Microeconomics

Failure to Achieve Pareto Efficiency

04/01/13

Microeconomics (EIM3232)

What is Market Failure?

Market failure exists when one or more of the efficiency conditions is not satisfied

MSB( MRS ) MSC ( MRT )

Points B & C indicate market failure Distributional failure may also occur Causes are monopoly, externalities (incl. public goods), uncertainty, & imperfect information

Market Failure

Units o f Wine

A B

CIC1 CIC2
Units of Bread

Units of Wine given up

MSC(MRT)

MSB(MRS)
Units of Bread

Increasing Returns/Monopoly
Increasing returns to scale imply declining LRAC This can lead to natural monopoly Barriers to entry can also create and maintain monopoly power Monopoly generates allocative inefficiency

Externalities
Direct effects on utility or output by consumption/production activities of others for which no price is paid Positive (benefits) & negative (costs) externalities Examples: pollution, environmental degradation, education & training

Why do externalities arise?

Jointness in consumption and production Lack of clearly defined property rights
e.g. common property

Property rights not enforceable

How do they cause market failure?

Divergence between private and social costs and benefits Rational agents act only on private costs/benefits Hence market outcome is not Pareto optimal

Externalities
MSC S(MPC) S(MSC)

P* P

P* P
D(MSB)

MSB

D(MPB)

Q* Q

Q Q*

 Private bargaining/negotiation can remove inefficiency by internalising the externality Most likely when Coases Theorem
potential gains, well defined property rights, few agents affected, low transaction costs

Private Market Solution

Whoever is assigned the property rights does not matter, as long as property rights are clearly defined and enforced, bargaining between parties ensures an efficient outcome Simply assigning property rights will not solve all externality problems (example river many people to negotiate with)
Distributional effects depends on the exact definition of property rights (Example of a farmer)

Assigning property rights can solve externality when there are small numbers of parties involved, but not as readily when there are large numbers due to the free rider problem

Whenever the effects are nonrival over a large group and exclusion is not feasible, the free-rider problem hinders the process of achieving agreement among all concerned Negotiation process costly and time consuming no pollution, but inefficient solution (PIDCO-Caprivi)

Government Policies
Taxation
to reduce production/consumption

Subsidy
to increase production/consumption

Regulation Public Production

Public Good
Public goods are goods which benefit all consumers, such as national defense A public good will be undersupplied by the market when consumers cannot be excluded from sharing in its benefit There is no incentive to pay for its production Even a public good is worth more to people than it costs to produce, private markets may fail to provide it When public good or externalities lead markets to generate an inefficient allocation of resources, government can intervene
(Note the problems associated with government intervention Rent controls)

What are public goods?

Does not necessarily refer to a good provided by government Economist define public good by its characteristics A good is nonrival in consumption (street lights) Public good is non-exclusion
Simultaneous consumption by many persons Cannot exclude others from benefiting A person benefits whether they pay or not

Free-Rider problem (Dam construction example)

Incentive to understate what the dam is real worth to them Free-Rider problem increases with the size of the group involved

Efficiency in the production of a public good What is efficient output of a public good?
Marginal benefits vs. marginal cost associated with the different levels of output
The opportunity cost of using the resources The marginal benefit of producing an additional unit of a burger is the value of the burger to a single person who consumes it (private) Public good such as defence, marginal benefit is not the marginal value to any one person alone
People benefit simultaneously from same unit

Therefore we must add the marginal benefits of every person who values the additional unit of defense The resulting sum indicates the combined willingness of the public to pay for more defence that is its marginal benefit

In general, the efficient output of Assume only 2 people benefit (Ted and Jane) a public good occurs where Ds, Their demand curve represented by obtained by vertical summing the dt and dj from their indifference demand curves for all consumers, curves the marginal cost curve summation Vertical Height of demand curve shows benefit intersect of a unit Add the marginal benefits of the 2 to N$ per tanks derive marginal social or combined demand curve (vertical summation) N$650 Teds N$400 benefit is added to Janes N$250 for social benefit of N$500 MC N$650 for the 1st tank Output level where Ds lies above the N$400 Ds marginal cost curve MC (Horizontal N$325 dt for simplicity) Ted and Jane willing to pay more for N$250 N$175 an additional unit than its marginal dj cost Efficiency require a high output When MC is lies above Ds too much 1 10 Tanks of public good demanded (combined marginal benefit is less than marginal cost

Deriving social marginal benefit

 There is no presumption that this output will be the actual, or equilibrium output The free-rider problem will generally mean that private markets will not produce an efficient output Government financing of a public good overcomes one aspect of the free-rider problem (the tendency of people to withhold payment) Another aspect of free-rider problem that is not overcome by government financing, is that people have no incentive accurately reveal their demands for the public good especially when they will be taxed commensurate to the benefit they report receiving Determining efficient output requires that we know every persons demand curve

Efficiency in Production and Distribution

In addition to an efficient level of output A second condition is that the output is be produced using the least costly combination of inputs Condition implicit in the figure for vertical summation, that N$500 is the minimum cost necessary to produce a tank Third condition relates to efficient distribution of the good among consumers So, how is public good rationed efficiently?

No rationing problem for public goods Due to simultaneous benefit It would be inefficient to exclude anyone even if we could

Nonrival, but exclusion possible

Patents legal monopoly Nonrival Its use cannot make someone else worse off Whether exclusion is possible depends on type of knowledge But its use can be prohibited if producing or selling its tangible embodiment is made illegal Patents encourage a greater, more efficient output of new knowledge, because inventors receive temporary monopoly right, to compensate for their research costs
illegal to manufacture and sell vaccine Knowledge of making an AIDS vaccine

Questions for thought

What two characteristics define a public good? Why will private markets produce an inefficient output of a public good? Explain how the efficient level of a public good is determined. Education is frequently cited as a source of external benefits. In what way, if at all will your receiving university education benefit other people? When public goods or externalities lead to inefficient resource allocation, government intervention is justified Is it? Why? From a public good perspective, critique the use of patents