© Pilot Publishing Company Ltd. 2005 Chapter 16 Market Failure?

© Pilot Publishing Company Ltd. 2005

Chapter 16Market Failure?


Contents:

• Examples of Market Failure

• Counter Argument – the Market Works!

• Government Intervention is Unnecessary and Inappropriate


Examples of Market Failure


Definitions:

Market failure

Externality

is the situation in which the invisible hand (the

market price) fails to allocate resources efficiently.

is the situation in which one’s action affects others (in a non-pecuniary way) without compensation.


Private cost is the cost borne by the decision maker.

External cost is the uncompensated cost borne by others.

Social cost is the total cost borne by the whole society = private cost + external cost.

External cost


Divergence between private and social costs

Example:

Noise from a construction site

is the situation in which the private cost is different from the social cost due to the presence of external cost


Deadweight loss

MEC

Qs Qp

MPB = MSB

MPC

MSCS

Q0

Equilibrium & efficiency:

Social optimum:

Qs (MSB = MSC)

Social optimum:

Qs (MSB = MSC)

Private optimum:

Qp (MPB = MPC)

Private optimum:

Qp (MPB = MPC)

Over-production


External benefit

Private benefit

is the benefit obtained by the decision maker.

External benefit

is the uncompensated benefit obtained by others.

Social benefit

is the total benefit obtained by the whole society

= private benefit + external benefit.


Divergence between private & social benefits

Example:

Fundamental education

private benefit social benefit

due to the existence of external benefit


Deadweight loss

QsQp

Social optimum:

Qs (MSB = MSC)

Social optimum:

Qs (MSB = MSC)

Private optimum:

Qp (MPB = MPC)

Private optimum:

Qp (MPB = MPC)

MPB

MPC = MSC

S

Q0

MSB

MEB

Equilibrium & efficiency:

Under-production


Result (by invisible

hand)

Remedy (by visible hand)

External cost

(e.g., congestion & pollution)

Over-production (Qp > Qs)

Impose unit tax

(to internalize the external cost)

External benefit

(e.g., public goods & make-up)

Under-production (Qp < Qs)

Impose unit subsidy

(to internalize the external benefit)

Effects of externality


Definitions:

Private good

is a good of which its consumption by any individual

reduces the amount available for others

it is exclusive in consumption


(Pure) Public good

its consumption by any individual does not reduces the amount available for others

it is non-exclusive in consumption

Example:

National defense

Pure public good:


Impure public good

Examples:Radio broadcast

Stage performance

Impure public good

can be consumed by many but not all individuals at the same time

not all individuals can consume it (or the whole amount of it) because usually an additional cost is involved in its consumption


Q16.3:

Explain why the above are examples of pure public goods & impure public goods.


Q16.4:

Distinguish between public goods & public services.


Q16.5:Some economists define public good as a good of which the marginal cost of serving an additional consumer is zero. Comment.


Demand for a public good

MUV1

MUV2

MUV1+MUV2= MSB

$

Q0

Public good is non-exclusive in consumption. Once produced, all individuals consume & pay for the same stock of public good.

Public good is non-exclusive in consumption. Once produced, all individuals consume & pay for the same stock of public good.

Market demand curve for a public good = vertical sum of MUV curves of all individuals in the market (= MSB curve)

Market demand curve for a public good = vertical sum of MUV curves of all individuals in the market (= MSB curve)


The social optimum

Qs

P2P1

MSC

MUV1

MUV2

MSB = MUV1+MUV2

$

Q0

MSCP2

P1

=

Optimal pricing scheme: Perfect price discrimination(i.e., Pi = MUVi)

then Pi = MUVi = MSC

Optimal output:

MSB(=MUV) = MSC(=MC)


Private optimum If uniform pricing is practised:

In equating MR=MC, private optimum is much smaller than social optimum

To high MUV users: MUV > P To low MUV users: MUV < P and refuse to consume MR collected (P) is much smaller than MSB (MUV)

Under-production and allocative inefficiency result

1. Cannot attain allocative efficiency

2. Cannot attain consumption efficiency Once produced, no additional cost is incurred in consumption, but low MUV users are excluded from consumption Under-consumption and consumption inefficiency result


If perfect price discrimination is practiced:

Under-production & allocative inefficiency result.

It is extremely costly for a producer to investigate the MUV of every individual & charge them accordingly.

Individuals may pretend to be low MUV users to bargain for a lower price.

The revenue collected from perfect price discrimination would also be smaller than MSB.


The free rider problem:

As public good is non-exclusive in consumption, it isdifficult to recognize & prevent free-riders (non-payers) from consuming the good.

This free-rider problem may appear under all kinds ofpricing schemes.

Under-production

As a result, the revenue collected would be further reduced.


Any remedy?

Pricing

Zero pricing

Under-production

Under-production

The visible hand faces similar problems as the

invisible hand.

Finance the production of pub

lic good by tax revenue

Unfair to taxpayers who bear the cost but do not consume t

he public good.

The sectors being taxed suffer inefficiency

When the gov’t estimate MSB from surveys, consumers may overstate their MUVs and

cause over-production


Q16.7:

“To achieve consumption efficiency, a private good should be consumed by the individual with the highest MUV, while a public good should be consumed by all individuals with positive MUVs.” Comment.


Q16.8:

Radio broadcast is a public good.

What are the problems in its pricing?

What are the ways to overcome the problems so that it can be provided privately?

Is the situation efficient?


Counter Argument--- the Market Works


Coase theorem (高斯理論 )

Zero transaction cost – Coase theorem

regardless of the initial assignment of property rights

the market equilibrium is identical and efficient

provided that property rights are well-defined and transaction costs are negligible.


A factory in upstream

A farm in downstream

Illustration of the theorem

Mr. B

Ms. A


The bleaching factory discharges sewage into the river.

The sewage pollutes the river and brings loss to the farm.

Initial situation:


Case I: The farm does not have the right of enjoying clean water.

Max. amount that Mr. B is willing to offer to Ms. A is the marginal external cost he borne = MSC - MPC

Assumptions:

1. No law restricting water pollution (pollution continues)

2. To min. loss, farm owner Mr. B negotiates with Ms. A and pay her to cut her output and pollution.

Min. amount that Ms. A is willing to accept is her net receipt from producing that unit = MPB - MPC = MSB - MPC


(Max. amount offered by Mr. B = External cost)

MSC - MPC=

(Min. amount accepted by Ms. A = Net receipt)

MSB - MPC

In equilibrium, In equilibrium,

MSC = MSB


Case II: The farm has the right of enjoying clean water

Max. amount that Ms. A is willing to offer to Mr. B is the her net receipt from production = MPB - MPC = MSB - MPC

Assumptions:

1. A law restricting water pollution (& prod. is banned)

2. To min. loss, factory owner Ms. A negotiates with Mr. B and pay him to allow her production & pollution.

Min. amount that Mr. B is willing to accept is the external cost he borne = MSC - MPC


(Max. amount offered by Ms. A = Net

receipt)

MSB - MPC=

(Min. amount accepted by Mr. B = External

cost)

MSC - MPC

In equilibrium, In equilibrium,

MSB = MSC


If transaction cost is zero, by Coase theorem, private contracting would occur. As a result, the private optimum is the social optimum.

Conclusion

Efficiency is achieved.

Notice that the initial assignment of property rights has no influence on the allocation of resources.

No deadweight loss.


If pollution cannot be avoided in production, (because the cost of preventing or eliminating pollution is extremely high)

Remarks: 1. Optimal level of pollution

it is efficient to allow pollution provided that the MSB of production can cover the MSC (including the loss brought by pollution).

So there exists an optimal level of pollution.


Remarks: 2. Reciprocal nature of the problem

There exists no reason why someone should have the right of a resource (e.g., clean water) instead of others.

Yet, whoever has the right will gain and whoever has to buy the right will lose.

Which party bears the loss is reciprocal, depending on the assignment of rights.


If TC in reallocating resources to restore efficiency & eliminate the deadweight loss > the deadweight loss itself, no private contracting or reallocation of resources is worth taking place.

Prohibitively high transaction costAchieving efficiency without reallocating resources

Although the private optimum is different from the ideal social optimum (under zero TC) & deadweight loss results, the resource allocation is still efficient (cannot be improved). No market failure results & no government intervention is needed.


Deadweight loss

MSC$

Q of factory0

MPC

MPB=MSB

QS QP1

If the farm does not have the right and the

TC is prohibitively high,

If the farm does not have the right and the

TC is prohibitively high,

Assignment of property rights affects the allocation of resources (when TC is prohibitively high)

the factory will produced at QP1

the factory will produced at QP1


Deadweight loss

0=QP2

MSC$

Q of factory

MPC

MPB=MSB

QS

If the farm has the right and the TC is

prohibitively high,

If the farm has the right and the TC is

prohibitively high,

the factory will be banned from production, i.e.,

QP2 = 0

the factory will be banned from production, i.e.,

QP2 = 0


Government Intervention is Unnecessary and Inappropriate


As resource allocation by the invisible hand must be efficient, there is no market failure.

Gov’t intervention is unnecessary and inappropriate

No government intervention is needed

The use of visible hand may be of undesirable motive, involve high administrative and information cost, and restrict individual freedom.

So even if there were “market failure”, the use of visible hand might not be appropriate.


Correcting Misconceptions:

1. Public good is a good produced by the government.

2. The market demand curve for a public good is the horizontal sum of MUV curves of all individuals in the market.

3. To achieve efficiency, private goods should be provided by the private sector and public goods should be provided by the public sector.


4. To achieve efficiency, pollution should be eliminated.

5. The existence of deadweight loss implies inefficiency.

6. Pareto efficiency requires zero transaction costs.


7. Pareto efficiency requires an even distribution of wealth.


8. Pareto efficiency implies the maximization of social welfare.

9. To achieve efficiency, a polluting firm should be banned from production or it should compensate the victims.


10. There is no divergence between private and social costs.

11. As the market fails to allocate resources efficiently, the government should intervene.


Survival Kit in Exam

Question16.1:

“A price-searching market allocates resources inefficiently.” Comment.


Survival Kit in ExamQuestion16.2: The construction of a rubbish collection point causes a fall in the value of nearby properties. To attain economic efficiency, which of the following options should be adopted?

(a) The rubbish collection point should compensate

the nearby property owners.

(b) The rubbish collection point should install

pollution reduction device.

(c) The rubbish collection point should be relocated.

(d) The nearby properties should be relocated.

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© Pilot Publishing Company Ltd. 2005 Chapter 16 Market Failure?

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