KEGAGALAN PASAR

BARANG PUBLIK
Review: Pareto optimality

• That is, the conventional theory sets out the

conditions for the functioning of efficient markets in
the absence of government, as well as the reasons for
departures from these efficiency conditions.
This approach is entirely neoclassical in its orientation,
with its overriding emphasis on the efficiency of
resource allocation.
Pareto optimality is defined as an allocation of
resources such that no individual can be made better
off without another person being made worse off.
• There are three necessary conditions for
Pareto optimality:
1. efficiency in consumption,
2. efficiency in production and
3. optimal allocation of output.
• Under perfect competition, these conditions are
satisfied when the following rules are applied:

1. The marginal rate of substitution (MRS) between

two goods must be the same for the two consumers
who buy those goods. That is, MRS1xy = MRS2xy
where x and y denote the two goods and the
superscripts denote the first and second consumer.
2. The marginal rates of technical substitution (MRTS)
between two factors of production, must be the
same in the production of goods x and y. That is,
MRTSxlk = MRTSylk
where l denotes labour and k denotes capital.
3. The marginal rate of transformation (MRT) for
goods x and y must equal the MRSxy for the two
consumers, the MRTSlk and the price ratio. That is,
MRTxy = MRS1xy = MRS2xy = MRTSlk = Px / Py
• These marginal conditions are based on static
assumptions and full employment of the
factors of production. Pareto optimality also
ignores the income distribution. The inability
of the economy to achieve a Pareto-efficient
allocation is known as market failure.
Market Failure
• Market failure is said to exist when the Pareto
optimality conditions break down. That is,
- consumers can no longer equalize their
marginal rates of substitution (MRSA ≠ MRSB or
MRS1xy ≠ MRS2xy ), and
- producers offer goods for sale at prices higher
than the marginal costs of production (P > MC).
• Market failure is widespread in developing
countries. In these economies goods and factor
markets are in a state of disequilibrium leading
to inefficiency in the allocation of resources.
Goods markets are characterized 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.
Sources of Market Failure
1. Imperfect Competition
Imperfect competition is a cause of market
failure. Under this market structure the firm
faces a downward-sloping demand curve for
its product. Marginal revenue diverges from
average revenue and price no longer equals
marginal cost (P > MC).
• In this scenario a monopolist charges a price that
exceeds marginal cost, in order to maximize profit.
This leads to an output which is much lower than
produced by the perfectly competitive firm,
operating under similar cost conditions. The
consumer has no sovereignty in terms of resource
allocation under monopoly. The operation of the
monopolist is said to be inefficient because it leads
to a less than optimal allocation of resources.
2. Public Goods and Externalities
Public goods are those goods and services which exhibit
the characteristics:
- non-rivalry in consumption, and
- non-excludability.
The literature makes the distinction between pure and
impure public goods. The latter exhibits partial rivalry in
consumption. Public goods include defence, national
parks, weather advisories, agricultural extension
services and so forth.
• Non-rivalry in consumption implies that one
persons consumption of the good does not reduce
the utility of the good to others. Non-excludability
means that it is impossible to exclude any persons
from benefiting from the good, as long as the good
is available. These two conditions imply that the
market will not be able to provide the goods or
services efficiently, since markets function by
excluding individuals who cannot pay for the good.
• Public goods such as publicly funded medical
research and education are a source of positive
externalities. Pollution is the classic case of
negative externalities. The market or the price
system cannot reflect these external costs and
benefits. This provides a rationale for government
intervention, either to promote positive
externalities or regulate negative externalities.
• The formal analysis of public goods began with
Samuelson (1954).
The private sector’s inability to provide efficient
quantities of public goods is most easily understood
by examining Samuelson’s concept of a pure public
good. Samuelson defined a pure public good to be
one that is both non-rivalrous and nonexcludable.
Private provision of a pure public good is inefficient
because people are able to “free ride,” that is, use
the good without paying for it.
• New firms are created in the expectation that they
will earn profits for their owners. These firms
undertake an initial capital investment (to set up a
production facility, open an office, or acquire
necessary tools and equipment), after which they
offer a good or a service to the public in return for
some fee. A firm will be set up only if the firm’s
revenues are expected to be high enough to allow the
firm to recover both its variable costs of production
and (slowly, over time) its initial capital outlay.
• Under these “rules of the game,” private firms
would never provide pure public goods. Access
to a public good cannot be restricted or
blocked, so people cannot be charged for
access. A firm offering access to public goods
would earn no revenue, and therefore would
be unable to recover its initial capital outlay or
cover its variable costs.
• When a public good is provided, it can be
consumed collectively by all households. Such
collective consumption violates the assumption of
the private nature of the goods in the Arrow-
Debreu competitive economy. The existence of
public goods then leads to a failure of the
competitive equilibrium to be efficient. Such failure
implies a potential role for the state in public good
provision to overcome the failure of the market.
• A public good can be distinguished from a
private good by the fact that it can provide
benefits to a number of users simultaneously
whereas a private good can, at any time, only
benefit a single user. If the public good can
accommodate any number of users then it is
said to be pure.
• The pure public good has been the subject of most of
the economic analysis of public goods.
A pure public good has the following two properties.
1. Non-excludability. If the public good is supplied, no
household can be excluded from consuming it
except, possibly, at infinite cost.
2. Non-rivalry. Consumption of the public good by
one household does not reduce the quantity
available for consumption by any other.
• The implication of non-excludability is that
consumption cannot be controlled efficiently
by a price system since no household can be
prevented from consuming the public good if it
is provided.
• From the property of non-rivalry it can be
deduced that all households can, if they so
desire, simultaneously consume a level of the
public good equal to its total supply.
DEMAND FOR PUBLIC GOODS

• Most textbooks compare in some detail the demand for

public goods with the demand for private goods using
partial-equilibrium analysis. The demand for private
goods is based on the competitive market clearing
model where market demand is found by summing
horizontally the individual demand curves. A single
equilibrium price prevails on the market, and consumers
have different effective demands for the good. Goods
are assumed to be divisible and the price mechanism
can exclude individuals who are unable to pay.
• Public goods, as we have seen, are subject to the non-
excludability principle. The demand for public goods is
found by adding the demand curves vertically. The
demand curves reflect consumers' willingness to pay a
particular tax price for the public good. Samuelson has
described these curves as "pseudo-demand curves" or
"marginal rates of substitution curves", because they
assume that each person reveals his willingness to pay
for the output of the public good. Equilibrium is found
when the total willingness to pay equals the tax price of
the public good.
• This equilibrium therefore reflects the summation of the
marginal rates of substitution which is equal to the marginal
rate of transformation. In a real world situation, the
estimation of "pseudo-demand curves" in the large group
case would require considerable information which it may be
impossible to provide. Estimation of demand is compounded
by the free-rider problem which arises when individuals do
not reveal their preferences, but still consume the public
goods. It is difficult to force all individuals to reveal their true
preferences. Sometimes compulsory taxation is necessary to
finance the provision of the public good.
OPTIMAL PROVISION OF PUBLIC GOODS

• Samuelson (1955) advanced a model of the

optimal provision of public goods, which was a
neoclassical formulation influenced by the
earlier work of Wicksell and Lindahl.
Samuelson argued that in he two-good case
where one good is public, efficient allocation
requires that
• MRS1xg + MRS2xg = MRTxg
where x = private good
g = public good

• This is compared to Pareto optimality for private

goods which requires that

• MRS1xy + MRS2xy = MRTxy

  where x and y are private goods.
3. Institutional Failure
Gillis, Perkins and Roemer (1992) have identified
institutional failure as a leading cause of market failure
in developing countries. This is based on the view:
- that under-developed institutions exclude many
persons from the market.
- money and capital markets are small and under-
developed, and are inefficient mobilizers of savings.
- further, money markets in these countries do not
respond quickly to interest rate signals.
4. Information Failure
Perfect competition, which guarantees Pareto
optimality, assumes perfect knowledge of goods and
prices in the market. In many developing countries
consumers and workers have incomplete knowledge
of goods and services and job opportunities. Gillis,
Perkins and Roemer (1992: 104) indicate that
investors, producers and traders are unable to hedge
against risks because financial, commodity, and
insurance markets are under-developed or missing.
• A reduction in market inefficiency can be
achieved if government intervenes to provide
the infrastructural facilities to ensure the
development of money and capital markets.
Some developing countries have pursued the
policy of liberalizing inefficient markets.
Sumber
Howard, Michael. 2001. Public Sector Economics
for Developing Countries. University of the
West Indies Press. Jamaica
Leach, John. 2004. A Course in Public
Economics. Cambridge University Press
Myles, Gareth D. 2001. Public Economics.
Cambridge University Press.