Lecture03 - Market Failure - Imperfect Competition

CHAPTER THREE
3 BEC 310: Public

Finance
Market Failure: Imperfect

Competition
In this chapter……
 Introduction
 Imperfect Competition
 Monopoly
 Two-Part Pricing
 Policies Towards Monopoly
 Cross subsidisation and Ramsey Pricing
 Patents
 Application: Corruption
 Cournot Oligopoly
1-2
Introduction
 Very often, the market does not generate Pareto

optimal outcomes in these scenarios, and we
can therefore identify causes of market failure.
 Economists speak of market failure when the
market fails to deliver a Pareto optimal
outcome.
 The perfectly competitive model is nothing
more than a theoretical nicety, a normative
ideal against which real world conditions can
be judged.
1-3
Introduction
 Perfect competition does not apply in most real

world situations, Pareto optimality can be
regarded as an ideal state.
 The inability of the economy to achieve a Pareto
efficient allocation is what is known as market
failure.
 In other words, market failure is the inability of
the market economy to reach certain desirable
outcomes in resource allocation.
1-4
Introduction
 These desirable outcomes are basically

efficiency and equitable outcomes.
 If the market economy is unable to ensure these
outcomes, we have market failure.
 Market failure is widespread in developing
countries because in these economies, goods
and factor markets are in a state of
disequilibrium leading to inefficiency in the
allocation of resources.
1-5
Introduction
 Goods markets are characterised by shortages

and surpluses, while factor markets
exhibit high levels of unemployment and
capital scarcities.
 In most cases the market price does not reflect
the marginal costs of production.
 There are several sources of market failure that
will be discussed here.
1-6
Introduction
 Recall the conditions, under which the market

equilibrium outcome is a Pareto optimal
allocation.
 We will discuss monopoly, externalities, public
goods and asymmetric information and see
what happens when we make alternative
assumptions.
 Very often, the market does not generate Pareto
optimal outcomes in these scenarios, and we
can therefore identify causes of market failure.
1-7
Introduction
 Economists speak of market failure when the

market fails to deliver a Pareto optimal
outcome.
 There are many causes of market failure but
we discuss the major ones:
 Imperfect competition
 Public goods
 Externalities
 Asymmetric information.
 We start our analysis of market failure with

the case of imperfect competition.
1-8
Market Failure: Imperfect Competition
 In the beginning, we will look at markets in

which only one firm is active as a monopolist.
 Similar effects are also present when there are
large few firms, so-called oligopoly markets.
 To analyse such markets, we need some
knowledge of game theory.
 Game theory is also very useful as a tool for the
analysis of other types of market failure.
1-9
 3.1 Monopoly
 A monopolist knows that the quantity he
chooses to sell has an effect on the price that he
can charge or vice versa.
 The inverse demand function is the function
that we interpret graphically as the consumers'
marginal willingness to pay for an additional
unit of the good, and is formally a function
P(x), where x is the quantity sold.
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 3.1 Monopoly
 The simplest form for P(x) is that this function
is linear, P(x) = a – bx.
 This means that the highest willingness to pay
is a, and to sell one more unit of the good, the
sale price must be decreased by K b.
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 3.1 Monopoly
 If marginal revenue were larger than marginal
cost, then the firm could still increase its profit
by selling more units.
 Further, if marginal revenue were smaller than
marginal cost, then the firm can increase its
profit by reducing its output.
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 3.1 Monopoly
Figure 3.1
1 - 18
 3.1 Monopoly
 What is the welfare effect of monopoly?
 In a market with perfect competition, the
quantity and price are determined by the
intersection of demand and supply (= marginal
cost) curve, point b in Figure 3.1.
 A monopolist reduces the quantity sold in
order to increase the price that he can charge.
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 3.1 Monopoly
 Consequently, units of the good that should be
produced from a social point of view are not
produced.
 This is because the benefit that they create, measured by the
marginal willingness to pay for that unit, is larger than the
marginal cost.
 The welfare loss is therefore given by the net
welfare that the units that are not produced
could have created, measured by the triangle
abc.
1 - 20
 3.1.1 Monopoly: Two-Part Pricing

 Sometimes, monopolists are able to use a
technique that is called two-part pricing to
increase their profit.
 To see how this works, suppose that the
demand curve represents the marginal
willingness to pay of a single customer for
different quantities of the good.
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 Rather than charging the monopoly price as in
Figure 3.1, suppose that the monopolist charges
a marginal price equal to its marginal cost,
evaluated at the efficient quantity.
 In addition, the monopolist also charges a fixed
fee for the “right to buy" at these lower prices.
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 In fact, as the number of units traded is the same
under two-part pricing as under perfect
competition, social welfare in these two cases is
also the same.
 A precondition for the use of two-part pricing is
that the monopolist is able to prevent resale
from one customer to another.
1 - 24

 If resale is possible, then consumers would have
an incentive to buy only one “membership" to
be able to enjoy a low marginal price, and resell
the good among each other.
 Hence, two-part pricing is observed in practice
when firms can prevent resale:
 For example, phone companies can offer two-part pricing
because it is very hard (or inconvenient) for a customer to
resell telephone services to some other customer.
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 3.1.1 Monopoly: Price Discrimination

 For example, the first of these inequalities, IC
H, says that the net utility that a high demand
type can get from buying the bundle designed
for him must be at least as large as the net
utility he could get by buying the bundle
designed for low demand types.
 This is because, if it is lower, than high demand types would just
pretend to be low demand types, and nobody would buy the high
demand bundle.
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 If a constraint is satisfied as a strict inequality in
the optimal solution, then it is certainly “not
binding":
 It can be ignored without changing the solution.
 The reverse is not necessarily true.
 A constraint may hold as equality, but if one

were to drop it from the optimisation problem,
the solution would not change.
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 Therefore, we can drop (PC H) from the
optimisation problem without having to worry
that the solution of this relaxed optimisation
problem could violate (PC H).
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1 - 38

 If both (PC H) and (PC L) do not bind, this
action is feasible, but since it increases profit, it
implies that the initial situation was not an
optimum.
 This contradiction proves that (PC L) must be
binding in the optimum.
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 It is intuitive, but hard to show ex-ante that the
last constraint, (IC L) is not binding, as we do
not think that low demand types disguising as
high demand types is a likely problem to arise.
 We can add the left-hand side and the right-
hand side of (IC H) to the respective sides of
(IC L).
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 The first result is called “No distortion at the
top."
 The “top" type receives a bundle that has the
socially optimal quantity.
 This is a quantity where the high types
marginal willingness to pay for the last unit is
just equal the marginal cost of producing the
last unit.
1 - 46

 The second result, says that the “bad" (low
demand) type gets a smaller quantity than in
the social optimum.
 Note that the marginal willingness to pay of
low types, 8 –2q, is equal to the marginal cost of
2 at q = 3, so this is the socially optimal quantity
for low-demand types.
1 - 47

 Intuitively, providing the socially optimal
amount for the bad type would be optimal for
the monopolist's profit from the bad market.
 However, it also makes it more attractive for
good types to pretend that they are bad types,
and therefore reduces the profit that the
monopolist can get from high-demand types.
1 - 48

 The more units are sold to low-demand types,
the higher is the rent that must be left to high-
demand types, and thus, the profit from selling
to high-demand types goes down.
 The optimal trade-off between these two effects
for the monopolist occurs at quantity that is
lower than the efficient level for low-demand
types.
1 - 49
 3.1.2 Policies Towards Monopoly

 Above, we have seen that a profit maximising
monopoly chooses an output level that is too
small from a social point of view.
 We now ask, “What can the government do to
correct this?”
1 - 50

 In principle, there are three possible solutions:
 Subsidise the monopoly.
 Regulate the monopoly.
 Institute an anti-trust legislation
 We briefly explain each of these in turn so that

we see how the solutions are implemented.
1 - 51

 Subsidise the Monopoly
 In Figure 3.2, we see a case where a monopoly
is subsidised.
 If the state subsidises the marginal cost, the
profit maximising quantity, and hence welfare,
increases.
 In Figure 3.2, a subsidy s is paid for every unit,
so that the effective marginal cost curve shifts
down.
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 Note, however, that this way to correct the
allocation is very expensive for the
government.
 It may not, politically, be feasible to subsidise a
firm that makes a big profit anyway, even if
this is desirable from a welfare point of view.
1 - 56

 Regulate the Monopoly
 The state can attempt to regulate monopolies.
 This approach is very often taken when it
would not be possible or reasonable to foster
competition between several firms.
 More specifically in the case of natural
monopolies.
1 - 57

 Regulate the Monopoly
 The regulatory approach is often to determine
a price that the firm may charge, that is
sufficient to cover fixed costs, but below the
profit maximizing price.
 Often, regulation is also used together with a
subsidy for the firm's fixed cost.
 For example, railroad companies very often receive subsidies from the state in
exchange for lower ticket prices for consumers.
 Farmers?
1 - 58

 Anti-Trust Legislation
 Even if competition is feasible, competing firms
have an incentive to collude with each other in
order to keep prices high and make higher
profits.
 The state should protect consumers and
prevent the formation of cartels.
 In Zambia, the CCPC is charged with anti-trust
enforcement.
1 - 59
 3.1.3 Cross Subsidisation and Ramsey Pricing

 In many cases, the state operates a monopoly as
a semi-independent entity.
 In principle, the state could let the firm run a
deficit and cover it from general tax revenue.
 In practice, politicians are usually reluctant to
let the firm accumulate a large deficit and
therefore, often require that the firm breaks
even over all its business lines.
1 - 60

 When a firm produces two (or more) different
products, then the question arises how should
we set the prices of the two products such that
we maximise total welfare?
 This is subject to the constraint that the firm has
to recover its cost.
 This problem is known as Ramsey pricing.
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1 - 66

 Intuitively, why should the relative mark-up be
higher in the less elastic market?
 In the less elastic market, more revenue can be
raised relative to the welfare loss associated with
too high prices.
 Try to draw a very steep, hence inelastic, demand
curve and consider the effects of a price increase
over the marginal cost.
1 - 67

 The deadweight loss triangle is small, because
the quantity reaction is small in the case of
inelastic demand.
 On the other hand, consider a very at, that is,
very elastic, demand curve.
 Here, a price increase by the same amount
results in a much larger welfare loss triangle,
because the quantity reaction is larger.
1 - 68

 In addition, increasing the price in the elastic
market will also raise less revenue than
increasing the price in the inelastic market.
 Suppose that the quantity sold would be the
same in both markets, if both goods were priced
at marginal costs; then the quantity sold in the
inelastic market is larger than the quantity in the
elastic market, for the same mark-up.
1 - 69
 3.1.4 Patents
 While monopolies are generally bad for social
welfare, there is one particular instance in which
the state prevents entry into the market, even
though competition in the market would be in
principle feasible.
 With a patent, an inventor gets the exclusive
right to use his invention for some time.
 Read more on your own!
1 - 70
 3.1.5 Application: Corruption

 A nice application of techniques from the
analysis of monopoly is to corruption.
 This is based on ideas in the paper “Corruption"
by Vishny and Shleifer (1993).
 Suppose that there is some government activity,
like giving a building permit, issuing a passport
etc. for which the demand curve is given.
1 - 71

 Let us suppose it is by x = 120 – 2p, so that the
marginal willingness to pay is 60 – 1/2x.
 While there is no cost of production, the access
to the service is controlled by some government
official(s) who set a “price" (i.e. bribe) for the
service.
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 Suppose first that there is a strictly organised
system of corruption in which one government
official sets a price.
 (a) Set up the official’s revenue maximisation
problem.
 (b) Determine the price that the government
official charges and the number of units sold.
 (c) Determine the total welfare generated in this
market.
1 - 73

 Consider now what happens if there are two
government officials who are necessary to
receive the service and who operate
independently.
 For example, suppose that in order to operate a
shop, a police permit and a tax authority
identification number are necessary, and both
are sold separately.
1 - 74

 Note that there is no point in just buying one of
these items, the buyer needs both in order to be
able to operate.
 Consequently, the buyer considers the sum of
the two prices and compares it to his
willingness to pay.
 (a) Formulate the new demand function.
 (b) Determine the total price that a citizen has to
pay in order to operate a shop.
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 (b) Determine the number of units sold by the
two government officials.
 (c) Determine the total welfare generated in this
market
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 Note that:
 A “strictly organised" corrupt society in which
only one official sets a price for the government
service generates a higher welfare for society
 than a system in which several agents all set
prices independently.
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 The reason is that each of these independent
agents exerts a negative externality on the other
one when he increases his own price.
 This is because a price increase by agent 1 does
not only decrease the demand for permits that
agent 1 faces, but also the demand for agent 2's
permits (and vice versa).
1 - 78

 When deciding how to set his price, agent 1
ignores his negative effect on agent 2's business.
 Therefore, agent 1 sets his price too high even if
one only considers the profit of the bribed
bureaucrats.
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 Of course, from the consumers' point of view, a
single monopolistic bureaucrat is far from
optimal.
 But still, a unitary bureaucratic bribing system
is much better than several independent
agencies.
1 - 80
 3.2 Cournot Oligopoly

 As mentioned before, similar effects are also
present when there are large few firms, called
oligopoly markets.
 To analyse such markets, we need some
knowledge of game theory.
 Game theory is also very useful as a tool for the
analysis of other types of market failure.
1 - 81

 Under the subject of imperfect competition, one
of the most influential oligopoly models was
already developed in the first half of the 19th
century.
 The French economist Auguste Cournot
developed the model under the following
conditions:
 Two firms (1 and 2) with constant marginal costs c, and no
fixed costs.
 The firms produce a homogeneous good.
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 Because the price is always equal to the
marginal willingness to pay of the last customer
(i.e., is equal to the function P(.), evaluated at the
quantity sold).
 A higher quantity implies that the market price
is lower in oligopoly than in monopoly.
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 Since a > c in any active market.
 That is, the highest willingness to pay of a
customer is larger than the marginal production
cost if this were not true, then no customer
would ever be willing to pay a price necessary
to induce some firm to produce.
 The price is higher in monopoly than in
oligopoly.
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 Thus, we can think of perfect competition as the
limit case of imperfectly-competitive markets
when the number of firms gets very large.
1 - 96
 Do it yourself:
 At this point, I would recommend the review of
Game Theory, which will be necessary in the
next topic.
1 - 97
END
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Lecture03 - Market Failure - Imperfect Competition

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CHAPTER THREE

3 BEC 310: Public

Market Failure: Imperfect

 Very often, the market does not generate Pareto

 Perfect competition does not apply in most real

 These desirable outcomes are basically

 Goods markets are characterised by shortages

 Recall the conditions, under which the market

 Economists speak of market failure when the

 We start our analysis of market failure with

 In the beginning, we will look at markets in

 3.1.1 Monopoly: Two-Part Pricing

 3.1.1 Monopoly: Two-Part Pricing

 3.1.1 Monopoly: Two-Part Pricing

 3.1.1 Monopoly: Two-Part Pricing

 3.1.1 Monopoly: Price Discrimination

 3.1.1 Monopoly: Price Discrimination

 A constraint may hold as equality, but if one

 3.1.1 Monopoly: Price Discrimination

 3.1.1 Monopoly: Price Discrimination

 3.1.1 Monopoly: Price Discrimination

 3.1.1 Monopoly: Price Discrimination

 3.1.1 Monopoly: Price Discrimination

 3.1.1 Monopoly: Price Discrimination

 3.1.1 Monopoly: Price Discrimination

 3.1.2 Policies Towards Monopoly

 3.1.2 Policies Towards Monopoly

 We briefly explain each of these in turn so that

 3.1.2 Policies Towards Monopoly

 3.1.2 Policies Towards Monopoly

 3.1.2 Policies Towards Monopoly

 3.1.2 Policies Towards Monopoly

 3.1.2 Policies Towards Monopoly

 3.1.2 Policies Towards Monopoly

 3.1.3 Cross Subsidisation and Ramsey Pricing

 3.1.3 Cross Subsidisation and Ramsey Pricing

 3.1.3 Cross Subsidisation and Ramsey Pricing

 3.1.3 Cross Subsidisation and Ramsey Pricing

 3.1.3 Cross Subsidisation and Ramsey Pricing

 3.1.5 Application: Corruption

 3.1.5 Application: Corruption

 3.1.5 Application: Corruption

 3.1.5 Application: Corruption

 3.1.5 Application: Corruption

 3.1.5 Application: Corruption

 3.1.5 Application: Corruption

 3.1.5 Application: Corruption

 3.1.5 Application: Corruption

 3.1.5 Application: Corruption

 3.2 Cournot Oligopoly

 3.2 Cournot Oligopoly

 3.2 Cournot Oligopoly

 3.2 Cournot Oligopoly

 3.2 Cournot Oligopoly

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