market success and market failure
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19- 1
MARKET SUCCESS AND
MARKET FAILURE
Chapter 19
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19- 2 Learning Outcomes
A perfectly competitive economy is allocatively efficientsince it operates where price equals marginal cost
Free markets can fail to achieve and efficient outcome forone of several possible causes of market failure
Private markets will tend to overexploit common propertyresources
oods that are !ointly consumed by more than one personare called public goods and cannot be provided efficientlyby the market
"he costs and benefits of production that are external tothe producer cause the level of production that is achieved
by the free market to deviate from the socially optimallevel
overnment policy towards competition is designed toencourage competitive practices and to discouragemonopoly
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19- 3 "he overnment in the #conomy
$arket #fficiency
%ow $arkets work
"he efficiency of perfect competition
Productive #fficiency
Productive efficiency implies being on& rather than inside&
the economys production possibility curve
Allocative #fficiency
Allocative efficiency relates to the choice amongalternative points on the production possibility curve
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19- 4
Allocative #fficiency
"he economys allocation of resources isefficient when the marginal cost ofproducing each good is equal to its market
price' (n perfectly competitive economy& )s'*worth of resources reallocated from theproduction of any one product would
produce )s'* worth of value for consumer&whatever product it was then used toproduce'
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19- 5
$arket Failure
Failure of the market economy to achieve
an efficient allocation of resources'
As the real market has some monopolypower over the prices& $)+$,& they do
not have perfect allocative efficiency'
"his provides the scope for the
overnment to intervene to improve
market efficiency'
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19- 6
,ircumstances of $arket
Failure -here producers with excess capacity charges positive
prices' -here the resources are used by everyone and belongs
to no one . common property resources'
-here there are goods whose consumption can not berestricted to those who are willing to pay for them .Public good'
-here people not party to some market bargain are nonethe less significantly effected by it . externalities.
-here one party to a market transaction has fullerknowledge of its consequences than is available to otherparty .Asymmetric information
Where substantial market power causes prices to
diverge from marginal cost.
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19- 7
)ivalrous and #xcludable oods'
A good is rivalrous is no two people canconsume the same unit' . one apple'
A good is excludable if people can beprevented from obtaining it . the ownercan exercise effective property right overthe good' "he consumer only those who
pay for it' Any normal good will be rivalrous and
excludable'
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19- 8
)ivalrous and #xcludable oods
#xcludability is necessary for a good to be
produced by a firm for sale in the market'
"he market works best when goods andservices are rivalrous and excludable'
Art alleries& museums& parks are
excludable but non/rivalrous'
,ommon property are non/excludable but
rivalrous'
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19- 9 Four Types of Goos
!i"a#rous
$resses
%pp#es
&useums
Public goods
'o#ice
()c#ua*#e
Normal goods
+roacast signa#s
T, sets
Fiseries
.ommon #an
/on-e)c#ua*#e
Common property
.omputers
% seat on an aerop#ane
%rt ga##eries
0i##ife
treams
%ir
/on-ri"a#rous
up to capacity
Fence
!oas
+riges
'u*#ic information
ome na"igation ais
$efence
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19- 1
(f one person consumes some of a rivalrousgood or service& that
reduces the amount available for consumption by others' (f one person consumes some of a non-rivalrousgood or service&
the amount available for consumption by others is not reduced'
Producers of an excludablegood or service can prevent people
from consuming it and hence can charge for providing it'
Producers of a non-excludablegood cannot prevent anyone formconsuming it and hence cannot charge for providing it'
0ormal goods& shown in the top left segment& are rivalrous and
excludable'
Four Types of Goos
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19- 11
$any goods are non/rivalrous 1up to the capacity of theproducing unit2 but are excludable 1bottom left hand
segment2' #xamples are listed in the bottom left segment'
"hese goods can be provided to an additional consumer 1up
to capacity2 at a 3ero marginal cost' ,ommon property resources are rivalrous but non/
excludable 1top right hand segment2' "hey will tend to be
over used in free market conditions because additional
users cannot be excluded'
Public goods are non/excludable and non rivalrous' "hey willnot be provided by the free market'
Four Types of Goos
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19- 12
#xternalities
#xternalities are the costs or benefits of atransaction that are incurred or receivedby other members of the society but not
taken into account by the parties to thetransaction'
#xternalities are also called as third/party
effect& spillover effect& neighborhoodeffect'
4ecause parties other than the parties intransaction are affected'
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19- 13
#xternalities
#xternalities arise in many ways and may be
beneficial or harmful'
#xternalities crates a divergences between
private benefits and costs and social benefitsand costs'
Private costs and benefits5 incurred and received
by the parties involved in the activity'
6ocial costs and benefits5 costs and benefits
incurred and en!oyed by whole society'
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19- 14
#xternalities
6ocietys resources are optimally allocatedwhen social marginal cost equals socialmarginal benefit'
"he outputs of firms that create harmfulexternalities will exceed the sociallyoptimal levels'
"he outputs of firms that create beneficialexternalities will be less than the sociallyoptimal levels'
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19- 15
'rouction
'
ric
e5c
ost
&.s
&.p
&argina#
pri"ate
cost
$
p1
p
'ri"ate an ocia# .ost
&aret price
Fu##
margina#
socia#
cost
&argina#
e)terna#
cost
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19- 16
0egative externalities cause marginal social cost to exceed
price in competitive equilibrium'
$arginal social cost& MCs exceeds marginal private cost&
MCp by the amount of the external cost imposed on others'
At the competitive output& !"& marginal private cost equals
price& but marginal social cost exceeds it' "he socially optimal output is !#& where MCs 7 market price'
For every unit between !8 and !"&marginal social cost
exceeds price and hence its production involves a social
loss'
'ri"ate an ocia# .ost
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19- 17
)esource allocation
"o achieve the optimal allocation of
resources in the face of externalities& the
production of goods with positive
externalities need to be encouraged and
the production of those with negative
externalities to be discouraged& compared
with what would be produced under freemarket condition'
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19- 18
#xternalities and the ,oase
"heorem
#xternalities arise because of the lack of
property rights'
"heorem5 (f the two sides to an externality
. the one causing it and the one suffering
from it . can bargain together with 3ero
transaction costs& they will produce the
efficient use of resources'
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19- 19
Firm +
Firm %
1296
1
8
5
. o s tp
e rt o n n
e e # imin
a te 2 9 3
Tons of po##ution e#iminate
'o##ution %*atement
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19- 2
#fficient methods of abating pollution take account of differences in
costs of abatement among firms'
For any given amount of abatement& firmAhas a higher cost of a
further unit of abatement than has $'
%&' (et each be ordered to reduce pollution by )" units'
As marginal cost of 9*:: exceeds $s marginal cost of 9;:'
"his is inefficient'
Acould cut its abatement by one unit& saving 9*::& while $
increased its abatement by one unit& adding 9;: to its costs'
"otal abatement would then be unchanged but costs would fall by
9;:'
'o##ution %*atement
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19- 21
%*' +ow let an emissions tax of ," per tonne of pollution
be imposed.
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19- 22
Firm +
Firm %
1296
12
8
5
. o s tp e rt o
nne e #
imina te 2 9
3
Tons of po##ution generate
Traa*#e 'o##ution %*atement
3
T *# ## ti it
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19- 23 Traa*#e po##ution permits
"radable permits achieve the same results as the most efficient tax'
#ach firm produces *;: tonnes of pollution when no abatement procedures
are followed'
Abatement reduces the amount of pollution but at a rising marginal cost'
#ach firm is originally given an endowment of permits to emit >: tonnes of
pollution'
(f no trading is allowed& the marginal costs of abatement are then 9*=: for A
and 9;: for $'
-ith trading& $sells @: tonnes worth of permits toA' FirmAthen pollutes by : tonnes and firm $by @: tonnes'
"he price of a permit is 9?:
"his is the same as both firms marginal cost of abatement at their new levels
of pollution'
i ' i i ' #i i f / t # & #i
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19- 24
i: Losses in a fa##ing-cost inustry
'ric e
Output
i 'ricing 'o#icies for /atura# &onopo#ies
&.
%T.
$1
1 1
p2
c1
p1
' i i #i i f t # #i ;i< f ##i t
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19- 25 'ricing po#icies for natura# monopo#ies ;i< fa##ing cost
Marginal cost pricing leads to losses
"he output at which marginal cost equals price is !& "he associated price isp&'
Average costs are falling at output !&so marginal costs are less than the
average cost of c&'
"here is a loss of c&.p&on each unit making a total loss equal to the dark
blue area'Average cost pricing is inefficient
"he output at which average cost equals price is !*'
"he associated price isp*'
$arginal cost is less than price at !*& so output is less than the socially
optimal level'
ii ' i i ' #i i f / t # & #i
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19- 26
i: 'rofits in a rising-cost inustry
'r ic e
Output
ii 'ricing 'o#icies for /atura# &onopo#ies
&.
%T.
$2
1 2
p2
c1
p1
' i i #i i f t # #i ;ii< i i t
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19- 27 'ricing po#icies for natura# monopo#ies ;ii< rising cost
Marginal cost pricing leads to profits
"he output at which marginal cost equals price is !&
"he associated price isp*'
Average cost of c&is less than price at output !&'
"here is a profit of p&/ c&on each unit sold& making a total profit
equal to the blue area'Average cost pricing is inefficient
"he output at which average cost equals price is !*.
"he associated price isp*'
$arginal cost exceeds price at !*& so output is greater than thesocially optimal level'
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19- 28 .=%'T(! 19> &%!?(T @..( %/$ &%!?(T F%AL@!(
4asic Functions of overnment
#ffective governments have a monopoly of violence'
"hey also define and protect the rights and obligations
of property owned by individuals and institutions'
Bey characteristics of market economies are CaD their
ability to co/ordinate decentralised decisions without
conscious control& CbD their determination of thedistribution of income& and CcD compared with the
alternatives& their minimisation of arbitrary economic
power'
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19- 29 .=%'T(! 19> &%!?(T @..( %/$ &%!?(T F%AL@!(
$arket #fficiency
A perfectly competitive economy is allocatively efficientbecause it produces where price& which measures thevalue consumers place on the last unit produced& equalsmarginal cost& which measures the value to consumersthat the resources used to produce the marginal unitcould produce in other uses'
"his maximises the sum of producers and consumerssurpluses'
Free markets can fail to achieve efficiency because ofinefficient exclusion of users from facilities with excesscapacity& common property resources& public goods&externalities& asymmetric information& missing marketsand market power'
19 3 .=%'T(! 19> &%!?(T @..( %/$ &%!?(T F%AL@!(
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19- 3
)ivalrous and #xcludable oods "he optimal price for the service of a facilitywith excess capacity is 3ero'
6ince private owners will charge a positiveprice& their facility will be inefficientlyunderused'
"he private market will exploit a commonproperty resource to the point where theaverage revenue per producer equals the
production cost of a new entrant instead of tothe socially optimal level& where the marginaladdition to total product caused by a newentrant equals its production cost'
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19 31 .=%'T(! 19> &%!?(T @..( %/$ &%!?(T F%AL@!(
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19- 31
#xternalities
"he ,oase theorem shows that if those parties that create an
externality and those that are affected by it can bargaintogether with minimal transaction costs& all inefficiencies can
be removed'
-here private bargaining is impossible& the government can
alleviate externalities by imposing rules and regulations or&
more efficiently& by internalising externalities through suchmeasures as taxes and tradable permits to pollute'
Public Policy "owards $onopoly and ,ompetition
overnment policy with respect to market power is designed
to encourage competitive practices and discouragemonopolistic ones'
(t seeks to regulate natural monopolies either by running
them as nationalised industries Cthe EB solution in the pastD
or by putting them in private hands and regulating them Cthe
typical EB solution todayD'
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19 32 .=%'T(! 19> &%!?(T @..( %/$ &%!?(T F%AL@!(
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19- 32
irect control of pricing and entry conditions of some
key oligopolistic industries has been common in the
past& but deregulation is reducing such control'
"he move to deregulation was largely the result of
the experiences that oligopolistic industries are a
ma!or engine of growth& as long as their firms are
kept competingG that direct control of such industries
has produced disappointing results in the pastG and
that forced cross/subsidisation can have serious
consequence for some users'
An important issue concerns the effect of market
structure on economic growth'
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