Market Failure
Market Failure
Market Failure
04/01/13
Microeconomics (EIM3232)
Points B & C indicate market failure Distributional failure may also occur Causes are monopoly, externalities (incl. public goods), uncertainty, & imperfect information
Market Failure
Units o f Wine
A B
CIC1 CIC2
Units of Bread
MSC(MRT)
MSB(MRS)
Units of Bread
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
Direct 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
Externalities
MSC S(MPC) S(MSC)
P* P
P* P
D(MSB)
MSB
D(MPB)
Q* Q
Q Q*
Private bargaining/negotiation can remove inefficiency by internalising the externality Most likely when Coases Theorem
potential gains, well defined property rights, few agents affected, low transaction costs
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 Simply assigning property rights will not solve all externality problems (example river many people to negotiate with)
Distributional effects depends on the exact definition of property rights (Example of a farmer)
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
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)
Government Policies
Taxation
to reduce production/consumption
Subsidy
to increase production/consumption
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)
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
In general, the efficient output of Assume only 2 people benefit (Ted and Jane) a public good occurs where Ds, Their demand curve represented by obtained by vertical summing the dt and dj from their indifference demand curves for all consumers, curves the marginal cost curve summation Vertical Height of demand curve shows benefit intersect of a unit Add the marginal benefits of the 2 to N$ per tanks derive marginal social or combined demand curve (vertical summation) N$650 Teds N$400 benefit is added to Janes N$250 for social benefit of N$500 MC N$650 for the 1st tank Output level where Ds lies above the N$400 Ds marginal cost curve MC (Horizontal N$325 dt for simplicity) Ted and Jane willing to pay more for N$250 N$175 an additional unit than its marginal dj cost Efficiency require a high output When MC is lies above Ds too much 1 10 Tanks of public good demanded (combined marginal benefit is less than marginal cost
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 persons demand curve
No rationing problem for public goods Due to simultaneous benefit It would be inefficient to exclude anyone even if we could