EC111LectNG10

EC111LectNG10 - University of Essex Department of Economics...

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1 University of Essex Session 2011/12 Department of Economics Autumn Term EC111: INTRODUCTION TO ECONOMICS Market Failure The competitive market mechanism has several important advantages: It coordinates decentralised decisions by a very large number of economic agents without the need for conscious control. It provides strong incentives and disciplines producers against the wasteful use of resources. Price signals convey information about changing market conditions which guides economic decisions. It does not usually lead to an excessive concentration of economic power. But on the other hand: It does not ensure a ‘fair’ distribution of income. It requires very stringent conditions that are associated with perfect competition. There are several sources of inefficiency that can arise including imperfect competition, public goods, externalities, missing markets and incomplete information. These are collectively known as market failure . Imperfect competition Monopoly or oligopoly are one source of market failure. Suppose that there is perfect competition in the industry producing good Y so that P Y = MC Y but monopoly in the industry producing X, so P X > MC X . Then XY Y X Y X XY MRS P P MC MC MRT The output choice efficiency criterion is violated.
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2 This is similar to the case where we had a tax on good X: not enough X is being produced. The welfare loss is captured as the deadweight loss in the partial equilibrium diagram: MR Q X A B MRT of economy Q Y MRS of consumers MC = AC P P M P PC Q M Q PC Q DWL
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3 How large is the cost of market power? Economists usually find that the deadweight loss is small—less than one percent of GDP. But market power may also result in inefficiency and higher costs than otherwise as well as lack of incentive to innovate. So the costs could be much larger, especially in the long run. Regulation may reduce the deadweight loss but it may result in less efficiency than if it is possible to introduce competition. Public Goods Public goods are one of the most important forms of market failure. There is a specific definition of public goods in economics: They are non-rival . This means that my enjoyment or consumption of the good does not prevent or reduce your enjoyment or consumption of it. They are non-excludable. A person cannot be excluded from consuming it even if he/she does not pay for that consumption. Defence is an obvious example, but there are other more locally provided public goods such as public parks, roads etc (assuming no congestion). I would be willing to pay towards the building of a road or a park. But if it does get built, you will enjoy it too at no cost. You have an incentive to say that you do not value it enough to pay more than a little (or nothing) towards it.
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EC111LectNG10 - University of Essex Department of Economics...

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