Economics of the Public Sector

Lecture 3: Market Failure

Alfa Farah

Department of Economics
Diponegoro University

The 2nd Semester of 2019/2010

Market Efficiency

Focus Questions
I What are the principal reasons why market fail to produce
efficient outcome?
I What role does government play in making it possible for
markets to work at all?
I Why might government intervene in the markets allocation of
resources, even when it is Pareto efficient? What are merit
goods? What is government role in distribution?

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 I Under certain conditions, the competitive market results in a
Pareto efficient resource allocation.
I When the conditions required for this are not satisfied, a
rationale for government intervention in the market is
provided.
I Government is required to establish and enforce property
rights and enforce contracts. Without this, markets by
themselves cannot function.
I Government activities aimed at protecting citizens and
property, enforcing contracts, and defining property rights can
be thought of as providing the foundation on which all market
economies rest.

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Market Failures

Six basic market failures

1. Imperfect competition
2. Public goods
3. Externalities
4. Incomplete markets
5. Imperfect information
6. Unemployment and other macroeconomic disturbances

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Imperfect competition

I For markets to result in Pareto efficiency, there must be

perfect com-petition; that is, there must be a sufficiently large
number of firms that each believes it has no effect on prices
I However, in some industries, there are alternative forms of
market structure, such as monopoly, oligopoly or monopolistic
competition
I In those imperfect market structure, there is still competition.
I However, Pareto efficiency requires three basic conditions that
are typically are satisfied only if each firm and household
believes that it has no effect on price

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1. Imperfect competition
Reasons why competition may be limited

I A natural monopoly
I High transportation costs mean that goods sold by a firm at
one location are not perfect substitutes for goods sold at
another location
I Firms may also engage in strategic behavior to discourage
competition. They may threaten to cut prices if potential
rivals enter; such threats may both be credible and serve to
discourage entry
I Some imperfections of competition arise out of government
actions (e.g. Governments grant patents—exclusive rights to
an invention—to innovators)

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2. Public Goods
Public Goods Some goods either will not be supplied by the market
or, if supplied, will be supplied in insufficient quantity. An example
on a large scale is national defense; on a small scale, navigational
aids (such as buoys).

Properties of Public Goods

1. It costs nothing for an additional individual to enjoy their
benefits: for-mally, there is zero marginal cost for the
additional individual enjoying the good.
2. It is, in general, diffi cult or impossible to exclude individuals
from the enjoy-ment of a pure public good.

The fact that private markets will not supply, or will supply too
little of, public goods provides a rationale for many government
activities.

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3. Externalities
I In many cases, the actions of one individual or one firm affect
other indi- viduals or firms,
I Positive Externalities One firm/individual imposes a cost on
other firms but does not compensate them
I Negative Externalities When one firm/individual confers a
benefit on other firms but does not reap a reward for providing
it
I Whenever such externalities exist, the resource allocation
provided by the market will not be efficient.
I Because individuals do not bear the full cost of the negative
externalities they generate, they will engage in an excessive
amount of such activities (e.g Without government
intervention of some kind, the level of pollution would be too
high) or
I Because individuals do not enjoy the full benefits of activities
generating positive externalities, they will engage in too little
of these.

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4. Incomplete Markets

I Pure public goods and services are not the only goods and
services that private markets fail to provide adequately
I Whenever private markets fail to provide a good or service
even though the cost of providing it is less than what
individuals are willing to pay, there is a market failure called as
incomplete markets (because a complete market would
provide all goods and services for which the cost of provision
is less than what individuals are willing to pay)
I Example: some economists believe that private markets have
done a particularly poor job of providing insurance and loans,
and that this provides a rationale for government activities in
these areas. The private market does not provide insurance/
loans for many important risks that individuals face

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4. Incomplete Markets
Why capital and insurance markets are imperfect?

Why capital and insurance markets are imperfect?

I Innovations
I There is often an undersupply of innovations, which is why
there is an important role for government in research
I Transaction costs
I It is costly to run markets, to enforce contracts, and to
introduce new insurance policies. An insurance firm may be
reluctant to go to the trouble of designing a new insurance
policy if it is unsure whether anyone will buy the policy, or if
even if the product is successful, whether it will be able to reap
the rewards as other competitors come into the market
I Asymmetries of information and enforcement costs
I The insurance company is often less informed about the nature
of some risks than the person purchasing insurance
I In capital markets, lenders worry about getting repaid. They
may not be able to tell which borrowers are likely to repay.

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4. Incomplete Markets
The absence of certain complementary markets

Example:
I Suppose all individuals enjoy only coffee with sugar.
I Assume, moreover, that without coffee there is no market for
sugar.
I Given that sugar was not produced, an entrepreneur
considering whether to produce coffee would not do so,
because he would realize that he would have no sales.
I Likewise, given that coffee was not produced, an entrepreneur
considering whether to produce sugar also would not do so,
since she too would realize that she would have no sales
I Without coordination, no coffe or sugar would be produced
I In less developed countries, large-scale coordination is
required; this may require government planning.

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5. Information Failures

I A number of government activities are motivated by imperfect

information by the belief that the market, by itself, will supply
too little information.
I In fact, much economic activity is directed at obtaining
information, from employers trying to find out who are good
employees, to lenders trying to find out who are good
borrowers, investors trying to find out what are good
investments, and insurers trying to find out who are good
risks.

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Unemployment and other macroeconomic disturbances

I Most economists take the high levels of unemployment as

prima facie evidence that something is not working well in the
market. To some economists, high unemployment is the most
dramatic and most convincing evidence of market failure.

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Interrelationship of Market Failures

The market failures we have discussed are not mutually exclusive.

Information problems often provide part of the explanation of

missing markets. In turn, externalities are often thought to arise
from missing markets, for instance: if fishermen could be charged
for using fishing grounds—if there were a market for fishing
rights—there would not be overfishing. Public goods are
sometimes viewed as an extreme case of externalities, where others
benefit from my production of the good as much as I do. Much of
the recent research on unemployment has attempted to relate it to
one of the other market failures.

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Further Grounds for Government Role

Even if the market is Pareto efficient, there may be two further

grounds for government action
1. Competitive market may give rise to a socially undesirable
distribution of income
I One of the most important role of government is to
redistribute income (such as Kartu Pintar and Kartu Sehat)
2. Some believe that individuals, even when well informed, do
not make good judgments concerning the goods they
consume, thus providing a rationale for regulations restricting
the consumption of some goods, and for the public provision
of other goods, called merit goods(Goods that the
government compels individuals to consume, like seat belts
and primary education)

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Two View on Government Intervention

1. Paternalism: the government should intervene because it

knows what is in the best interest of individuals better than
they do themselves
I Government policies toward drugs
I The paternalism differ from the externalities argument.
Example: Smoking causes cancer, and that individuals who get
cancer may be treated in public hospitals (financed by public
funds), smokers impose a cost on nonsmokers. This can be
dealt with by making smokers pay their full costs such a tax on
cigarettes (Externalities argument). The paternalism instead
argues that individual should not be allowed to smoke
2. Libertarianism: the government should respect consumer’s
preferences
I Caveat: Special interest groups might use government to
further their own views about how individual should act or
what should they consume

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Further Grounds for Government Role

I Even though the presence of market failures implies that there

may be scope for government activity, it does not imply that a
particular government program aimed at correcting the market
failure is necessarily desirable. To evaluate government
programs, one must take into account not only their
objectives, but also how they are implemented
I To evaluate government program we can use two analysis
I The normative approach to the role of government asks: How
can government address market failures and other perceived
inadequacies in the market’s resource allocation?
I The positive approach asks: What is it that the government
does, what are its effects, and how does the nature of the
political process, including the incentives it provides
bureaucrats and politicians, help explain what the government
does and how it does it?

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