Market Failure & Role of Regulation

RRS I ² What is a Regulation
Emergence of Broad Framework of Study Are we regulating or de-regulating? Feedback ± Market failures -> Regulation

Framework
Free Market Competitive Forces Market Efficiency

Market Failure

Regulation

Regulation

Equitable Distribution

Objective of Regulation ± Market Efficiency and Equitable Distribution

price takers Oligopoly   Few sellers Each participant is aware of the actions of the others Monopolistic   Goods/services are slightly differentiated Numerous sellers ± each seller has some ability to influence the price Monopoly   No substitute available for the goods/services offered Only one seller and this seller sets the price ± price maker .Free Market Competitive Forces Market Efficiency Types of Market Perfectly Competitive Market   Goods/services offered are all same Numerous buyers and sellers and no single buyer or seller can influence the market price .

Existence of an equilibrium for a competitive economy.Free Market Competitive Forces Market Efficiency Perfectly Competitive Market Free markets allocate  Supply of goods to the buyers who values them most  Demand for goods to the sellers who can produce them at least cost Free market produces the quantity of goods that maximizes the sum of consumer and producer surplus Competitive forces efficiently allocate the scarce resources (Arrow. Kenneth. 1954 ± Formal proof under which the market equilibrium is Pareto efficient) . and Debreu.

³ «while he intends only his own gain«he is «led by an invisible hand to promote an end which was no part of his intention«´ ± that is to maximize the wealth of the nation The competitive market guides and controls the self seeking activities of each individual to maximize the wealth of the nation. 1774) . Principles of Trade.Free Market Competitive Forces Market Efficiency The Invisible Hand Adam Smith stated in 1776. Laissez faire ± ³Allow them to do´ opposes state economic interventionism (George Whatley.

fail to deliver an efficient or optimal allocation of resources Therefore economic and social welfare may not be maximized This leads to a loss of economic efficiency . operating without government intervention.Market Failure Regulation What is a Market Failure Market failure occurs when freely functioning markets.

1992) . 2004) The concept of market failure initially appeared as a means of explaining in economic terms why the need for government expenditures should arise ± normative judgement about the role of government As it matured the market failure concept on an additional characteristics ± diagnostic tool by which policy makers learned how to objectively determine the exact scope and type of intervention (Weimer and Vining. Medema. nineteenth century classical economics ± harmonization of self interest and social interest. Henry Sidgwick mark a turning point in the literature of market failure (Steven G.Market Failure Regulation Brief History of Market Failure Preclassical economics ± primarily government regulation. neoclassical economics ± presence of market failures and government to act as an efficient coordinating force John Stuart Mill.

such as the perfect competition model´ .Market Failure Regulation Definition of Market Failure Market failure when the competitive outcome of markets is not efficient from the point of view of the economy as a whole This is usually because the benefits that the market confers on individuals or firms carrying out a particular activity diverge from the benefits as a whole ³a case in which a market fails to efficiently provide or allocate goods and services´ in comparison to some ideal standard.

Moral Hazards ± ignorant party lacks information about performance of the of the agreed upon transaction (Peltzman argument on insured driver taking more risks).Market Failure Regulation Main causes of Market Failure Externalities causing private and social costs and/or benefits to diverge Public goods and Common Resources Market dominance and abuse of monopoly power Imperfect Asymmetry   Adverse Selection ± Ignorant party lacks information while negotiating a transaction (Akerlof ± Lemon¶s Problem). Equity issues ± Markets can generate an unacceptable distribution of income and social exclusion .

Market Failure Regulation Market Failure due to Externalities Externalities create divergence between private and social costs and benefits Individual consumers and producers may fail to take externalities into account when making consumption and production decisions Consumers and suppliers are assumed to consider their own private costs and benefits .

Market Failure Regulation Market Failure due to Externalities Negative Externalities   Over production of goods where the social costs > private cost Over consumption of demerit goods where social benefit < private benefit Positive Externalities   Under consumption/provision of merit goods where the social benefit > private benefit Information failure may lead to under-consumption (individuals not fully aware of the benefits to themselves of consuming a merit good) .

Positive externalities lead markets to produce a smaller quantity than is socially desirable .Market Failure Regulation Market Failure due to Externalities Negative Externalities Positive Externalities Negative externalities lead markets to produce a larger quantity than socially desirable.

Market Failure Regulation Market Failure due to Public Good In the case of public goods and common resources. externalities arises because something of value has no price attached to it. 1954) . ³goods which will enjoy in common in the sense that each individual¶s consumption of such a good leads to no subtractions from any other individual¶s consumption of that good «´ (Samuleson.

Market Failure Regulation Market Failure due to Public Good Free market economy will fail to deliver the efficient quantity of public goods because of their characteristics  A problem arising from public goods is the free rider issue  People take a free ride when they benefit from consuming a good or a service without paying for the costs of provision Many goods have a public element but they are not pure public goods ± congested motorway  Common resources ± non excludable but rival ± example fishing etc Because people are not charged for their use of common resources. Garret Hardin 1968) . they tend to use them excessively (The Tragedy of Commons.

Market Failure Regulation Market Failure due to Market Power Monopoly ± A price maker compared to price taker of a firm in competitive market A firm is monopoly because of   It owns a key resources The government provide a single firm an exclusive right to produce some good or service ± patents and copyrights given by the government Provide incentive for research and creativity activity offset by the monopoly prices  Natural Monopoly .The costs of production make a single producer more efficient than a larger number of producers .

while the social planner would choose the quantity at which the demanded marginal cost curves intersect. Therefore the social loss from monopoly includes both these costs and the deadweight loss resulting from a price above marginal cost . The monopoly may also use some of its profit paying for its monopoly profits paying for these additional costs.Market Failure Regulation Market Failure due to Market Power Monopoly In a competitive firm ± price equals marginal cost while in the case of monopolized market price exceeds marginal cost Monopolist charges a higher price therefore earning a higher profit Also there is a deadweight loss implying that the monopolist produces less than the socially efficient quantity of output. Monopolist chooses to produce and sell the quantity of output at which the marginal revenue and marginal cost curve intersect.

electricity. water. Telecommunications. are some natural monopolies (Mankiw.Market Failure Regulation Market Failure due to Natural Monopoly High fixed costs of entering an industry which causes long run average costs to decline as output expands The marginal cost of producing one more unit is constant ± average cost declines as output increases over a much large range of output levels. 2007) . railways etc.

Market Failure Regulation Market Failure due to Oligopoly In reality a firm is neither perfectly competitive or monopoly in nature rather somewhere between. The group of oligopolists is best off co-operating and acting like a monopolist ± producing small quantity of output and charging a price above marginal cost ± cartel or collusion However the self interest is hindrance to co-operate (example of two prisoners) ± dominant strategy leading to Nash equilibrium which is less than what monopolist would make profit As the number of sellers in an oligopoly grows larger. . and the quantity produced approaches the socially efficient level Co-operation between oligopolists is undesirable from the standpoint of society ± to move the allocation of resources closer to social optimum. Oligopoly is a market with only a few sellers:     A key feature of oligopoly is the tension between co-operation and selfinterest. policy makers should try to induce firms in an oligopoly to compete rather than co-operate. an oligopolistic market looks more like a competitive market. The price approaches marginal cost.

Moral hazards are a result of information asymmetry Wiemer and Vining (1999) .Market Failure Regulation Market Failure due to Information Asymmetry (Principal Agent problem) Buyers and Sellers will have different information about the product¶s attributes In one instance when the consumer is less informed ± there will be a producer surplus but also a net loss to society Adverse Selection.

Market Failure Regulation Adverse Selection ² The Market for Lemons Finally the market for poor quality of cars only exist ± Good products and good customers are under represented while bad products and bad customers are over represented (Pindyck and Rubinfeld (2001) .

the more effective will be the threat of dismissal (Pindyck and Rubinfeld (2001) .Market Failure Regulation Moral Hazards ² Shirking of Workers The higher the current rate of unemployment. and the higher the wage paid over the market wage.

(Weimer & Vining. analysts attempt to identify both the precise type of problem that gives rise to the market failure Policy analysts argue that existence of a market failure provides a necessary.Market Failure Regulation Government Intervention to Correct Market Failure The economic rationale for Government intervention   (i) Correction for market failure/loss of economic efficiency (ii) Desire for greater degree of equity in the distribution of income and wealth Several forms of government intervention are possible to correct for perceived market failure To employ the diagnostic approach. 1992). Sufficiency is established when the gains from government intervention outwieghs the dangers of government intervention . not a sufficient justification for public policy interventions. A double market failure test is required.

Market Failure Regulation Government Intervention to Correct Market Failure (1) Command and Control technique (including regulation) (2) Government subsidy and other forms of financial assistance (including research grants and tax allowances/tax exemptions) (3) Taxation (including indirect taxes designed to control pollution) (4) Policies to increase competition and reduce the immobility of factors of production (5) Provision and finance of public and merit goods (6) Introduction/expansion of market based incentives to change both consumer and producer behaviour .

society s welfare is not always maximized) Effectiveness of tax dependent on PED Legislation: laws and administrative rules are passed to prohibit or regulate behaviour that imposes an EC.Market Failure Regulation Government Intervention to Correct Market Failure Problem Zero provision of public goods Negative externalities Intervention Direct provision of public goods Evaluation Financial intervention: taxes (equal to the monetary value of the MEC) are imposed on individuals or a firm. discouraging demand Enforcement is difficult and expensive Benefits must outweigh the costs of implementation. pollution permits Education. campaigns and advertisements solve the problem of imperfect information by allowing the external costs to be made known to the consumer. e.g. internalizing ECs Advantages Leaves space for market forces to interact Provision of revenue for the government Disadvantages Difficulty in valuating EC Overvaluation means output is below social optimum. as with undervaluation means that output is not sufficiently lowered (ie. A lot of time may be needed for effects to be felt .

compulsory education etc. . arising from the redistribution Legislation include regulation seatbelt usage. attitudes etc. Enforcement requires constant checking which may translate to high costs. changes in work effort. Leaks arise as a result of administrative costs. the valuation of EB is difficult High government expenditure is required Okun s leaky bucket: each dollar transferred from a richer to a poorer individual.Market Failure Regulation Government Intervention to Correct Market Failure Positive Externalities Financial intervention: subsidies made to the producer or consumer Advantages Considered the most effective way of solving underconsumption as it is easily implemented Disadvantages Like taxes. results in less than a dollar increase in income for the recipient.

and supernormal profits are taken as tax. Government may impose regulations to control a monopolies 1.Ensuring competition exists (e.g.Social justice: they should be provided according to need and not ability to pay 2. antitrust laws) 2.Ensuring standards of provision. for example in the provision of free health services helps to contain and combat the spread of disease 3... Governments may also regulate MC/AC pricing for monopolies.Forbidding monopolistic behaviour (like predatory pricing) 3.g. 4.Dependants are subject to their guardians decision which are not necessarily the best.Ignorance: The problem of imperfect information makes consumers unaware of the positive externalities and benefits that arise from consumption Imperfect markets Imposition of a lump-sum tax on a monopolist (shifts AC upwards). deregulation) .Market Failure Regulation Government Intervention to Correct Market Failure Non provision of merit goods There is a need to produce merit goods (which are naturally underconsumed) at low prices or for free due to four reasons 1.Forbidding the formation of monopolies (e.Large positive externalities. therefore the provision of services like free education and dental treatment is needed to protect dependants from uninformed or bad decisions 4.

(The principles of economic regulation. price fixing.Kahn) . A.E.Market Failure Regulation Government Intervention to Correct Market Failure Natural Monopolies In the case of Natural Monopoly the essence of regulation is the explicit replacement of competition with governmental orders with principal institutional device for assuring good performance. prescription of quality and conditions of service. In the case of natural monopoly the primary guarantor of acceptable performance is conceived to be not competition or self restraint but direct governmental prescription of major aspects of their structure and economic There are four principal components of this regulation that in combination distinguish the public utility from other sectors of the economy: control of entry. and an imposition of an obligation to serve all applicants under reasonable conditions.

Externalities Petroleum and Natural Gas Regulatory Board Licensing. Interconnection. Oligopoly TRAI Licensing. Tariff fixation. SERCs Licensing. Public Good. Dispute Resolution Petroleum and Natural Gas Regulatory Board Act 2006 Petroleum Act 1934 Petroleum and Minerals Pipelines Act. RBI Banking Act 1959 Consultation paper on Approach to Regulation Issues and Options. Spectrum Management (Advisory) Monetary policy Supervision & Regulation Banking Information Asymmetry. QoS standards. Externalities. QoS standards. Tariff fixation.Market Failure Regulation Some regulating act in India Sectors Type of Market Failure Regulator Type of Regulation Relevant Statutes Utilities Natural Monopoly. Dispute Resolution Electricity Act 2003 Oil & Gas Natural Monopoly. 1962 TRAI Act 1997 Tele Communications Monopolistic. Tariff fixation. Planning Commission India . CERC. QoS standards.

safety regulations and environmental regulations can be rationalized on the basis of imperfect information and externalities Economic regulation of public utilities can be explained by economies of scale and scope and need to protect the consumers from monopoly exploitation Aspects of fiscal policy can be rationalized on the basis in terms of wealth and income redistribution Regulatory intervention for universal service obligations etc.    . Regulations can take different forms with different roles  Health.Regulation .Summary The possibility of market failure underpin the economic rationale for state regulation of market economies.

political and bureaucratic factors and cannot be attributed to one set of factors alone Involvement of disciplines other than economics (law.) Broad definition ± ³ the use of public authority to set and apply rules and standards´ (Hood et al. social.Summary Regulation cannot be limited to economic issues ± means to ultimately achieve non-economic ends Intentions and outcomes are therefore defined by a combination of economic. market failure or equity concerns through rule based direction of individual and society´ (Planning Commission consultation paper on Regulation) . sociology etc. political science. 1999) (Economic Regulation ± A Preliminary literature review and summary of research questions ± Parker) As an effort by the state ³to address social risk.Regulation .

Summary Regulation is a complex balancing act between advancing the interests of consumers. (Parker.Regulation . µpublic interest¶ agenda. 2000) . provide an environment conducive for new firms to enter the industry and expand competition (police anti-competitive behavior by the dominant supplier). take into consideration social and environmental issues (e. identify those parts of the business which are naturally monopolistic (statutory monopolies that are not necessarily justified in terms of either economies of scale or scope). when removing cross subsidization of services).       minimum prices to benefit the consumer (maximize consumer surplus).g. ensure adequate profits are earned to finance the proper investment needs of the industry (earn at least a normal rate of return on capital employed). while promoting a wider. preserve or improve the quality of service (ensure higher profitability is not achieved by cutting services to reduce costs). competitors and investors.

The Economics of Competition ± The Race to Monopoly. Normative Economic Theories of Government Failure. Michael. Djolov. Mankiw. (1971). George. Stigler. and Worthington. 27-39. A. Page 3-21 . Principles of Economics. Southwestern Publishing 3. (2008). Bell Journal of Economics 2(1). J. Medema. B. A quiet revolution in welfare economics. Journal of Interdisciplinary Economics 7(1):pp. & Hahnel. Price Theory. The Evaluation of Public Policy. A. Mill. 2. Gregory. Jaico publishing house 4. Chapter 18. N. Dollery.References Books 1. (1990). Online book. Market Failures. Journals 1. History of Political Economy 3. Steven. (1996). G. Sidgwick. and the evolution of the theory of market failure. G. R. Friedman. (2004). 2. The theory of economic regulation. (2007).. D. 3rd Indian Edition. George.

Working Paper in Economics 8. Vol 12. 4. European School of Management. No. Parker. J. pp 439 ± 451 5. J. Approach to Regulation: Issues and Options. B. 2005.References 4. Basil Blackwell 6.The Efficiency Theorems and Market Failure. Government of India . Planning Commission. D. 7. (2001). Vol 11. Understanding Regulation. The theory of market failure and policy making in contemporary Local Government. Andrei. Hammond. International Journal of Public Sector Management. Dollery.. & Wallis. Consultation Paper(2006). Elements of General Equilibrium Analysis. Shleifer. pp 213-236. Regulation of privatized public utilities in the UK: performance and governance. Peter. (1997). (1999).

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