market success and market failure

7/26/2019 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 !&


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 !*.


$arginal cost exceeds price at !*& so output is greater than thesocially optimal level'

.=%'T(! 19 &%!?(T @..( %/$ &%!?(T F%AL@!(


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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'

.=%'T(! 19> &%!?(T @..( %/$ &%!?(T F%AL@!(


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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'

.=%'T(! 19> &%!?(T @..( %/$ &%!?(T F%AL@!(

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'

.=%'T(! 19> &%!?(T @..( %/$ &%!?(T F%AL@!(

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'

.=%'T(! 19> &%!?(T @..( %/$ &%!?(T F%AL@!(

market success and market failure

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