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Unformatted text preview: 9/12/11 PADP 8670 POLICY ANALYSIS I Market Failures Angela Fer7g, Ph.D. The Role of Government in a Market Economy Under a system of compe>>ve markets, resources will be allocated efficiently without direct government interven>on in the produc>on or distribu>on of goods As long as all market par>cipants take into account the full social costs and benefits of their ac>ons (no externali>es exist) Even without market failure, there is always poten>ally an equity ra>onale for government interven>on However, this role is simply to redistribute resources while crea>ng as few price and quan>ty distor>ons as possible. Also note that for compe>>ve markets to func>on properly it is necessary for the government to establish a system of legal ins>tu>ons to protect property rights and facilitate the voluntary exchange of goods and services 1 9/12/11 An efficiency ra>onale for government interven>on In some cases, a market system can fail to allocate resources efficiently in the absence of government interven>on. These cases, where a market failure exists, include: Public Goods Externali>es Monopoly Power Informa>on Asymmetry Market Failure: In general, the existence of a market failure provides an "efficiency ra>onale" for government interven>on Private Goods A private good is a good with the following two characteris>cs: Rival: if one person benefits from the good, it prevents anyone else from benefi>ng from it Excludable: those who do not pay for the good can be excluded from consuming it The demand curve for a private good is the horizontal summa>on of the demand curves of the individual consumers. Private markets provide efficient quan>>es of private goods as long as no externali>es exist Because marginal social benefit (demand) equals marginal social cost (supply) at the market equilibrium price and quan>ty 2 9/12/11 Public Goods A public good is a good with the following two characteris>cs: Non-rival: if one person consumes the good it doesn't prevent anyone else from consuming it at the same >me Non-excludable: once the good has been provided to one person, it is available to everyone. Thus, it is impossible or imprac>cal to exclude non- payers from consuming it. As we will see on the next slide, the demand curve for a public good is the ver>cal summa>on of the demand curves of the individual consumers Private markets generally do not provide efficient quan>>es of public goods Private firms tend to only want to sell goods to individuals who are willing and able to pay for them Demand Summa>on for Private and Public Goods Private Goods 5 4 3 2 1 2 4 6 8 10 12 14 16 Q 1 2 3 4 5 dA dB D 25 20 15 10 5 Public Goods MSB = MBi MB2 MB1 Q The market demand curve for a private good is the horizontal summa>on of the individual demand curves because of rivalry (the benefit of one unit can only go to the one who buys it) The market demand curve for public good is ver>cal summa>on of individual demand curves because of non-rivalry (the benefit of one unit goes to everyone who enjoys it) 3 9/12/11 Socially op>mal quan>ty of a public good The op>mal quan>ty of a public good is where the marginal social cost curve intersects the marginal social benefit curve: MB, MC MSB MB2 MB1 MSC Q Q0 Private equilibrium quan>ty of a public good If we rely on private provision, the equilibrium quan>ty of a public good is where the highest individual MB curve intersects the MC curve: MSB MB2 MB1 DWL Once Q* has been provided by person 2, person 1 gets to enjoy it without paying Person 1 is a free-rider MSC End up with an inefficiently low quan>ty (Q* < Q0) and a DWL Q* Q0 4 9/12/11 Free Rider Problem Private markets will generally not provide public goods efficiently (especially if a large number of beneficiaries) Since the good is available to everyone once it has been provided to anyone, each person has an incen>ve to just let others pay for it The person then enjoys the goods provided through the contribu>ons of others, even though he/she did not contribute anything. If everyone behaves this way, then there will not be enough contribu>ons to pay for the efficient quan>ty This is known as the free-rider problem Simplified Figure 5.2 A Classifica7on of Goods: Private and Public RIVALROUS Private Good Efficient Market Supply EXCLUDABLE NONRIVALROUS Toll Good No private supply at efficient price of zero; under-consumption at any positive price. Common Property Resources NONEXCLUDABLE Consumers respond to MPC rather than MSC -- over-consumption and underinvestment Pure Public Good Private supply unlikely because exclusion not possible 5 9/12/11 Toll goods A toll good is a good that is non-rival, but is excludable Examples: roads, bridges, wilderness areas, large lakes Because they are excludable (can demand payment), toll goods may be privately supplied. Problem: Marginal cost is zero so should be supplied to everyone who desires to use it (efficient price) However, no private supplier will choose P=0. Private supplier had to build the bridge, road, etc., and need to re-coup costs. So, they will charge a posi>ve price and there will be consump>on lower than the efficient level. Common Property Resource goods A common property resource good is a good that is rival, but not excludable Examples: pastureland, fish in the ocean, open forest Problem: overconsump>on and underinvestment Because it is not feasible to exclude anyone, and because each consumer diminishes the u>lity of other consumers (e.g. if I catch a fish, no one else can catch it), consumers may race to consume the good before others consumer it Consumers only respond to their private costs, and not to the external costs Because no one owns the good, there is underinvestment in sustaining the good. Tragedy of the Commons: pastureland is ruined because of overconsump>on. If each owned a patch of land or if they coordinated, they would work to sustain it over >me. 6 9/12/11 Externali>es An externality is an example of a market failure The ac>ons of some agent (consumer or producer) impose costs or benefits on other agents that are not priced in market transac>ons When there is an externality, the market does not produce the efficient quan>ty of the good that creates the externality There is an opportunity for government interven>on to increase the efficiency of resource alloca>on Economic Analysis of Nega>ve Externali>es Consider a nega>ve externality in produc>on (such as pollu>on) Then the marginal social cost of produc>on exceeds the marginal private cost: MSC MEC = marginal external cost MEC MPC = S Market equilibrium quan>ty (Q*) is greater than socially op>mal quan>ty (Q0) MB = D Q0 Q* 7 9/12/11 Economic Analysis of Posi>ve Externali>es Consider a posi>ve externality in consump>on (e.g., educa>on) Then the marginal social benefit of consump>on is greater than the marginal private benefit: MC= S MEB = marginal external benefit MEB Market equilibrium quan>ty (Q*) is less than socially op>mal quan>ty (Q0) MSB MPB = D Q* Qo SS is lower for monopoly than compe>>ve firm Recall from day 2: There is a deadweight loss rela>ve to compe>>on so SS must be lower under monopoly. P MC P* Pc DWL D MR Q* Qc Q 8 9/12/11 Natural Monopoly A natural monopoly is a single firm that can produce all of the output demanded by the market at a lower cost than compe>>on because of economies of scale. A firm has economies of scale if the long-run average cost (AC) curve is downward sloped. Recall that when AC is falling, it must be above MC Can't force natural monopoly to set P=MC because P<AC so profit<0. Pm Compromise would be P=AC such that profit=0, but s>ll some DWL. PRICE AND ACm AVERAGE PAC COST P0 MR 0 Qm QAC Q0 AC MC D QUANTITY / TIME Informa>on Asymmetry Informa>on asymmetries occur when the two sides of a transac>on have different amounts of informa>on. Inefficiency results when consumer purchases more than they would if fully informed Inefficiencies due to info asymmetry occurs when: Frequency of purchase is low Cannot know quality un>l aler the purchase & there is high varia>on in quality Info Asymmetries can be reduced by 3rd par>es who provide the informa>on for a fee (agents, subscrip>on services). Inefficiencies can s>ll occur if 3rd par>es cannot protect their informa>on (if it is not excludable) 9 9/12/11 Figure 5.12 Consumer Surplus from Uninformed Demand S PRICE PU Pe Extra DWL Dinformed 0 Qinformed QUninformed DUninformed QUANTITY / TIME Summary of Problems associated with Market Failures A public good is a good that benefits the en>re community, but cannot be withheld from those who do not pay for it Problem is that it will not be supplied by the private market An externality is a situa>on where the ac>ons of one agent impose costs or benefits on other agents, but these spillover costs and benefits are not priced in market transac>ons Problem is that good will be oversupplied/consumed if externality is nega>ve or undersupplied/consumed if externality is posi>ve Monopoly power is the failure of too liole compe>>on. Problem is that price will be too high, quan>ty will be too low. Informa>on asymmetries occur when the two sides of a transac>on have different amounts of informa>on. Problem is overconsump>on rela>ve to the full-informa>on scenario 10 9/12/11 Case Study: Cable Wars For next >me Read Ch. 6 Group Memo Due 11 ...
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This note was uploaded on 01/18/2012 for the course PADP 8670 taught by Professor Staff during the Fall '10 term at University of Georgia Athens.
- Fall '10