degree of competition even under monopoly/oligopoly • 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