Unit 2 Why Markets Fail N

7/31/2019 Unit 2 Why Markets Fail N

1/74

WHY MARKETS FAIL

Compiled By: www.O-Alevel.com

AS /A Le ve l

Economics


2/74

1www.O-ALevel.com

2-1. INTRODUCTION

As we learned in Unit 1, in a perfect world the price mechanism can give us aperfect allocation of resources: what is demanded is produced, changes indemand lead to changes in what is produced, and the workers move from adying industry to a growing one.

But the world is not perfect! Some things stop us getting to thisbeautiful market solution. It only needs one of these particular elementsto be operative, and we will fail to reach the perfect market solutionabove!

And in fact most of them are frequently operative in the real world in which welive! So we know that free markets do not give a perfectanswer. However,we have yet to find a better way to get what we want produced: running thewhole economy by central planning gives even worse results. So, poor asthey may be, free markets are still the best way we have found for organisingthe economy. So almost all countries use the market system, then wheneveras a society we do not like a particular result that they give, the governmentcan step in and change it.

Listing these 8 major factors:

o Monopoly elements or marketdominance. o Externalities.o Publicgoods. o Meritgoods.o De-merit goods.o Informationfailures. o Factorimmobility.o Undesirable income and wealth distribution.

Unit Two deals with such imperfections and reasons for market failure. Wewill go through them in the order just listed.

Q. What can we do if some or all of these are operating and preventing agood market result?

A. The government can intervene and put it right.

NB These Units are a way of organising the teaching and learning of economics. Youcan use knowledge from one unit when answering a question in another unit andyoushould!

Why Markets Fail


3/74

2www.O-ALevel.com

How Mar kets W or k AS/ A Level Economics

What does market failure mean?

It means that we do not have full efficiency; we could produce more with theresources we have; and we could satisfy consumer demands better with theresources we have. There is waste in the system.

Types of efficiency in economics:

A.) Allocative efficiency. This means good resource allocation, when wecannot make any consumer better off without making some otherconsumer worse off.

This approach looks at the given resources and tries to get the most outputfrom them andit also means that firms sell at a fair price to consumers that reflectsthe real resource use.

B.) Productive efficiency. This means that production is done at the lowestpossible cost.

We are at the bottom of the average cost curve (which is always U-shaped). In that position we have what is called X-efficiency.

And this means we are also on the production frontier, not somewhereinside it.

A.) Allocative efficiency

Allocative efficiency occurs when the value the consumer puts on a good orservices is the same as the cost of the resources used in producing it. Thisoccurs when price

= marginal cost! In this position, total economic welfare is maximised.

In the perfect competition diagram below, where MC = MR for the firm, wehave allocative efficiency because the firms price is the marginal revenue (itcan sell any amount at the unchanged price - each extra unit sold at that priceprovides the marginal revenue), so MC = P. In fact, at that point we havemore equalities MC = P= MR = AR.

AR is merely another word for price it is average revenue which we getby dividing total revenue by quantity. We know that quantity multiplied byprice gives us total revenue, so it follows that price actually is averagerevenue.

Why Markets Fail


4/74

3www.O-ALevel.com

Price, Costs

MCAC

P

0 Ot Output

B.) Productive efficiency

This exists when we are actually on the production frontier. That means weare using the least resources we can. In turn, it says that we are at minimumaverage costs = the bottom of the AC curve.

Perfect competition is like this so economists prefer this position and you will

recall that it is known as X-efficiency it is where we are totally efficient.

Where market equilibrium is totally efficient, we cannot make someonebetter off without making someone else worse off (this is sometimes calledthe Pareto optimum position).

The production possibility curve:

When we are below the production possibility curve (e.g., at X in the

diagram below), we can move north-east and get onto the curve, thusmaking everyone better off; only when we are on it do we have properproductive efficiency.

And only when we are on it does the concept of opportunity cost arise. Ifwe are below it, we do not have to give anything up to get more of the otherthing; we can have more of both simply by moving out to the curve.

Why Markets Fail


5/74

4www.O-ALevel.com


Apples

ppc1

0Banana

s

Apples

X ppc1

0 Bananas

Note: we can have allocative efficiency andproductive efficiency but stillhaveinequityin the country, which can also stop us reaching perfection.

Example 1. If you personally have all the income in your suburb, the otherresidents will be poor and might even starve, which does not sound at all likeperfect! The market system is amoral i.e., it is not concerned with good orbad. Economics is not about ethics.

Example 2. Drug dealers could wait at the gates of primary schools, giveaway drugs for free to six year old children and in this way build up a marketas they become addicted. This would create a demand, which the drugdealers could then supply later at a price. Most people would regard this situation as totally wrong,exploitative, and immoral but the market would be working - and possiblyvery efficiently too.

Social efficiency matter not just private!

We might produce too much or too little as a society, for our own good, evenif have perfect competition andan acceptable distribution of income andnothing illegal or immoral is occurring. This can happen because ofexternalities. We move on to consider these next.

NB The whole of Unit Two consists of two main components:

1. What is efficiency, why the market mechanism (price mechanism) providesthe best solution for allocating resources to meet consumer demand, (Unit

1 is how it does this, with some overlap on why it is best). You need to beable to defend this proposition.

2. What prevents the market mechanism from achieving this perfection,

Why Markets Fail


6/74

5www.O-ALevel.com


which is the core of this whole unit. You also need to know and answerquestions about how this prevents the achievement of perfection henceyou need to understand what efficiency is! We turn to consider in detailthe things that stop the price mechanism working perfectly next.

Why Markets Fail


7/74

6www.O-ALevel.com


2-2. MONOPOLY ELEMENTS OR MARKET DOMINANCE = the firstreason for free markets not working perfectly

TR = totalrevenue. TC =total costs.

MONOPOLY

What is a monopoly?

Definition: Technically a monopolist is a sole supplier, that is to say, one firm

is the industry.

But there are degrees of monopoly - if one firm supplies, say, eighty percent of the market, it is close to being a monopolist and will usually act likeone.

If two (or more) firms supply most of the output, it pays them to work together,to act like a monopoly, and to keep prices high (if there are two firmswe call it a duopoly).

Types of monopoly, (sometimes called causes of monopoly;"sources of monopoly"; or "conditions for monopoly"

Economies of scale, i.e. one firm grows large, its costs fall as aresult and become lower than the others, so it can reduce its price andsell more produce. The others cannot compete because they are smalland higher cost. The firm grows to become the sole one, which thensupplies the entire market. We return to examine economies of scalein more detail later.

The result of law the government may restrict an industry to onehuge nationalised firm, e.g., British Steel in 1964 - or a trade union canhave a monopoly over the supply of one kind of labour theBritish Medical Association for instance is the trade union fordoctors and can strongly influence their supply.

An agreement between firms, so that all act together as one monopolist- often it is illegal but it happens. We call this a cartel.

This can happen under oligopolyconditions (which are covered later).

Exclusive ownership of a unique resource: perhaps there is only onesource of supply of a raw material, e.g., all the known supply of iron

Why Markets Fail


8/74

7www.O-ALevel.com


ore in Australia was once in the hands of a company called BHP, untilnew sources were discovered. As another example, in SouthAfrica, de Beers once owned virtually all the diamond mining and it

still has control over much of theglobal diamond supply.

Why Markets Fail


9/74

8www.O-ALevel.com


Copyrights, patents and licences are particular forms of thisexclusive ownership.

So-called natural monopoly. This is often the result of economies ofscale - e.g., electricity supply, telephone supply, or railways - becausewe do not want twenty different sets of rail lines, all parallel, betweenLondon and Birmingham!

Problems with monopoly (what is wrong with monopoly or "the welfareeffects of monopoly")

It limits output and keeps price high - as just said. Really this meansthat a monopolist misallocates (and misuses) resources.

This behaviour of the monopolist redistributes income from all theconsumers ofthe product (they are paying more than they need) to onefirm or person (the monopolist). This is an equity issue.

A monopolist may develop political and social power over otherswhich reduces the efficiency of democracy and the amount ofequity. There is a strong political danger from a very few rich and

powerful people emergingand changing the course of events. Conrad Black? Robert Maxwell? Itseems to be most serious in the media area, like newspapers or TV, asthey can influence the way people think or what they believe.

A monopolist may behave badly in an anti-social way. For instance, heor she may force out a potential rival firm by selling at give-away prices(well below cost). After they have forced out the honest competitor,they will put the price back up again.

**5. Lack of competition tends to encourage inefficiency in the firm.

The monopolist tends to rest on his laurels, has no need to tryhard, and lacks dynamism this is probably the main criticism -said Austin Robinson.

As a result, we can get the emergence of lazy managers and owners.

And it may mean that technical progress is slow, leading to slow growthof the country as a whole, and a lower standard of living than we couldenjoy.

A monopoly breeds inefficiency which means that the cost curves

will be higher than they need be; this means that the intersection ofMC and MR may be higher.

Why Markets Fail


10/74

9www.O-ALevel.com


Resources are misallocated - too many are going to the monopolistwho does not fully use them. This is a waste for society. It reallymeans that the price mechanism is prevented from working efficiently.

Why Markets Fail


11/74

10www.O-ALevel.com


A monopoly may reduce consumer choice. He may ignore smallmarket demands as he cannot be bothered to meet them. As HenryFord is reputed to have said about his motor cars You can have anycolour you want, as long as its black.

Q Which of the following 10 main economic goals does monopoly hurt?

1. To maximise (raise) economic growth.2. To minimise (reduce) unemployment.3. To end (reduce) inflation.4. To increase the standard of living.5. To keep a satisfactory balance of payments.

6. To maintain a satisfactory international value of the currency ().7. To allocate resources in the best way (to meet the needs of society).8. To obtain an acceptable distribution of income.9. To look after the environment.10. To avoid unwanted fluctuations in above items.

THINK FIRST; WRITE DOWN THE NUMBERS YOU THINKMONOPOLY DAMAGES THEN TURN TO THE NEXT PAGE!

Why Markets Fail


12/74

11www.O-ALevel.com


Answers:

The long run damaging effects may include slower growth; a lower standard ofliving; higher unemployment (because employ fewer); higher prices; aslightly poorer balance of payments; less equal income distribution; and poorresource allocation.That is to say, most of the goals! In the exam room, the inefficiency inresource allocation, the higher costs, and the monopoly profit are usuallyworth stressing.

Benefits of Monopoly

There are few benefits really - economists are almost united in opposition tomonopolies, and many are against both public and private ones those on thepolitical left wing tend to prefer public ones more than those on the right wing.

Economists usually favour reducing or ending monopolies andincreasing competition.

BUT some defence ispossible!

The monopoly profits can be used for research and development,leading to product improvement, faster growth, and lower costs.

Joseph Schumpeter's argument on innovation - that big firms are theonly ones able to afford the necessary laboratories and research staff may apply.

Against this, research shows that many breakthroughs come from

smaller firms, not the large ones. For instance, Apple computers beganin a garage.

A monopolist may reap economies of scale, e.g., the Royal Mail,telephone lines, electricity supply, gas supply, or the railways. Thismeans lower costs.

A redistribution of income is not too bad perhaps:

It is always happening in a dynamic economy

anyway. If necessary, it can be corrected by

government action.

Why Markets Fail


13/74

12www.O-ALevel.com


OLIGOPOLY

Oligopoly is where there are only a few producers or sellers (between three andnine maybe! The number is not fixed), so the actions of one can affect another -who may (or may not) choose to react in some way. For example, if firm Areduces its selling price, firm B may choose to reduce its selling price, or justleave it where it is and instead to increase its advertising, expand its sales force,or take other measures. Because of the inherent uncertainty of the reaction ofrivals, rather than one model of oligopoly, we have several types, which is tosay there is no general theory of oligopoly!

Examples of oligopoly:

In Britain only three companies controlled allcomputer sales from shops in thehigh street (the main shopping areas) in 1998; they operated under a varietyof different names, so the consumers thought there was a lot more competitionthan really existed.

In the same year, De Beers had a 70% share of the marketing of the worldsquality diamonds.

The degree of oligopoly is measured by the concentration ratio

This can be measured at the level of, say, three firms, or five firms or

seven firms. The concentration ratio measures their combined share of the totalmarket.

We can measure the share of employment or output in that particularindustry

- or both.

An example of the UK in 1992: the 5-Firm concentration ratio:

Iron & steel had 90.9% measured by employment and 95.3% by grossoutput.

Wines, cider and perry: 97.7% by employment and 99.5% by gross output.

Tobacco; 97.7% by employment and 99.5% by gross output.

What can increase the concentration ratio? (i.e., reduce competition)

A merger within the industry (between a firm already in the top 3, or 5 etc.and a much smaller one previously outside).

When a large firm (in the top 5 etc.) takes customers away from asmall one outside the top few.

CARTELS

Cartels work like a monopoly. A cartel exists when several suppliers get

Why Markets Fail


14/74

13www.O-ALevel.com


together to sell as a group, i.e., they reduce the competition and form amonopoly. The object is to increase profits, usually by increasing the pricejointly, to lower the risks, and to keep out new entrants.

It is often found in the primary produce - usually they say they wish tostabilise the price but they actually try to increase it in many cases.

Why Markets Fail


15/74

14www.O-ALevel.com


Cartels are common with oligopoly. Firms get together and transfer powerto the centre in order to act as one firm. In effect they behave like a singlemonopolist, thereby obtaining monopoly profits. These will be higher than theycan get by competing with each other. This is called collusion.

Cartels are inherently unstable, because:

It is always in the interests of one member to break the rules, andreduce its price a bit, or sell more than it has agreed, so increasing itsprofits. Effectively, the individual faces a more elastic demand curvethan the cartel as a whole!

The higher (monopoly-type) price attracts newcomers to the industry,

who eventually break the cartel by selling as much as they can at the(high) cartel- established price.

The OPEC oil cartel lasted about a decade (a long time) because of severalspecialfactors:

There is a long lead time to find oil and develop new wells.

There is an inelastic supply of oil.

The market for oil was growing rapidly because of global economicexpansion, so it was easier to live with high prices.

Oil is durable it does not rot if left in the ground. Arab unity may have helped a bit though they do not seem very unified

usually! If a cartel is fully successful - the diagram is simply that of a

monopolist!

The Wastes of Oligopoly

An oligopoly restricts output where it can, so less is produced than couldbe, and at higher position on the cost curve.

Price is higher than if the firms in the market were perfectly competitive.

Collusion to try to establish a cartel and behave like a monopoly islikely; if successful, we get all the problems of monopoly.

Price wars may emerge, perhaps caused by new entrants, or theexisting firms reduce price because they fear the high price mightattract entrants.

Why Markets Fail


16/74

15www.O-ALevel.com


There may be wastes (for society) of high advertising costs, oroffers to consumers of free trips or lotteries. These are not cheap to

run and use real resources.

We may get bribery or other pressure on, government to keep or establishMarketing Boards or other devices of

restriction.

Why Markets Fail


17/74

16www.O-ALevel.com


There is a time and energy waste involved when firms are forced to watchrivals, try to guess their likely innovations, or whether they will react towhat the first firm did.

Industrial espionage and other illegal acts may be promoted. Somefirms are reputed to pay people to search the waste bins of theirrivals!

Employment is restricted, because an oligopoly keeps output down.

Uncertainty levels are increased; this is generally felt to be bad thing.

The Benefits of Oligopoly

Price does not change much (until we get a price war!).

There is fierce competition to improve the product in order toincrease the demand for ones own output - so we may see fasttechnical change, great dynamism and much R & D effort.

Countervailing Power - if a single monopoly is bad (as we feel), thena few more competing firms can stand up against it, so the situation

has to be better.

The size of firms is usually larger this means they can reap economiesof scale

(unlike the tiny firms in perfect competition which will never be bigenough).

Why Markets Fail


18/74

17www.O-ALevel.com


IMPERFECT COMPETITION OR MONOPOLISTIC COMPETITION (theterms are interchangeable)

Reminder: this is the bit in the middle!

Monopoly

Monopolisticcompetition Perfect

Competition

Oligopoly

WHAT IS MONOPOLISTIC COMPETITION?

It is defined as:

Many buyers and sellers of that type of good or service (= competition).

Free entry and exit (= competition). But each firm has its own brand ofthe good or service (= a monopoly on the brand name).

So each faces a downward sloping demand curve for its own brandedproduct (= a monopoly effect).

i.e., we see elements of both monopoly and competition, hence the name.

The long run equilibrium position is where the demand curve is tangent to theaverage cost curve.

The Long Run Equilibrium Condition

Price,Costs

MC

AC

P1

Why Markets Fail


19/74

18www.O-ALevel.com


D0 Ot1 Output

Why Markets Fail


20/74

19www.O-ALevel.com


Q. Why is long run equilibrium in this tangential position?

A. Because of the assumptions of strong competition and free entry/exit.

Lets think about the short term.

If the firm suddenly improves its product, e.g. colours it fashionably, thedemand for the product will increase, this allows a price increase, and hencemeans higher profits for the firm.

So the firm receives monopoly profits and in this short run position, thediagram is identical with that for monopoly. It has a monopoly because the

firm is the only one with these new fashionable colours.

But what is going to happen? The higher profits and visible higher pricedraw the attention of this firms existing competitors, andthere may be newentrants. Both groups can successfully compete by colouring their productalso! They then earnsome monopoly profits. But the increase in total supply means that pricestarts to fall. In addition to this, the demand curve of the original producer driftsback, as the firm loses part of its market to these competitors.

Q. How far does it fall back?

A. Until the monopoly profits are eroded to zero when we are again at thetangent which is when competitors will stop coming in! There is no reason toenter once there are no excess profits to be made.

So in the long run there are no monopoly profits equilibrium is always

tangential!! The short run increase in demand:

If you draw the basic diagram for monopolistic competition in equilibrium andthen increase the demand for the product, you will see that it turns the

diagram into the monopoly one, with monopoly profits. This situation lastsuntil the attracted new entrants cease when we are back to the tangent asjust described.

Problems with Monopolistic Competition

Waste of time and effort the firms have to worry about competitorsactions.

Waste of underused resources. In the tangential position, we are not at thebottom of the AC curve the firm could produce more, and more cheaply,but cannot do it. This is to say that excess capacity exists.

Why Markets Fail


21/74

20www.O-ALevel.com


There may be too much differentiation firms often pretend their productis better but in fact it is merely different! As a consumer, you should be

wary of miracle ingredient claims, especially in the health and beautyarea.

Why Markets Fail


22/74

21www.O-ALevel.com


Advertising wastes.

Free gifts, free lottery tickets, 2-for-1 offers, competitions to get a free trip toLondon, to the coast, to Paris etc. They all use up real resources to runthem.

We could have had better or cheaper products instead of all these offers!

Benefits of Monopolistic Competition

The situation is very competitive firms watch their competitors very closely.

This strong competition drives the firms along:

They strive to improve product quality and design, as well as(hopefully) to lower the price.

The firms engage in much research and development.

Free entry and exit keeps competition fierce.

Variety is great there is more choice for purchasers and hence, weassume, greaterconsumer satisfaction. Some observers now feel that toomuch choice worries people and does not make them happier but the juryis still out on this one.

Some possible areas for data response questions

There may be a question about how insufficient competition prevents themarket solution from being optimal or the market working properly

You might get asked to explain why monopoly is undesirable generally oryou might get a specific simple question, like working out what is themonopoly profit in a diagram and/or figures.

You might get asked how much of a monopoly a company is (definitional); beasked to work out a concentration ratio; or expected to mention cartels, ormonopolistic competition. Duopoly (= only two firms in the industry) is rare butif the examiners find one in the real world to set a question about, you will be

expected to use the term.

It could be teamed with the issue of privatisation, because natural monopolieswere often nationalised a long time ago, then privatised after Margaret

Why Markets Fail


23/74

22www.O-ALevel.com


Thatcher became Prime Minister in 1979. Efficiency and competition arekey words to use! Monopoly is seen as essentially inefficient and bureaucraticwith higher costs, as well as taking monopoly profits, higher than they might

be.

Why Markets Fail


24/74

23www.O-ALevel.com


Privatisation is seen as an effort to increase competition and hence lowercosts, to allocate resources better, and to reduce the monopoly profitelement.

We will look at these issues more closely later.

Why Markets Fail


25/74

24www.O-ALevel.com


2-3. EXTERNALITIES, SOCIAL COST AND PRIVATE COSTS = thesecond reason for markets being less than perfect.

EXTERNALITIES

Private costs are what they say the costs incurred when producing

something. Social costs are greater than private costs. Social costs include

things like pollutionand congestion that are suffered by society in general, not by any oneproducer.

These problems are called externalities i.e., they are external to the firmproducing them. They can be negative externalities (which harm society) orpositive externalities (which help).

Social cost = private cost + externality (if any).

Cost-benefit analysis tries to measure allthe costs to society of a project.

A new tube line in London may never run at a private profit but stillgenerate large savings elsewhere. For example, the new line might reducemotorcar use, reduce congestion, speed up traffic flow, and save peoplestime. The Victoria line, built1968-71, was established knowing it would lose money - but the socialbenefits were so great.

We have a diagram for social costs:

Social

Costs,Social costs

Pb

Pa

0 Qb Qa

Private costs

Demand(Social Marginal Benefit)

Quantity

Why Markets Fail


26/74

25www.O-ALevel.com


Equilibrium will be where private costs cut the demand curve at Qa, asfirms try to maximise profits and charge price OPa for quantity OQa.

Why Markets Fail


27/74

26www.O-ALevel.com


But because of negative externalities (pollution maybe), the socially optimumposition should be where socialcosts cut the demand curve. These wouldmean producing at Qb, reading from the social costs curve, and selling at thehigher price OPb to cover these costs.

NEGATIVE EXTERNALITIES

Common types of negative externalities by producers:

Air pollution, e.g., smoky factory chimneys.

Soil pollution, especially by farm chemicals (closely related to the next type).

Water pollution, e.g., rainwater run-off containing farmingpesticides and fertilisers.

Noise pollution. Do you live near an airport or by a building site?

Some types of negative externalities by consumers:

Pollution of air and water.

Soil pollution, e.g., lead pollution in soils from motorcar exhaust emissions.

Litter on streets; decomposing rubbish in land-fill sites.

Noise pollution, e.g., motorcycle noise in urban areas, especially when thebaffles have been deliberately removed from the silencer.

Vandalism; graffiti on walls.

Smoking and alcohol abuse, causing NHS expenditures to rise.

We are unsure why the urban sparrow population has plummeted in recentdecades but it would seem to be the result ofsome externality.

POSITIVE EXTERNALITIES

When these exist, society would gain more than the producer whotherefore is producing less than the optimal social amount.

Examples include:

Labour training in firms; one firm may do little, as it knows that when atrained worker leaves, someone else benefits - but the first firm paid forall the training!

Education generally.

Health generally, especially in poor Third World countries.

The provision of playing fields at or near schools so that the health andsporting skills of the children improves.

Free museums and art galleries that can encourage the poor and

uneducated to widen their horizons, educate themselves, and generallyimprove.

Why Markets Fail


28/74

27www.O-ALevel.com


To draw the diagram for positive externalities: just reverse the labelling of thecurves of social cost and private costs above. This is done in the diagrambelow where you can see that we produce too little for society if firms profitmaximise for themselves (as they do). They choose to produce at OQa andsell for a price of OPa, but for the greatest good of society they should be atOQb and selling at the lower price of OPb.

SocialCosts,Price Private costs

Pa

Pb

0 Qa Qb

Social costs


Quantity

Government intervention may be necessary to correct or offset marketfailure caused by negative externalities usually the governmentchooses to tax those producing too much, or they may use the law toprosecute for water pollution or whatever externality the government istackling.

There are probably fewer cases of external benefits, but if we find any (such as

private firms training labour well) we can encourage this by tax breaks orsubsidies.

Government action with external diseconomies

Government might try (and does):

1. Taxation.2. Regulation.

3. Perhaps extending property rights.

Why Markets Fail


29/74

28www.O-ALevel.com


Lets think about polluters what can the government do using thethree points above?

a) Taxing polluters

The need is to try to stop the problem being external and try to internaliseit, i.e., to make the polluter pay for it via a tax. As economists, what we arereally doing is trying to get the firm to stop looking only at the private costsand benefits. In the diagram below, we do this by putting a tax on, whichshifts the supply curve up from S Private costs to Private costs + tax. If weget it right, this moves the equilibrium quantity produced from Qa to thesmaller output Qb.

SocialCosts, Price

Social costsS + tax

Pb

Pa

0 Qb

Qa

S


Quantity

In the UK, we now have a Landfill Tax (since October 1996) to encouragerecycling. Landfill operators have to pay a tax to the government. It wasintroduced at the rate for inactive waste, which is easy to deal with, of 2 aton and other waste at 10 per ton. These amounts might increase shortly.

But there are problems with taxing polluters:

When it works, output is reduced and prices are higher but this canreduce the consumer surplus, which some feel is not a good thing (Unit4 looks at this concept).

It is often hard to identify the particular firms that are causing thepollution, and then determine how much each is responsible for the totalpollution.

Poor legislation can hurt the innocent, e.g. households who wish to get rid

of large items of waste may not be allowed to take them to the dump. It is not easy to put a monetary figure on the damage pollution is causing.

Producers can pass on much of the tax to consumers if demand is inelasticand not pay it themselves.

Why Markets Fail


30/74

29www.O-ALevel.com


Taxes on demerit goods (to limit their consumption) can be regressive,i.e., hit poor households the hardest. The tax on cigarettes does thisbecause the poor are statistically more likely to smoke than the wealthier.

Why Markets Fail


31/74

30www.O-ALevel.com


In the UK, the government quite regularly increases duty on petrol, &

tax on cigarettes.

b) Regulating polluters approach (a second way that can be used inaddition to tax)

Banning cigarette advertising at sporting events, or in places like cinemas.

Making workplaces no-smoking areas.

Increasing the penalties for firms that break the regulations.

c) Extending property rights (a third way that can be used)

If a lorry crashes into your garden and destroys the wall and all your trees youcan get compensation but if a polluting factory puts out acid smoke anddestroys the same trees you cannot.

If we extend property rights so you could sue for compensation, it wouldmake the polluter think again and perhaps install anti-smoke devices onfactory chimneys!

Benefits

The property owner knows the value of the property better than thegovernment does, so the figures will probably be more accurate (butowners can, and perhaps would, lie!).

The polluter is forced to pay those suffering from his or her activities.

Disadvantages

The damage may occur abroad, e.g., German acid rain destroys East

European forests but it is next to impossible to enforce law acrossborders!

Global interests and national interests may conflict. The UK cannot makeBrazil extend property rights over Brazilian trees which are being killed offat a rapid rate, yet the world might feel the destruction of the Amazon rainforest is wrong.

Trading permits to pollute

Many believe that it is so difficult and expensive to stop companies polluting(identifying who did it can be impossible e.g., with one stream and dozens offactories discharging into it) that instead we should auction off the right topollute. Only those firms that pay a high price for the limited number of

Why Markets Fail


32/74

31www.O-ALevel.com


licences would be allowed to pollute. The government could then use thelarge sum of money raised to tackle the pollution itself. The end result couldbe much better than we currently have!

Why Markets Fail


33/74

32www.O-ALevel.com


If we allow a firm to sell its right to pollute (it may have used only 80 per cent ofwhat it is permitted, for example) then those with the greatest demand for theirproduct, and hence the most profitable, can buy the remaining 20 per cent. Itmeans the things we most desire still get produced but the government has theresources to tackle the resulting pollution.

Yet many think it is morally wrong to allow permits to pollute at

all! Singapore uses such permits for ozone-depleting

substances.

The Kyoto Summit on Climate Change (Dec. 1997) saw a move towards such

permits as being an improvement at least! But the United States and Russiarefuse to ratify this. In September 2004, President Putin of Russia agreed to it,but it still has to go before the Russian Parliament.

Coases Theorem

Ronald Coase established that there is no need to tax or regulate polluters atall! He saw that if polluters compensated those suffering, the market wouldsolve it properly, with just enough acceptable pollution occurring and still noone suffers without being compensated. He got the Nobel Prize in Economics

1991 for this! It is worth trying to get the phrase Coases Theorem into ananswer about how to deal with pollution.

Why Markets Fail


34/74

33www.O-ALevel.com


2-4. PUBLIC GOODS, MERIT GOODS, DEMERIT GOODS ANDINFORMATION FAILURES = the third to the sixth reasons why marketsmay not give us a perfect solution.

Even when the market appears to be working perfectly, we can have aproblem with some goods. These are:

public goods;

merit goods; and

demerit goods.

These may all be supplied in the wrong amounts, or even not supplied at all.

When this occurs, it renders the market system inefficient and it is failing inthis area

Public Goods

These are collectively consumed and the market may simply not supplythem; e.g., defence of the country (a police force and army), a fire brigade,street lighting, or lighthouses. The market system does not work well in thisarea.

Some goods are semi-public goods, quasi public goods or collectiveconsumption goods, for instance roads. These are often supplied by thestate, but in principle they can be privately supplied, and sometimes are.Examples include the British Toll Roads in the Nineteenth Century or thepage motorways in France today; when you use them, you pay.

In some countries, such as Thailand when I lived there, the fire brigade falls inthis area. People insure with a private fire brigade and call them when thehouse is burning. If you are not insured and you still call them, the marketswings into action and they negotiate a rate on the spot for putting out the fire given the urgency of the event, the demand by the burning house owner is

highly inelastic and the price can be very high indeed!

Public goods require

The lack of ability to exclude (if I am defended, so are you, even if youdo not pay!)

The consumption by one does not reduce the consumption available tothe others (if you walk down the street after dark you do not use up any ofthe street lighting.)

These two requirements may be called the non-rivalry and non-excludabilityfeatures.

Why Markets Fail


35/74

34www.O-ALevel.com


One of the jobs of government, both central and local, is to supply publicgoods or services that are needed but otherwise would not be madeavailable by the market.

Why Markets Fail


36/74

35www.O-ALevel.com


Merit Goods

These are provided by the market - but in smaller amounts than are neededfor the good of the state. Health and education are the most obvious ones there will be some privately-supplied health and education but the state as awhole benefits if everyone has access to them, not just a few. For instance,in the health area, the National Health service and inoculations tend toreduce mass epidemics; the health service also means that fewer people willbe off work sick. We see a contemporary example with the dispute over theMMR jab for young children. The fear that it may be linked with autism inchildren prevents some parents from getting their child injected and there is afear that an epidemic of measles could emerge as a result. In the case ofeducation, society would not function as well if half the population could not

read the instructions on the label!

Private consumers individually value merit goods less than the state does.The market system fails to provide enough merit goods which is why the statesteps in to make them more widely available. It does this by subsidising theproduction of some merit goods or services.

Merit goods may be targetted at certain groups and rationed; for instance,we might limit access to higher education to those passing A levels well! Itis assumed that such people are the most intelligent in society. Which ofcourse you are!

In the diagram below, a subsidy equal to AB is applied by the government this shifts the supply curve downward and to the right. The equilibriumposition then moves from P1Q1 to P2Q2. The result is that more is thenconsumed at the lower price i.e., the demand for merit goods has extended. (Iam stressing that the demand has not increased; that would have meant anew demand curve!)

Price

P1

P2

S1

B S2

A

D

0 Q1 Q2 Quantity

Why Markets Fail


37/74

36www.O-ALevel.com


Demerit goods

Demerit goods are exactly the opposite of merit goods in that they are over-consumed by individual people and this causes problems for the nation as awhole.

Cigarettes are a clear example: they cause unpleasant smoke which isdangerous to people in the area who are forced to become passive smokers.They also cause cancer and a whole range of nasty diseases, includingemphysema. They inflate the national health bill because both the smokersand the passive smokers get sick and visit the doctor. But smokers will notstop, perhaps are unable to stop, because they are addicted.

Too many demerit goods are demanded, so the government steps in andtaxes cigarettes highly in order to reduce consumption andto raise revenuewhich is needed anyway to spend on treating smokers. The government alsoadvertises heavily to try to persuade people to stop smoking and the youngnot to start and is seriously considering banning smoking in all public workplaces, as Ireland did in 2004. Some individual doctors are also refusing totreat smokers for smoke-related diseases unless they stop smoking whichadds to the pressure.

The effect of the government taxation is in the diagram below. The indirecttax EB is added vertically to the supply curve, which shifts upward and to the

left from S1 to S2.

This reduces the consumption from OQ1 down to OQ2, (a move from theequilibrium point A to B) as price rises from P1 to P2 and consumers contractup the unchanged demand curve.

Price S2

S1

P2B

P1C

A

E

D

0 Q2

Q1 Quantity

Why Markets Fail


38/74

37www.O-ALevel.com


Rather than simply relying on tax to decrease the supply curve and force upthe price, the government may also try to tackle the demand side. It can dothis in the ways mentioned above and the diagram is reproduced below.

Why Markets Fail


39/74

38www.O-ALevel.com


PriceS1

P1P2

D1

D2

0 Q2 Q1 Quantity

You will observe that, if successful, the quantity smoked falls.

The government uses both methods, reducing demand and taxing heavily, todeal with smoking as a demerit activity!

Information failures

Knowledge is never perfect!

Consumers lack information on things like:

What goods are available and what new goods have recently comeonto the market.

What the quality of the different models or makes available is like.

How long an item will last before breaking down.

Information lack is particularly common in both the health service and ineducation where consumers do not know much - although we now knowmore than a few years ago.

This lack of perfect knowledge means that we may choose badly throughignorance. The demand curves would be different, and better, if we did knoweverything. This means of course that the existing demand curves do notgive us a perfect market solution.

Why Markets Fail


40/74

39www.O-ALevel.com


Producers lack information on:

What new demands are arising and how old ones are starting tochange, so the producers may produce more (or less) than theyshould.

What their existing rivals, and any new ones about to emerge, are doingor might do.

Which means that the producers may produce the wrong type of goods orthe wrong quantity of goods.

We know that in the world in which we live, new firms start up and many die

away within the first two years they usually got it wrong on the demand fortheir service or goods in that particular place, although sometimes theysimply were not goodenough at the job. In the process of being born and dying, the firms used upresources(including the labour of the would-be entrepreneur) in a less than fruitful way.

Workers lack information on:

All the jobs available now. Many of these will be local but more particularly

they are usually ignorant of opportunities elsewhere in the country or in theEU for that matter. So the workers may not move to where they areneeded though simplelack of knowledge.

Which industries will grow and which will wither away in the future. Thismeans that workers may join a firm that will disappear in a few years time,throwing them out of work but not for any fault of their own. Technicalchange can render whole jobs out of date: the handloom weavers are aclassic example of the late18th and early 19th century; coal trimmers stacking the coal in the depth ofshipsin the mid 20th century; and coal miners of the late 20th century. As aconsequence of workers not being able to predict future job needs,resources may be tied up in dying industries too long.

- A real problem is that those leaving school or college mayjoin an industry and train in skills that will shortly be nolonger needed.

So here again the market does not reach the correct or optimal solution.

The response to information failures

Why Markets Fail


41/74

40www.O-ALevel.com


Private firms gather information and try to

sell it. For instance:

Private job centres may open up to try to find a job for people. These aremostly in large cities and for service workers, rather than formanufacturing. Such firms are trying to improve the flow of information forprofit.

Why Markets Fail


42/74

41www.O-ALevel.com


Magazines like Which?exist. They test and investigate the quality ofgoods and services and publish the results.

Specialist magazines are produced for things like hi-fi, TV,motorcars, or computers such magazines also test and reportthe results.

In order to help producers, various trade associations and chambers ofcommerce gather information and inform their members about what ishappening. They also organise conferences and set up fact-finding tripsabroad and the like.

The state tries to provide information by:

Establishing job centres. Providing advice to careers advisers in schools.

Issuing pamphlets and working papers to try to improve peoplesknowledge. The newspapers pick up this information and may publicise it.

Overall, as information improves, consumers adjust their demand patterns tofavour what fits their needs best. Producers chose the most suitable andcheapest sources for their inputs. This of course means the marketmechanism then works better to supply what people want and are willing to

pay for.

Why Markets Fail


43/74

42www.O-ALevel.com


2-5. FACTOR IMMOBILITY = the seventh reason for free marketsnot providing a perfect solution.

The factors of production that we have are land, labour and capital plus aremainder term (L, N, K, + R) most economists and textbooks focus onlabourimmobility, but this is not guaranteed for the exam!

We can also have land immobility

Some land is good for growing one or two particular crops and not very

good at some other crops. It is not easy to change rice (which needswet soils) to wheat (which needs drier conditions).

It is not possible to move land from where it is to somewhere else.

Climate change may be occurring and farmers are often traditional,growing what they or their family have done for years or even generations.They may be unaware of, or refuse to try growing, a now more suitable crop.

Economic Union subsidies keep many farmers attention on producing thecrops that are highly subsidised (as it gains them a higher income) ratherthan what might be more suitable for their land or sell better. Quite often theEU gets it wrong, sowe ending up with a lot of produce that is hard to sell. Dumping it oninternational markets annoys other countries that produce such goodsefficiently as it reduces their market. Dumping it into the sea causescriticisms of waste in a world of poverty.

And capital immobility

Some capital is specific e.g., it makes light bulbs, and it cannot betransferred to another use, like producing ball point pens.

Some capital is very big and heavy, e.g., a steel mill, and it is difficult orimpossible to move it to another geographic areas.

Some old decaying industries may be subsidised by government andcontinue to exist for years, well beyond their shelf life. This keepsthe capital (and the associated land and labour) where it is so that it is notreleased for use where it is more wanted by society. That is to say,government subsidises prevent factors of production moving to turn out whatpeople now demand. The fact that the industry is decaying shows thatdemand has changed and people no longer want that good or service asmuch as they once did.

Some (usually small) firms stay in business despite making poor profitsbecause the owner does not want to move or to cease production; orperhaps the owner is tooold to bother to make any major change.

Why Markets Fail


44/74

43www.O-ALevel.com


Labour immobility (the really interesting one we ourselves are people!)

Geographic immobility of labour

People do not up and move easily from Leeds to Watford, just becausethey can earn 20 a week more there. Even less do they move from Toursin France to Hull in Yorkshire.

People are usually happy where they are: they have got relatives andfriends, they know the town and area, and they are members of variousclubs and other social groupings. They do not wish to move.

They may not know about the extra 20 they could get if they were tomove (information failure). Information failure actually costs money to

overcome: people must pay to use the Internet, or have to buynewspapers and magazines.

Moving house costs money: there are estate agents fees, lawyersfees, a government stamp duty and the cost of transporting furniture and allthe other household effects.

Inertia: people often do not like a big move as they have a sort of fearabout it, so they just stay where they are.

Institutional immobility of labour

Trade unions and government pass rules or laws that prevent people fromentering a new job easily.

Pension schemes may tie people into a particular company if a workermoves, he or she will probably lose the amount paid in by the employer ontheir behalf (this can amount to several thousand pounds).

Council houses (state subsidised housing) are let below market rentsand can prevent people moving; if they move it means they must give uptheir cheap house unless they are able to arrange for a house-exchangewith another council tenant.

Foreign-trained doctors may not be allowed to work in the UK unless theyspend several years retraining - and not always even then.

Sociological and economic differences causing immobility of labour

Minority groups often get paid less. For instance, it may be harder formigrants who do not naturally speak English to find work and to receivethe same pay. If they are not selected for a vacancy, it renders them lessmobile. Even women, hardly a minority, find it hard to get the same pay as

men, despite the existence of long-standing legislation. We can think of this as a lower demand curve for them, because

employers do not like hiring them as much.

Why Markets Fail


45/74

44www.O-ALevel.com


Married or very close couples: one may not be able to take a better paid joboffered elsewhere because it would render the other partner unemployed,so total family income would fall if they moved.

Why Markets Fail


46/74

45www.O-ALevel.com


The skills a person has may not fit the new demand for workers, so he orshe would find it hard to get another job. As demands in society change

(taste + higherincomes + new goods + new technology + fashion and trends) it meansnew skills are needed and old ones become redundant. How many chariotwheel makers dowe now need?

Age: once past fifty years, or even forty years of age, it is difficult to get a newjob.

Employers often prefer younger people. If an applicant is old, theemployer fears that they will not learn new skills quickly; and if theapplicant is older than the employer, he or she may feel uncomfortablegiving them orders and so simply refuse to hire them in the first place; and

old workers who join the firm will only pay into pension scheme for, say,ten years until they retire, but will take out for perhaps another thirty yearsuntil they die. An ageing population makes this scenario more common.

Such factors mean that wage differences (and unemployment) canpermanently exist between industries and between regions. The marketdoes not work well enough to equalise wages and long term wagedifferences persist.

Diagram: the wage of labourers in London and Cornwall: London has a greatersupply but a much greater demand so the curves are further to the right. Andof course in London, the level of wages and the quantity of workers are higher.

Wages Wages

S lab

W 1 S lab

0 Ql

D labW 1

0 Ql

D lab

Quantity oflabour

London

Quantity oflabour

Cornwall

Why Markets Fail


47/74

46www.O-ALevel.com


What can be done? Government intervention may help produce a bettermarket solution.

Government training and retraining for the new skills that society needs.

The government may improve or alter the educational system andencourage academic courses to be more geared to the needs of amodern economy (although some intellectuals disagree and thinkeducation should notdo this).

We can retrain workers at government expense. The state can pay forretraining courses and give generous tax breaks to those choosing toreceive new skills.

The government may tackle the geographic problem

It may pay workers to move; or pay the costs of buying or selling the house; orend(or reduce) the stamp duty for such people; or pay the unemployed to travel tolook at job opportunities in a new area.

It may subsidise firms to move to old decaying areas. This approach isgenerally inefficient, as it means costs will be higher than they need be, as it is

probably not a good location for the firm (which we can assume or the firmwould be there already or willing to go without a subsidy). This would makethe UK less competitive withother countries.

The government may allow pension mobility, i.e. when a person leaves a firmhe or she can take their pension rights with them the new stakeholderpensions do this. The push for people to take out their own private pensionsmeans that workers are more mobile than they once were. There is a slightproblem in that the rich who are usually already mobile are taking outstakeholder pensions, but the poor, less mobile, are tending to avoid them.

The government could change the laws as needed

Example 1. The government could make all company pension schemespay out the employers contribution when worker leaves.

Example 2. The government could make the British Medical Association (BMA)allow foreign doctors in to work more easily. The BMA is rather restrictive andkeeps some well-trained foreign doctors from working in the UK unless theyrequalify ortake special tests. This reduction in supply means there is apermanent shortage of doctors which helps the BMA to pressure thegovernment for pay increases, better conditions, or whatever it wants.

Example 3. The government could pass non ageist legislation to try to

Why Markets Fail


48/74

47www.O-ALevel.com


stop older but good being refused jobs or even fired (government isplanning to do this - eventually).

Why Markets Fail


49/74

48www.O-ALevel.com


Other areas of law no doubt could be similarly changed watch thenewspapers for articles and examples that you could quote in the examroom.

Why Markets Fail


50/74

49www.O-ALevel.com


2-6. THE DISTRIBUTION OF INCOME AND WEALTH = the eighthreason why markets may not work perfectly.

The demand curves we see in the economy are for the given distribution ofincome and wealth in that economy. If we were to change the distributionof income or wealth, we could expect to see a different set of demandcurves.

For example, if London were to suddenly gain all the income and wealth inthe country, everyone outside that city would reduce their consumption ofalmost everything and do so quickly. They would have no income and haveonly limited savings to draw on. So the demand curves for many goods andservices would alter.

We can imagine that if all the income in the UK were to be redistributed sothat everyone had exactly the same income, it would be insufficient perperson to buy Porsche or Rolls Royce motor cars, or indeed many luxurygoods and services. The demand for these would diminish sharply orperhaps even cease to exist.

This means that unless we have a good, proper, desirable or acceptabledistribution of income and wealth, then the market will provide a less thansatisfactory result! It merely reflects the existing income distribution and notwhat would make everyone better off. Only if we can all agree that the current

income distribution is the best, will the market distribute according to whatpeople needrather than have the money to buy(remember, demand meanseffective demand, that is, backed by money, and it is not merely a need).Every time we change the distribution ofincome, we change the pattern of demand.

Note that as time passes the economy grows, and some sectors and peopledo better than others, so the pattern of demand is in fact constantly changing.Other factors that can change demand include new technological goods(mobile phones, scanners); new goods generally; advertising; weatherchanges; and new tastes or fashion.

Measuring the distribution of income

The Lorenz curve

We can show the degree of inequality in income distribution in a diagram. If10 per cent of families have 10 per cent of the income, and 20 per cent have20 per cent, and so on, we have perfect equality.

The Lorenz curve shows the actual difference from the 45 degree line of

Why Markets Fail


51/74

50www.O-ALevel.com


perfect equality. We can actually see the inequality gap in the diagrambelow!

Why Markets Fail


52/74

51www.O-ALevel.com


100%% of income(cumulative)

50%

Perfect

equality on 45

degrees curve

45 degrees

Inequality

gap

25%The Lorenz

Curve

0 50% 60%

% of families(cumulative)

100%

Here, we see that about 60% of the families have only 25% of the income.

The Gini Coefficient

The Gini Coefficient is a more accurate measure than the Lorenz curve - andfrankly it is much easier to compare numbers than pictures!

The Gini Coefficient measures the degree of inequality by usingnumbers it is calculated as:

Area between diagonal line and Lorenzcurve

Triangular area under diagonalline

i.e., this is the inequality gap in the diagram above as a proportion of the wholebottom triangle. The bigger the inequality gap, the closer it gets to the whole;eventually it is the same as the whole and a number divided by the samenumber always equals one. So the higher the Gini coefficient, the less equalis the distribution of income.

Perfect equality = 0.0Perfect inequality = 1.0

Why Markets Fail


53/74

52www.O-ALevel.com


When the Gini Coefficient equals zero we have perfect equality

100%

% of income(cumulative)

50%

Perfect

equality on 45

degrees curve

45 degrees

0 50%

% of familes(cumulative)

100%

Some actual Gini Coefficient figures for three countries

1980 1994

UK 0.327 0.345

Spain 0.397 0.340

France 0.417 0.290

Using these figures, rather than trying to compare by eye some threeseparate diagrams, we can now compare easily.

We can see that:

In 1980, the income distribution in the UK is more equal than in Spain.

The UKs income distribution got less equal (under the Thatchergovernment).

Spains income distribution got more equal over the period.

By 1994, Spain had a more equal income distribution than the UK.

Why Markets Fail


54/74

53www.O-ALevel.com


And France, which in 1980 had less equality, is revealed to have amore equal income distribution in 1994 than either of the other twocountries!

Why Markets Fail


55/74

54www.O-ALevel.com


This is the sort of thing that the Gini coefficient is used for.

Oh! One more thing! Latin America has the highest Gini coefficients of any ofthe continents in the world (that is, it has the widest income disparities). Thatmight be a useful statement you could make.

The Gini Coefficient can easily be set in exams, either as an essay oras data response.

Why Markets Fail


56/74

37Copyright Kevin Bucknall 81


2-7. ECONOMIES OF SCALE

What are they concerned with?

We look at what happens to costs as the size (the scale) of a firm increases;e.g., if afirm grows by a given percentage, say 20 per cent, we examine what happens tothe cost structure.

There are three logical outcomes if firm grows by 20%:

Output grows more than 20% = economies of scale or increasing

returns to scale.

Output grows less than 20% = diseconomies of scale or decreasingreturns to scale.

Output just grows 20% = constant returns to scale.

NOTE it does not have to be 20 per cent it is what happens to costs whenthe firm grows by any amount that interests us.

The Envelope Curve or Long Run Average Cost Curve

It often occurs that as a small firm grows, its average costs fall at first, then levelout for some time, then finally start to rise. If we join up the tangents we get theenvelope curve or the long run average cost curve (LRAC curve).

Average Costs

ACLRAC

AC

AC

0 Time

Why Markets Fail


57/74

38Copyright Kevin Bucknall


Digression: When drawing the envelope curve it is far easier to draw in theLRAC curve first, then fit the small AC curves to it. This is the reverse of theway we actually get the LRAC curve.

Remember that the average costs are always drawn U-shaped whatever thecompetitive state of the firm we are considering (perfect competition,imperfect competition, or monopoly). This helps you, because so you nowknow that you can always start your diagrams in the same way in all theoryof the firm questions.

How can we get economies of scale? (increasing returns to scale)

1. Technical: a new machine can be used that reduces costs as outputincreases :

Such a process is often referred to as mass production.

2. Financial:

(a) Banking:

A large company can borrow at cheaper rate than others, e.g., Shellpays lower interest than I do to borrow money.

When output is larger, it spreads the interest cost of borrowing over agreater number of units, so the average cost per unit is lower.

(b) Insurance

A larger output again spreads the cost over more units.

A large company may be big enough to do its own insurance and nothave to pay premiums to others.

(c) Advertising

Once more, the larger company spreads the advertising cost over moreunits.

(d) Purchasing

Bulk buying is cheaper.

3. Managerial

A large firm spreads the cost of management over more units.

Management may be underused in small firm.

In a large company the managers can specialise: there might be amarketing manger, a transport manager, a production manager andso on - each does a better job as a result of specialisation..

Why Markets Fail


58/74



4. Risk spreading

A large company can have a greater variety of produce - if the demandfor one product falls off, the demand for others will probably be still begood.

A large company can sell in different markets, perhaps including severalexport markets.

The firms own insurance can be done (already mentioned).

Note: cost curve eventually turns up at the right hand end. Thisreflects

diseconomies of scale, ordecreasingreturns to scale

Q. Why does it turn up in this way or why do they occur?

A. There are three main reasons:

Managerial limitations

Financial factors.

Quality deterioration.

1. Management. This is the most important reason usually.

Management becomes a fixed factor in a sense. The firm gets too complex forone person to manage everything, mistakes are made, and decisions are slowercausing costs to increase.

A firm can increase the number of managers to offset this diseconomy andperhaps put it off until a larger output is reached - butas managers increase innumber we can expect to see new problems arising.

Red tape arises, that is to say, there is a slow and cumbersomebureaucracy.

Meetings proliferate and a paper war starts.

Factionalism arises, each department starts to try to score off others anddo them down. This is often an effort to advance ones self in thepromotion race but some people simply develop a loyalty to their owndivision and start to dislike other divisions.

A new idea of safety and security arises. The new managerstend to be administrators with less entrepreneurial skills,and they alsotry to protect their backs rather than promote the interests of the

company. A new breed of people, "corporation people" emerge the firm is no

longer chasing profit and taking risks but coasting along.

Communications falter, up and down as well as sideways. People do

Why Markets Fail


59/74



not all know what is going on.

Why Markets Fail


60/74



Some things may offset the managerial diseconomy:

Computers and technological progress, e.g., photocopying machinesspeed up the paper chain (although they increase its length!)

Various incentive and bonus schemes are possible, including stockpurchase options (mostly for managers who can later buy shares incompany at a price agreed now. It means that if they work hard and thecompany makes profits, the share price will rise, and they can buycheaply - so they get rich).

Bonus may be linked to growth in profit level, for workers or managers.

No absenteeism or unauthorised sick leave by a worker for a definedperiod of time may attract a bonus. British Airways were consideringthis in 2004.

Possibly a person might receive a bonus if he or she is never late forwork for a defined period (this applies to lower grade workers moreoften).

Suggestions boxes, meetings to invigorate staff, etc. might be used andcan help to some extent.

2. Financial diseconomies may arise:

As a firm grows, it increases its demand for everything, including perhapssome particular factor of production, a needed raw material, or certain

spare parts. As demand increases it can turn the price up against itself (anincrease in demand with normal supply curve; we will look at the diagramagain later on).

Price

S

P2

P1

D2

D1

0 Q1 Q2 Quantity

3. Quality diseconomies may occur:

When a firm starts up, it hires the best labour it can find, and buys from the bestsource of materials available; but when it has taken all that is possible from

Why Markets Fail


61/74



these sources, to grow further it may be forced to:

a) Hire lower quality labour, which will mean a lower productivity.

Why Markets Fail


62/74



b) Take worse raw materials, or hire less suitable transport vehicles (say, notwell refrigerated) because the really good ones have already been taken andthere are none of comparable quality left available.

And both these actions will increase the firms costs of production.

Why Markets Fail


63/74



D

2-8. PRICE FIXING BY GOVERNMENT OR ONE OF ITS BODIES

The government might decide that the prices determined by the market aretoo high or too low and may wish to intervene and change them.

When some institution fixes a price other than at equilibrium, logically it must beeither:

a) Maximum price fixing, orb) Minimum price fixing.

a) Maximum price fixing

When fixing a maximum price, it is always set below the equilibrium

level. Q. Why?

A. There is no point setting a maximum of say 1 million for the price of a loaf ofbread it would have no effect! It is always less than that anyway.

When someone sets an effective maximum price we always see the same

result: Demand will exceed supply at the set price. We did this in an earlier

diagram but wewill do it again now.

Price

S

P1

Set Price

0 Qs Q1Qd

Quantity

With this maximum price fixing we have an excess demand of OQd OQs(which is the distance Qs to Qd).

Why Markets Fail


64/74



Therefore we can expect to see:

shortages.

black markets emerging.

Why Markets Fail


65/74



D

possibly rationing will be introduced.

corruption might arise.

In the rental housing market if there is rent control:

key money might be demanded, a bribe in order to be able to rent thecheap house; or

a silly bet can be made which is deliberately lost, just to hand overmoney; or

the person renting has to purchase the fixtures and fittings at anextremely high price; or

perhaps sexual favours will be demanded before the owner will rent to aperson.

In other markets, such as for meat in war time, there will be shortages andqueues (=rationing by time) until a rationing system is introduced by government.

b) Minimum price fixing:

Minimum price fixing may occur with agricultural products in rich countries,where the government tries to help its farmers by giving them a larger income.

It may also be encountered in primary produce in the third world, withmarketing schemes and buffer stocks.

The same results always emerge: the quantity demanded is less than thequantity supplied at the prevailing price,

Price

Set Price

P1

0 Qd Q1 Qs

S

Quantity

With this minimum price fixing at Set Price, above the equilibrium level ofP1, we see a surplus of OQs minus OQd, or the gap Qd to Qs.

Why Markets Fail


66/74



Andwe can also expect to observe:

Why Markets Fail


67/74



storage problems and high storage costs (agricultural produce is likethat!);

the spoilage rate likely to be high (agricultural produce); there may be dumping of some of the produce in the sea; or

selling part of it below cost to countries abroad.

The surplus will continue to grow each year as long as the minimum pricepersists above the equilibrium one, so the problem (and storage costs)keep on increasing.

Primary produce marketing schemes

Primary produce is prone to large fluctuations in price, the result of both demandand supply being relatively inelastic, so that a change in either altersprice quite considerably.

Supply is likely to alter sharply for all agricultural crops, as the harvest can bepoor or a bumper one, depending on the weather.

Demand is likely to alter sharply for things like rubber if there is a slump in themotor vehicle industry so that fewer tyres are required.

So if we look at a diagram of inelastic supply and demand and alter either,price will rise or fall substantially.

Remember to draw the curves very steeply they are very inelastic and thesteep slope gives us the large price alterations.

Bumperharvest, supplyincrease

Maybe a newdietfad, demandincrease

Price Price D2D S1 S2 D1S

P1 P2

P1

P2

0 Q1Q2 0 Q1Q2

Why Markets Fail


68/74



Quantity Quantity

Why Markets Fail


69/74



D

As a result of the wide price fluctuations, it is tempting to set up a marketingscheme, which can buy when prices are low and sell when prices are high,

thus stabilising the price. A buying price and selling price are set by themarketing board and all should be well. This is how it looks (the curves wouldbe much steeper; I have drawn them flatter so you can see what is happeningmore easily):

Price

D S

Selling price

P1

Buying price

0 Q1 Quantity

However, there is a major problem! Unless the board guesses the long termprice it will set the buying and selling prices incorrectly. If the board buys at arelatively high price, it will run out of money rapidly. If it sells at a relatively high

price, it will end up with stocks of the produce that cannot be sold.

In the worst scenario it would look something like this in the diagram below:

Price

Selling price

P1 Buying price

0 Q1 Quantity

You can see that the excess supply is great at the selling price, but there is

little excess demand at the lower buying price. So stocks mustbuild up assupply permanently exceeds demand.

Typically this happens, for the board normally also wishes to increase the

Why Markets Fail


70/74



incomes of the farmers a bit so that when setting the prices it tends to erron the generous side.

Why Markets Fail


71/74



Does this sort of thing occur in the real world? Yes it does! Cocoa, coffee,rubber, sugar and tin have all had such boards and suffered problems withthem, including attempts by the boards to raise the long term price byrestricting supply.

NOTE: all price fixing brings problems in its wake, even if the intentions aregood!

Economists generally favour free markets for this reason. If there areparticular problems, like pockets of poverty, it is usually better to tackle themdirectly rather than try to fix the price of the product forall which includes therich and the poor.

Price fixing can also be found in labour markets where the governmenttries to help the lowly paid by setting a minimum wage.

As economic analysis predicts, problems will emerge. In the case of labour,we would see unemployment at the prevailing wage rate. There might also bekickbacks and bribes by workers to get one of the few jobs available. MarlonBrando in the movie On the Waterfront was involved in such a process itsan old film but worth seeing!

That is not to say that we should never have a minimum wage and thebenefits (a minimum income, preventing the exploitation of the poor andneedy by unscrupulous employers, and generally feeling that a wealthysociety can afford to be slightly generous to those at the bottom) may beworth the problems.

What are the problems of setting a minimum wage?

When the government legislates for a national minimum wage, it does notaffect all industries and firms. Many are already paying well above theminimum, in order to attract the right kind and quantity of workers. Sominimum wage legislation only impinges on lowly paid jobs in someindustries, as in firm C in the diagram below.

Firm ANo

effectW

WSlab

Firm BNo

effectW

Slab

Firm CMin wage works

W Min Wage

Why Markets Fail


72/74



W

Dlab

Dlab Slab

W Min Wage

Dlab

0 Q1 Labour 0 Q1 Labour 0 Q2 Q1Q3

Labour

Why Markets Fail


73/74


74/74


Copyright Kevin Bucknall

47

Why Markets Fail

Date post:	05-Apr-2018
Category:	Documents
Upload:	oalevels
View:	217 times
Download:	0 times

Unit 2 Why Markets Fail N

Documents