Government Intervention and the Market System

Session 4 (chs 8, 6, 7, 9)

Professor Dermot McAleese

OUTLINE

Government spending in the economy

Case for government intervention

Types of government intervention

Problem of government failure

Government spending (% GDP)

Sources: European Economy, OECD; pre-Second World War figures taken from Vito Tanzi and Ludger Schuknecht, ‘The Growth of Government and the Reform of the State in Industrial Countries’, IMF Working Paper, December 1995

1937 1960 1970 1984 2000

Eur 12 29.0 32.2 37.4 50.0 44.0Japan 25.4 17.1 19.4 32.9 31.8US 8.6 27.0 31.6 35.6 33.4

France 29.0 34.6 38.9 52.5 47.7Germany 42.4 32.5 38.5 47.6 44.0Netherlands 19.0 33.7 42.4 59.6 42.1Ireland … 28.0 39.6 51.3 29.5Italy 24.5 30.1 34.2 49.4 44.2UK 30.0 32.2 37.3 45.3 36.8

General government net debt (% GDP)

Source: European Monetary Institute, First Annual Report, April 1995; OECD Economic Outlook,, various issues.

1978 1990 1995 2000

EU(15) 23.9 40.8 75.2 68.5

Japan 11.3 9.5 76.2 112.8

US 21.3 31.5 74.5 60.2

Belgium 57.2 124.9 129.8 109.8

Italy 62.4 103.7 123.1 112.9

Greece 29.4 89.0 108.7 103.8

Netherlands 40.2 75.6 75.5 56.5

Denmark 21.9 65.8 73.9 50.8

Portugal 37.6 65.3 65.9 58.8

Germany 30.1 42.0 59.1 63.5

France 31.0 39.5 59.3 63.9

Spain 14.4 48.5 68.4 65.7

UK 58.6 39.1 58.9 49.7

Ireland 65.7 92.6 80.8 42.9

Elderly dependency ratios

Source: Eurostat

65+ as % total population

1960 2000 2050

US 9.2 12.4 21.2

Japan 6.1 16.5 30.4

EC15 10.6 16.1 27.6

Table. 6 Public sector debt and net public pensions liabilities, 1990 (% GDP)

Source: Van Noord and Herd (1994)

Public debt

Net pensions liabilities

Extended public debt

US 56 43 99

Japan 70 200 270

Germany 44 160 204

France 47 216 263

Italy 101 233 334

UK 35 100 135

ADAM SMITH: THE REASONS FOR GOVERNMENT INTERVENTION

Monopoly

Defence/national security

Police and justice system

Public health

Modern Case for Government Intervention

• Income Distribution

• Market Failure

INCOME DISTRIBUTION

Income equalisation utility maximised by distributing from rich to poor

adverse effect on incentive to work and enterprise

Efficiency efficiency less ambiguous objective than equality

Pareto efficiency

(an outcome where nobody can be made better off without making at least one other individual less well off)

Equality/efficiency trade-off

EMPIRICAL EVIDENCE ON INCOME DISTRIBUTION

Governments are concerned about inequality

Market forces can produce highly unequal income distribution

Government redistribution reduces inequality

Declining emphasis on redistribution through taxation

More emphasis on targeting expenditure to the poor

GINI INDICES FOR SELECTION OF HIGH-INCOME COUNTRIES

Soruces: Gini coefficients: A. Atkinson, Income Inequality in OECD countries: evidence from CIS data, paris: OECD, 1995.

0 0.1 0.2 0.3 0.4 0.5

Switzerland

US

France

Netherland

Canada

Australia

UK

Germany

Norway

Sweden

before redistribution after redistribution

MARKET FAILURES

Monopoly power (dead-weight loss, X-efficiency loss, etc.)

Externalities (congestions, pollution, …)

Public goods (‘free rider’ problem)

Information asymmetries (insurance, banking, taxis, health)

Begin with monopoly – one seller only -- the extreme case of

absence of competition

THE THEORY OF MONOPOLY

Static Efficiency effect

Income distribution effect

Dynamic effects

THE SINGLE MONOPOLIST

QuantityQm0

Pm

Price

MR

D

AC

MC

S

T

F

R

Profit maximisation dictates that firms in the market system

are motivated to discover, exploit and ruthlessly protect a

monopoly niche.

MONOPOLY vs. COMPETITION

QuantityQcQm0

Pc

Pm

Price

S

R

D

DT

Deadweight loss = RST

Same costs

MONOPOLY vs. COMPETITION

R

S

D

V

Costs under monopoly

MC = AC

Cost under competition

MC = AC

QuantityQcQxQm0

A

B

Higher costs under monopolyPrice

MONOPOLY PRICE DISCRIMINATION

Quantity Quantity Quantity

Q1 Q(1+2)Q2

Price PricePrice

MR1 MR2 CMR

CMC

C

P1

C

P2

E

FOUR REASONS FOR A MONOPOLY

Economies of scale

Government policies

Ownership know-how

Ownership of natural resources

SUSTAINING MARKET POWER

Distinctive capability

Architecture

Reputation

Innovation

Strategic entry-deterrent measures

Setting price deliberately below profit-maximising level in order to reduce attractiveness of the industry to the outsiders

Conceasing profit figures for monopolised parts of business Below cost selling, predatory pricing and dumping Deliberate over-investment in capacity and extension of

product range

MARKET POWER WITH A FEW FIRMS

The case of cartel

Price leadership

Kinked oligopoly model

Non-price competition

CONCLUSIONS

Large section of modern industrial economies can be described as ‘effectively competitive’

Yet monopolies influence and market power are important realities in the business world

Hence need for competition policy

MARKET STRUCTURE IS DETERMINED BY

Numbers and size-distribution of sellers and buyers

Characteristics of the product and degree of market segmentation

Barriers to entry into the industry

Barriers to exit from the industry

MARKET STRUCTURE AND FIRMS PERFORMANCE

Contestability – firms may be few in number and yet competition can be intense

Innovation – thrives more in competitive conditions than under monopoly

COMPETITION – ADVANTAGES OVER MONOPOLY

It makes organisations internally more efficient

It allows the more efficient organisations to prosper at the expense of the inefficient (selection process)

It improves dynamic efficiency by stimulating innovation

EXTERNALITIES

Primary education

Training employees in general skills

Aesthetic company headquarter buildings

Vaccine against contagious disease

Neighbour’s well-kept garden

Air, water and noise pollution

Ugly factory buildings

Congestion

Radio noise

Production Consumption

EFFECT

ORIGIN

NEGATIVE PRODUCTION EXTERNALITY

SMC

PMC

Demand

Output of chemical plant

Q1Q2

£

P

ŒE

Chemical Plant Polluting River

Q 1- private profit maximum output level

Q2 - social optimum level

DEFINITION OF A PUBLIC GOOD

Non-Rivalrous the marginal cost of an additional individual consuming the good is zero, at least up to a certain level

Non-Excludablethe cost of excluding an individual from consuming it is prohibitively high

Note: Public goods are not the same as merit goods

PUBLIC GOODS

Marginal cost of consumption (rivalry)

Ease of excludability

Clean Air

Innovation –basic research

National Defence

Monetary stability

TV Programme

National Parks

Motorways Bridges

Art Galleries

City Parks

Cinemas

Fire service

Apples

Cars

Private Goods and Public Goods

Examples of Information Asymmetries

• Medical bills – inflated demand

• Fake antiques

• Gasoline

• Bank deposits

Government Action is needed to Prevent or Correct Market

Failure

COMPETITION POLICY IN ACTION– THE EXAMPLE OF EU

Prohibited agreements

Abuse of dominant position

Control of mergers

State aids

COMPETITION POLICY IN ACTION

Horizontal restraints

restraints in markets for close substitutes

(e.g. price fixing, market sharing)

presumption of illegality

Vertical restraints

restraints between producers of complementary goods and services

presumption of legality unless interest of consumers, existing competitors, potential entrants are shown to be damaged

COMPETITION LAW WITH TEETH Breaches of competition law can carry severe penalties. In 1999, two top European companies were fined a record $725 million in the US for their part in a worldwide conspiracy to control the market in vitamins. According to US investigators, the executives met once a year to fix the annual “budget” of a fictitious company Vitamins Inc. In practice this involved setting prices, sharing geographic markets and setting sales volume. The annual summit was followed by meetings, quarterly reviews and frequent correspondence. The cartel controlled the most popular vitamins including vitamins A, C and vitamin premixes. A former executive of Roche agreed to serve a four-month prison sentence; he was the first European national to submit to such a sentence for anti-trust offences. The European Commission said it was investigating the same matter. Practices that once would have been tolerated if not condoned in the past are now being subjected to the full rigour of the law.  Source: Financial Times 24 May 1999 

COMPETITION AND GLOBALISATION

A more open market is more competitive

A need for ‘level playing field’

Monopoly power by giant multinationals

COMPETITION POLICY DOES NOT SOLVE ALL PROBLEMS …

Natural monopolies – the core activities where economies of scale dominate

Can be controlled by

1. Regulation

2. Outcontracting and franchising

3. Privatisation

REASONS FOR PRIVATISATION

new managerial ‘culture’

source of funds for government

disposes of loss making

weaken trade unions

encourage efficiency (access to capital, avoid policy confusion)

develop and expand domestic capital market

engender competition

METHODS OF PRIVATISATION

Share flotation (British Telecom 1984)

Direct sale to existing private sector business or institutional buyers (Rover cars to British Aerospace)

Management buy-outs (National Freight corporation 1982)

Contracting out (competitive tender)

EFFECTS OF PRIVATISATION

Efficiency

Government revenue

Income distribution

Privatsation not necessarily superior to state ownership (Railways, London underground)

DEREGULATION – THE CASE OF NATURAL MONOPOLY

Isolate the core natural monopoly element in the industry

Deal with the natural monopoly element: Pricing: P = MC;

break-even or average return on K; RPI minus X

Access

Quality

REGULATION

Costs of direct regulation can be high

Incentive regulation can also be problematic- RPI minus X (UK)- ‘Fair’ return on capital (US)

Competition the best solution- Break up into separate competing firms- Competitive tendering for provision of services- Encourage new entrants (including foreign)- Separate ‘natural’ monopoly (network) and regulate that only

Solutions to Market Failure -- Externalities

Taxes and subsidies

Regulation

State provision

COASE THEOREM

Externalities do not necessarily require government intervention.

Market system can correct externalities, provided property rights are defined and transactions costs are

low.

REGULATION

Regulation is costly …

High administrative costs

Insufficient flexibility in implementation

Stultifying effects of standardisation on industrial innovation

… but necessary …

Natural monopolies

Asymmetric information

When risks of catastrophic failure exists

When the pollution generated by the polluter cannot be measured

When major health risks are involved

Solutions to Market Failure –

Public Goods

Asymmetric InformationYOUR SOLUTIONS!

GOVERNMENT FAILURE

Government failure arises when the cost of attempting to ‘correct’ free market distortions turn out to be greater than the cost of the original distortion itself.

CAUSES OF GOVERNMENT FAILURE

Absence of ‘invisible hand’

Absence of full information

Theory of public choice

‘political parties formulate policies in order to win elections, rather than win elections in order to formulate policies’ Prof. Anthony Down

Distortions created by taxes and subsidies

(rent-seeking society and the ‘grantepreneurs’)

RESPONSE TO GOVERNMENT FAILURE

Reduce direct public provision (1)

privatisation

out-contracting

Standards

regulation

Response (2)

Use market incentives instead of regulation where possible

Reform public sector – learning from the private sector

Management by objectives

Incentives

Example: The Polluter Pays Principle

Tax the polluter, get as near to the source of the problem as possible, use market incentive instead of regulation

The Polluter Pays Principle

• Gives firm incentive to reduce pollution

• Cuts down on compliance and monitoring costs

• Incentive to innovation with pollution costs integrated into market signals

• Pollution may not be costly or impossible to measure accurately

• Lessens government control over amount of pollution created

FUNCTIONS OF THE STATE

Source: The State in a Changing World, World Development Report 1977, Jun, p. 27.

Improving equity

Protecting the poor:

Antipoverty progrems, disaster relier

Addressing externalities:

Regulating monopoly:

Overcoming imperfect

information: Providing social

insurance:

Intermediate functions

Basic education, environmental protection

Utility regulation, aniitrust policy

Insurance, financial regulation, consumer protection

Redistributive pensions, family allowances, unemployment insurance

Redistribution:

Activist functions

Progressive income taxes, wealth taxes, biasing expenditure towards lower

Addressing market failure

Fostering markets, cluster initiatives, regional development

Co-ordinating private acivity:

Defence, property rights, law and order, public health, macroeconomic management

Minimal functions

Providing pure public goods: