College of Arts and Sciences
Department of Economics

—Lecture Notes—

ECO 6120 Economic Policy Analysis Fall Semester 2013
W 6:20–9:05 p.m., CMC 204 J . S. DeSalvo

4. Introduction to Market Failure and Government Failure

I. Review: Perfect Competition and Efficiency
A. The Twin Theorems Reviewed
B. What is Government’s Role in a Perfectly Competitive Economy?
1. Ensuring, protecting, and enforcing property rights (not modeled)
2. Redistribution (2nd Fundamental Theorem)

II. Notes on the Readings
A. Friedman: Reviews efficiency of competitive markets, discusses violations of
the competitive assumptions, provides a brief discussion of government failure,
and a discussion of second-best failures; read and study pp. 604–606 on se-
cond best; read but do not study the rest; we’ll deal with all that more thorough-
ly, returning to Friedman’s discussion of government failure, pp. 606–613
B. Wetzstein: Discusses second-best policy failure and provides a mathematical
illustration; read and study the graph and text, but don’t worry about the math if
you can’t follow it
C. Zygmont: An exposition of the Socialist Calculation Debate (SCD), which we
follow fairly closely in the lecture notes; read and study
D. Maskin: The Nobel laureate’s exposition of mechanism design, which also as-
sesses the SCD; read and study

III. A Rationale for Government Intervention: Market Failure
A. Why Might Markets Fail?
1. In general: When the assumptions of the perfectly competitive model are
violated, markets may not achieve Pareto efficiency
2. The most commonly cited sources of market failure are:
a. Public goods: Goods that have the characteristics of non-rivalry and
non-exclusion and which, therefore, may not be provided by private mar-
kets even though the total benefits of provision exceed the total costs of
provision, thereby providing a rationale for government provision and fi-
nancing through the tax system
b. Externalities: Goods whose consumption imposes costs or benefits on
other consumers or firms, or outputs that impose costs or benefits on
other firms or consumers; since these costs or benefits are not recog-
nized by markets, they are either over- or under-supplied, a situation that
may call for government intervention in the form of taxes (e.g., pollution
taxes or congestion tolls) or regulations (e.g., requirement of smoke-
stack scrubbers)
c. Imperfect competition: Markets made up of sufficiently few firms to con-
fer market power which results in price greater than marginal cost; gov-
ernment response is antitrust action
d. Natural monopoly: A market structure in which there exist economies of
scale large relative to market demand, thereby resulting in monopoliza-
tion of the market; to retain the advantage of economies of scale, gov-
ernments regulate natural monopolies
e. Imperfect information: Because the competitive model assumes perfect
information, imperfect information may lead to market failure, which pro-
vides a rationale for government intervention to correct the information
B. How Economists Deal with These Situations
1. Specify Pareto efficiency conditions in the presence of market failures
2. Devise ways of achieving these conditions, which usually involves govern-
ment intervention into private markets

IV. Government Failure: The “Standard” Approach: Identify a market failure and pro-
pose a governmental solution; this approach began with the British economist, Al-
fred Pigou, in the 1930s
A. Implicit Assumption: That government was efficient and operated in the public
B. Efficiency assumption questioned: Starting in the late 1950s, economists, such
as Charles Wolf, began writing about “non-market failure” or “government fail-
ure,” pointing out that government was far from efficient
C. Public-interest assumption questioned: J ames Buchanan and Gordon Tullock’s
book, The Calculus of Consent (1962), questioned the “public interest” assump-
tion and replaced it with the “public choice” assumption, i.e., that government
officials behave in their own self-interest; the field that they started is now called
“public choice theory”
D. The “standard” approach is meant to apply to a market economy; an important
issue, overlooked by the “standard” approach, is what kind of economy is best,
which came to a head in the “socialist calculation debate”

V. The Socialist Calculation Debate: This follows the Zygmont article but also in-
cludes some ideas drawn from writings not on the reading list
A. Introduction
1. Zygmont’s view of the importance of the debate (p. 229): “The SCD con-
cerned an issue that remains one of the most consequential of the 20th cen-
tury—the belief in the superiority of socialism and central planning over
capitalism and the free market.”
2. Nature of the debate: It dealt with the feasibility of market socialism
B. The Socialist Calculation Debate: History (Note: The following discussion of
Barone is not in the readings)
1. Enrico Barone published the article, “The Ministry of Production in the Col-
lectivist State,” in 1908, but it was ignored until reprinted in a 1935 (Zygmont
says 1938) book edited by Friedrich A. Hayek, Collectivist Economic Plan-
ning: Critical Studies on the Possibility of Socialism
a. Barone asserted that the central planner, like the Walrasian auctioneer,
could solve the system of supply and demand equations for all input and
output markets, thereby obtaining a general equilibrium, including the
prices that would clear all markets
b. Then, the state could dictate those prices to firms, tell them to maximize
profits, and they would produce the efficient quantities of outputs and the
efficient allocation of inputs, thereby generating production efficiency
(this is usually what is meant by market socialism)
c. Although Barone didn’t consider consumers, he could have asserted that
consumers reacting to those prices would generate exchange efficiency
d. Together, as we’ve seen, these conditions would produce product-mix
e. Barone also contended that lump-sum redistributions of income should
occur to promote equality and that this would not affect the efficient out-
f. As you can see, Barone had a pretty good grasp of what we now call the
first and second fundamental theorems of welfare economics
2. Hayek also reprinted in the same book an article originally published in 1920
by Ludwig von Mises, “Economic Calculation in the Socialist Common-
wealth,” as well as two articles of his own, all of which criticized Barone’s
3. This led Oskar Lange, a Polish economist, to publish two articles in 1936
and 1937, “On the Economic Theory of Socialism: Part One/Part Two,”
which attempted to refute Mises and Hayek
4. There were several other exchanges among the three, but these are the
most important
C. The Substance of the Debate
1. Hayek and Mises argued that socialism was theoretically impossible (they
had in mind Soviet-style socialism, but their criticisms applied to what Lange
dubbed market socialism)
2. Hayek and Mises gave many reasons to buttress their position, given in
Zygmont, some of which are vague and irrelevant, but the most important
was that the state does not have the necessary information to determine
equilibrium prices
3. Lange rebutted their argument as follows
a. He conceded that the state has only limited information, but said that this
is also true of the Walrasian auctioneer
b. He contended that the process of price adjustment in a market economy
takes the form of price increases on goods that are in excess demand
and price decreases on goods that are in excess supply
c. The central planner can follow exactly the same procedure: raising pric-
es in response to shortages and lowering them in response to surpluses
d. Lange thus established equivalence between market and socialist re-
source allocation
4. He argued further that socialism was superior to a market economy on other
grounds as well
a. The state can redistribute income more effectively
b. Since the state controls all firms, it can solve the problem of externalities
c. Since the state sets prices and determines entry, it can avoid monopo-
d. He also believed that monopolies were responsible for business cycles
and that, therefore, socialism could cure the business cycle
5. Hayek and Mises responded to this with a variety of arguments
a. Planners are unable to collect and process sufficient data to coordinate
the economy
b. The method of trial and error is fundamentally flawed
(1) Product and input prices serve as signals to firms and consumers
which direct purchases and production
(2) They are not parameters that can be dictated to consumers and firms
but are discovered in the process of the economy’s operation
(3) They are unique to circumstance of time and place
c. Socialism ignores managerial incentives
d. Socialism can’t ensure entrepreneurship, i.e., the process of discovering
innovations and making the investment to bring new goods to market
D. The Outcome of the Debate
1. Lange “won”
a. Basically, he presented the arguments of the first and second fundamen-
tal theorems of welfare economics
b. Academic economists agreed with him because he operated within the
neoclassical economics mainstream, which is what is still taught; he was
one of them, albeit one favoring socialism
c. Mises and Hayek were not neoclassical economists, but of the Austrian
school of economics
(1) Austrian economics is not about the allocation of resources
(2) It is about the market process itself, the ways in which dispersed and
fragmented tacit knowledge is socially mobilized through rival entre-
preneurial activities
2. Relevance of Lange’s win
a. Academic economists believed he had established the case that social-
ism (at least market socialism) was feasible, both theoretically and prac-
b. Zygmont quotes from the 1989 edition of the widely used principles text
by Samuelson and Nordhaus: “the Soviet economy is proof that, contra-
ry to what many skeptics had earlier believed, a socialist economy can
function and even thrive” (this statement should have been a profound
embarrassment to Samuelson and Nordhaus; Samuelson is now beyond
3. Economists Were Oblivious to Aspects of Centrally Planned Economies that
Led to Their Demise
a. Pervasive shortages
b. Principal-agent problems
c. Absence of entrepreneurship
d. Black markets
e. Inadequate investment and willingness to take risks
f. Perverse incentives due to failure to assign property rights to individuals
and firms
g. Hidden unemployment
h. Inegalitarian income distribution
i. Existence of externalities
4. Why this is so should be a source of puzzlement and embarrassment to
mainstream economists

VI. A Modern View of the Debate from the Perspective of Mechanism Design: This
follows the Maskin article, which is a revised version of the lecture he delivered in
Stockholm, on December 8, 2007, when he received the Bank of Sweden Prize in
Economic Sciences in Memory of Alfred Nobel
A. What Is Mechanism Design?
1. Standard theory: Intends to explain or forecast the economic and social
outcomes of existing economic institutions, e.g., capitalism
2. Mechanism design: Identifies a desired outcome or social goal and then
asks whether or not an appropriate institution (or mechanism) could be de-
signed to attain the goal
B. Basic Difficulty in Achieving Social Goals
1. Level of information: Those assigned the task of arranging for institutions to
achieve social goals (planners) don’t know consumer preferences
2. Incentive-incompatibility: Economic agents who have the necessary infor-
mation may not have the incentive to behave in a way that reveals what
they know (e.g., public good problem), so the mechanism must be incentive-
C. Basic Questions of Mechanism Design
1. When is it possible to design incentive-compatible mechanisms for attaining
social goals?
2. What form might these mechanisms take when they exist?
3. When is finding such mechanisms ruled out theoretically?
D. Relation to the SCD (Maskin’s Section III): Hurwicz (the founder of mechanism
design and also a Nobel prize winner along with Maskin) found the SCD frus-
1. It lacked conceptual precision, e.g., undefined terms, such as decentraliza-
2. It presented incomplete arguments and unpersuasive conclusions
3. In trying to understand the debate, Hurwicz introduced the concept of incen-

E. Maskin’s Conclusion: Mises and Hayek Were Right
1. The market is the best mechanism, where
a. There are large numbers of buyers and sellers, so that no single agent
has significant market power
b. There are no significant externalities
2. If either assumption is violated, however, mechanisms improving the market
are generally possible
3. Thus, we’re back to the “standard” market-failure approach earlier dis-
cussed, but with a firmer foundation for it

VII. Second-Best Failure
A. Introduction
1. Second-best failure is neither a government nor a market failure
2. It refers instead to the fact that correcting one inefficiency in a situation of
many inefficiencies does not necessarily produce a Pareto superior out-
B. First best: The Pareto-efficiency conditions are necessary conditions for a "first-
best" Pareto optimum (first-order conditions)
C. What If One of These Conditions Does Not Hold?
1. If one of the conditions does not hold, then we do not have Pareto efficiency
2. If, however, the one condition is brought back into alignment, then we do
have Pareto efficiency
3. Analogous to maximizing a multivariate objective function
a. If the maximum exists, all first partial derivatives of the objective function
equal zero
b. If one of the first partial derivatives does not equal zero, then the others
do not determine a maximum
D. What If More Than One of the Pareto Efficiency Conditions Do Not Hold?
1. The remaining conditions do not determine an efficient allocation
2. Bringing all but one into alignment would not result in Pareto efficiency ei-
3. Would that action produce a result closer to Pareto efficiency? It might or it
might not; that’s the second-best problem
E. Why Is This a Problem?
1. In the real world there are many divergences from Pareto efficiency condi-
2. Economists cannot assume that correcting one divergence will be an im-
3. Each case must be evaluated on its own merits
F. Illustration of the Second-Best Problem (Friedman, pp. 604-606; Fig. 15-1, p.
1. Assumptions
a. Both trucking and rail freight industries are regulated
b. Both could operate as competitive industries if deregulated
2. Results of Regulation
a. Suppose both industries are regulated (an error according to our as-
sumptions because both industries could operate competitively)
b. Regulated prices would be P
and P
and the resulting quantities
would be Q
and Q

c. Clearly this is not Pareto efficient
3. First-best policy: Deregulate both
a. Since the regulated prices are greater than marginal cost, both prices
would fall under deregulation
b. Since the goods are substitutes (they're both ways to transport commod-
ities), both demands would fall, say to D
′ and D

c. The competitive equilibrium would be found where supply equaled de-
mand in both markets, with prices P
and P
(not shown in Friedman’s
the figure) and quantities Q
and Q

d. This would be Pareto efficient (ignoring any other divergences from the
efficiency conditions elsewhere in the economy)
4. Second-best policy: Deregulate one
a. Assumption: Rail can’t be deregulated for political reasons
b. Question: Should trucking be deregulated? That is, would this second-
best policy be an improvement?
c. Effects of deregulation of trucking on prices and quantities in both mar-
(1) If rail isn't deregulated, its price stays at P

(2) Thus trucking demand stays at D

(3) Deregulated trucking price falls to P
and quantity rises to Q

(4) For rail, the D curve shifts to D
′ because P
has fallen, but since P

is regulated at P
, quantity demanded falls to Q

d. Effects of deregulation of trucking on efficiency in both markets
(1) In the trucking industry, deregulated quantity Q
is farther away from
the efficient quantity Q
than is the regulated quantity Q
, i.e., de-
regulation has made trucking more inefficient than regulation did
(2) In the rail industry, after deregulation of trucking, quantity Q
′ is far-
ther away from efficient quantity Q
than is the initial regulated
quantity Q
, i.e., deregulation of trucking has made rail even more
inefficient than if both modes were regulated
(3) Why this happens: The failure to deregulate rail keeps its price high,
so that the fall in trucking price stimulates trucking quantity demand-
ed substantially while reducing the demand for rail transport
e. While this is only an example, and the analysis is simplified, this is es-
sentially what happened in the US when trucking was deregulated
5. Summary of the second-best problem in this example
a. It would be best to deregulate both
b. If that can't be done, it might be better not to deregulate either
G. Conclusion on the Second-Best Problem
1. The is no general theory of second best: Because many sectors deviate
from the Pareto-efficiency conditions, it may not improve efficiency to cor-
rect the condition in one sector
2. Implication: Policy proposals must be decided on a case-by-case basis and
preferably in a general equilibrium context
3. General consensus: In the absence of a case-by-case study, assume mar-
ginal cost pricing will improve efficiency except in those cases with closely
related sectors (like trucking and rail)

VIII. Our Approach to Market and Government Failure
A. Market Failure: Syllabus sections 5–8 deal with the most common (alleged)
market failures, but with readings in the public choice literature to provide a
counterpoint to the standard approach
B Government Failure: Dealt with briefly in Syllabus Section 9; also, Sections 11
and 12 deal with government failure in taxation and redistribution policies