Introduction to market failure
Market failure occurs whenever markets fail to deliver an efficient allocation of resources and the result is a loss of economic and social welfare.
Market failure exists when the competitive outcome of markets is not satisfactory from the point of view of society. What is satisfactory nearly always involves value judgments.
Complete and partial market failure
- Complete market failure occurs when the market simply does not supply products at all – we see “missing markets”
- Partial market failure occurs when the market does actually function but it produces either the wrong quantity of a product or at the wrong price.
Markets can fail for lots of reasons:
Negative externalities (e.g. the effects of environmental pollution) causing the social cost of production to exceed the private cost
Positive externalities (e.g. the provision of education and health care) causing the social benefit of consumption to exceed the private benefit
Imperfect information or information failure means that merit goods are under-produced while demerit goods are over-produced or over-consumed
The private sector in a free-markets cannot profitably supply to consumers pure public goods andquasi-public goods that are needed to meet people’s needs and wants
Market dominance by monopolies can lead to under-production and higher prices than would exist under conditions of competition, causing consumer welfare to be damaged
Factor immobility causes unemployment and a loss of productive efficiency
Equity (fairness) issues. Markets can generate an ‘unacceptable’ distribution of income and consequent social exclusion which the government may choose to change
Efficiency is about a society making optimal use of scarce resources to satisfy wants & needs
There are several meanings of efficiency but they all link to how well a market allocates our scarce resources to satisfy consumers
Normally the market mechanism is good at allocating these inputs, but there are occasions when the market can fail
Allocative efficiency is concerned with whether we are producing the goods and services that match ourchanging needs and preferences and which we place the greatest value on
Allocative efficiency is reached when no one can be made better off without making someone else worse off. This is also known as Pareto efficiency
Allocative efficiency occurs when the value that consumers place on a good or service (reflected in the price they are willing and able to pay) equals the cost of the resources used up in production.
The condition required for allocative efficiency is that price = marginal cost of supply.
In the diagram above, the market is in equilibrium at price P1 and output Q1. At this point, the total area of consumer and producer surplus is maximised. If for example, suppliers were able to restrict output to Q2 and hike the market price up to P2, sellers would gain extra producer surplus by widening their profit margins, but there also would be an even greater loss of consumer surplus. Thus P2 is not an allocative efficient allocation of resources for this market whereas P1, the market equilibrium price is deemed to be allocative efficient.
We will see when we study the economics of monopoly that when businesses have ‘pricing power’ in their own markets, they may increase their profit margins to squeeze extra profit from consumers (they are turning consumer surplus into producer surplus). This has an effect on allocative efficiency for if a monopoly supplier can select a price well above the costs of supply, consumers will suffer a reduction in their welfare. Have you ever felt ripped off buying sandwiches from a motorway service station? The producer has become better off but someone else has become worse off.
Using the production possibility frontier to show allocative efficiency
Pareto defined allocative efficiency as a position “where no one could be made better off without making someone else at least as worth off.”
This can be illustrated using a production possibility frontier – all points that lie on the PPF are allocatively efficient because we cannot produce more of one product without affecting the amount of all other products available
In the diagram below, the combination of output shown by Point A is allocatively efficient as is the combination shown at point B – but at the output combination C we can increase production of both goods by making fuller use of existing resources or increasing efficiency. C represents a loss of economic efficiency.
If an economy is operating within the PPF there will be an under-utilisation of resources causing output of goods and services to be lower than is feasible.
In this sense unemployment is a waste of scare resources; indeed the hours lost through jobless workers can never be recovered – unemployment can be costly from both an economic and social viewpoint.
If every market in the economy is a competitive free market, the resulting equilibrium throughout the economy will be Pareto-efficient.
- Productive efficiency is achieved when the output is produced at minimum average total cost
- Productive efficiency exists when producers minimise the wastage of resources in their production processes.
- Dynamic efficiency occurs over time and it focuses on changes in the amount of consumer choice available in markets together with the quality of goods and services available.
- The socially efficient level of output and or consumption occurs when marginal social benefit = marginal social cost. At this point we have maximized social welfare.
- The existence of negative and positive externalities means that the private optimum level of consumption or production often differs from the social optimum leading to some form of market failure and a loss of social welfare.
- The price mechanism does not always take into account social costs and benefits of production
In the diagram below the socially optimum level of output occurs where the social cost of production (i.e. the private cost of the producer plus the external costs arising from externality effects) equals demand
A private producer who ignores the negative production externalities might choose to maximise their own profits at point A. This divergence between private and social costs of production can lead to market failure
There are many occasions when the production and/or consumption of a good or a service creates external benefits which boost social welfare.
- External benefits from development of renewable energy sources such as wind power
- External benefits from other new production technologies
- External benefits from vaccination / immunisation programmes
- Social benefits from providing milk to young schoolchildren
- Social benefits from the maintenance of a post-office network
Positive externalities and market failure
Where positive externalities exist, the good or service may be under-consumed or under-providedsince the free market may fail to value them correctly or take them into account when pricing the product. In the diagram above, the normal market equilibrium is at P1 and Q1 – but if there are external benefits, the Q1 is an output below the level that maximises social welfare.
There is a case for government intervention in the market designed to increase consumption towards output level Q2 so as to increase economic welfare.
The economics of vaccination
What good is a vaccination? Obviously there are benefits for the person receiving the vaccine, they are less susceptible to disease and children in particular are more likely to attend school and earn more income over their lifetime. A study from the World Bank finds that comprehensive vaccination programmes have a positive effect on savings and wealth and encourage families to have fewer children which lead to less demographic pressures on scarce resources.
More subtly, it can be good for an entire population since, if enough of its members are vaccinated, even those who are not will receive a measure of protection. That is because, with only a few susceptible individuals, the transmission of the infection cannot be maintained and the disease spread. The dispassionate economic case for vaccination, therefore, looks at least as strong as the compassionate medical one. Spending on vaccination programmes appears to be a sound social investment for the future.
Source: Adapted from the Economist, October 2009
Externalities are third party effects arising from production and consumption of goods and services for which no appropriate compensation is paid.
Externalities occur outside of the market i.e. they affect people not directly involved in the production and/or consumption of a good or service. They are also known as spill-over effects.
Economic activity creates spill over benefits and spill over costs – with negative externalities we focus on the spill over costs
Negative externalities occur when production and/or consumption impose external costs on third parties outside of the market for which no appropriate compensation is paid.
- Smokers ignore the harmful impact of toxic ‘passive smoking’ on non-smokers
- Air pollution from road use and traffic congestion and the impact of road fumes on lungs
- External costs of scraping the seabed for supplies of gravel
- The external cost of food waste
- The external costs of cleaning up from litter and the dropping of chewing gum
- The external costs of the miles that food travels from producer to the final consumer
- The externalities linked to the oil sands project in the Canadian wilderness
The importance of property rights
- Property rights confer legal control or ownership of a good.
- For markets to operate efficiently, property rights must be protected – perhaps through regulation.
- Put another way, if an asset is un-owned, no one has an incentive to protect it from abuse. The right to own property is an essential building block of a market-based system
- Failure to protect property rights may lead to what is known as the Tragedy of the Commons – examples include the over use of common land and the long-term decline of fish stocks caused by over-fishing which leads to long term permanent damage to the stock of natural resources.
Private Costs and Social Costs
The existence of externalities creates a divergence between private and social costs of production and the private and social benefits of consumption.
Social Cost = Private Cost + External Cost
Social Benefit = Private Benefit + External Benefit
When negative production externalities exist, social costs exceed private cost. This leads to over-production if producers do not take into account the externalities.
Social costs are the total costs incurred by society from an economic action – they include private and external costs
External costs from production
Production externalities are generated and received in supplying goods and services – examples include noise and atmospheric pollution from factories.
External costs from consumption
- Consumption externalities are generated and received in consumption – examples include pollution from driving cars and motorbikes and externalities created by smoking and alcohol abuse and also the noise pollution created by loud music being played in built-up areas.
- Negative consumption externalities lead to a situation where the social benefit of consumption is less than the private benefit.
Negative externalities from production – social cost > private cost
Marginal cost or marginal benefit is the change in total cost or benefits that results from an increase in production or consumption by one unit
In the absence of externalities, the private marginal costs of the supplier are the same as the costs for society. But if there are negative externalities, we must add the external costs to the firm’s supply curve to find the social marginal cost curve.
If the market fails to include these external costs, then the private equilibrium output will be Q1 and the price P1 where private marginal cost = private marginal benefit.
From a social welfare viewpoint, we want less output from activities that create an “economic-bad” such as pollution. A socially-efficient output would be Q2 with a higher price P2. At this price level, theexternal costs have been taken into account. We have not eliminated the pollution – but at least the market has recognised them and priced them into the price of the product.
Economic and Social Welfare
Private economic welfare requires us to consider only the private (or internal) costs and benefits of production and consumption of goods and services.
But if we wish to look at the economic welfare of the whole community (i.e. the social welfare) then we need to calculate the positive and negative externalities and add them to private benefits and costs. Here is a simple numerical example:
A government is considering four possible capital investment projects. It has the resources to finance and implement only one of these projects. The table below shows the estimated value of the private and external costs and benefits that each project is expected to yield:
New tunnel-pass($ million)
New schools ($ million)
Improvement to an existing airport ($ million)
New hospitals($ million)
Net private benefit
Net social benefit
Net social benefit may be taken into account by a government when deciding which project offers the best potential return for society as a whole
Negative Externalities and Government Intervention
To many economists interested in environmental problems the key is to internalise external costs and benefits to ensure that those who create the externalities include them when making decisions.
One common approach to adjust for externalities is to tax those who create negative externalities.
- This is known as “making the polluter pay”.
- Introducing a tax increases the private cost of consumption or production and ought to reduce demand and output for the good that is creating the externality.
- Some economists argue that the revenue from pollution taxes should be ‘ring-fenced’ and allocated to projects that protect or enhance our environment.
- For example, the money raised from a ERP on vehicles entering busy urban roads, might be allocated towards improving mass transport services; or the revenue from higher taxes on cigarettes might be used to fund better health care programmes.
Problems with Environmental Taxes
Many economists argue that pollution taxes can create problems which lead to government failure.
- Assigning the right level of taxation: There are problems in setting tax so that private cost will exactly equate with the social cost.
- Consumer welfare effects: Producers may pass on the tax to the consumers if the demand for the good is inelastic and, as result, the tax may only have a small effect in reducing demand. Taxes on some de-merit goods (for example cigarettes) may have a regressive effect on lower-income consumers and leader to a widening of inequalities in the distribution of income.
- Employment and investment consequences: If pollution taxes are raised in one country, producers may shift to countries with lower taxes. This will not reduce global pollution, and may create problems such as structural unemployment and a loss of international competitiveness.
Externalities and Regulation
- The government may intervene through the use of regulations and laws.
- For example, the Health and Safety at Work Act covers all public and private sector businesses. Local Town Councils can take action against noisy, unruly neighbours and can pass by-laws preventing the public consumption of alcohol. The Singapore government introduced a ban on smoking in public places.
Merit goods and services
Merit goods are those goods and services that the government feels that people will under-consume, and which ought to be subsidised or provided free at the point of use so that consumption does notdepend primarily on the ability to pay for the good or service.
Both the state and private sector provide merit goods & services. We have an independent education system and people can buy private health care insurance.
Consumption of merit goods is believed often to generate positive externalities– where the social benefit from consumption exceeds the private benefit.
A merit good is a product that society values and judges that people should have regardless of their ability to pay. In this sense, the government is acting paternally in providing these merit goods and services. They believe that individuals may not act in their own best interest in part because of imperfect information.
Good examples of merit goods include health services, education, work training programmes, public libraries and inoculations for children
Education as a merit good
The argument concerning imperfect information is an important one here. Parents may be unaware of the longer-term benefits that their children might derive from education.
Education is a long-term investment decision. The private costs must be paid now but the private benefits (including higher earnings potential over one’s working life) take time to emerge. Education should provide a number of external benefits including rising incomes and productivity for current and future generations; an increase in the occupational mobility of the labour force which should help to reduce unemployment.
Increased spending on education should also provide a stimulus for higher-level research which can add to the long run trend rate of growth. Other external benefits might include the encouragement of a more enlightened and cultured society. Providing that the education system provides a sufficiently good education across all regions and sections of society, increased education and training spending should also open up more equality of opportunity.
Notice here that we are talking about the sorts of goods and services that society judges to be in our best welfare. Judgements involve subjective opinions – and we cannot escape from making value judgements when we are discussing merit goods.
Why does the government provide merit goods and services?
- To encourage consumption so that positive externalities of merit goods can be achieved for example free inoculation against infectious diseases
- To overcome the information failures linked to merit goods
- On grounds of equity – because the government believes that consumption should not be based solely on the grounds of ability to pay for a good or service
Comparing and contrasting merit goods with pure public goods
Pure Public Goods
Provided by both the public and private sector
Normally funded & provided by the government
Positive marginal cost to supply to extra users
Marginal cost of supply close to zero – if provided to one, it is provided to all
Limited in supply – may be a high opportunity cost
Largely unconstrained in supply
Rival – consumption reduces availability for other
Non-rival – one person’s consumption does not reduce availability for others
Non-excludable giving rise to the free rider
Rejectable by those unwilling to pay
Non rejectable – usually funded by general taxes
Market failure with demerit goods
The free market may fail to take into account the negative externalities of consumption because the social cost exceeds the private cost. Consumers too may experience imperfect information about the long term costs to themselves of consuming products deemed to be de-merit goods
Obesity – a time bomb
There is a huge debate at the moment about the root causes of obesity and the social costs that arise from increasing levels of obesity. Obesity is also an international problem. Across the Atlantic in the USA, two out of every three Americans are overweight; one out of every three is obese. One in three is expected to have diabetes by 2050. Minorities have been even more profoundly affected.
What of harder drugs?
Should hard drugs be prohibited at all costs by the government in a bid to control demand by restricting supply? Regulation has been the route chosen by most governments in developed countries – but economists are divided on the issue. Some believe that legalisation and taxation of harder class drugs is a better policy to pursue, arguing that regulation is ineffective and costly. Another approach would be to divert resources away from regulation towards giving better information to drug users about the longer term health implications of their consumption decisions.
The case for a complete ban
The case for a complete ban on de-merit goods such as class A narcotics could be justified on the ground that the social marginal cost of consumption is always higher than the social marginal benefit. In the diagram above there is no output where the social benefit equals the social cost and welfare would be best protected by trying to enforce a total ban on the product.
Food additives – a de-merit good?
- The use of food additives has long been a subject of controversy.
- Examples include the preservatives used in products from soft drinks to barbecue sauce – designed to lengthen the shelf life of products available for sale in supermarkets.
- Research published in 2007 by the Food Standards Agency claimed a link between food additives and hyperactive behaviour in children leading to losses of concentration and a worsening in behaviour ands they want a number of food colourings to be banned.
Gambling – economic and social effects
From betting on the results of general elections, the Grand National, the number of corners that England win in one of their World Cup matches or the temperature in London on Christmas Day, we seem to have an almost insatiable desire for gambling on the outcomes of virtually every sporting, political, meteorological event.
Inevitably the rapid expansion of this industry raises important questions about the external costs and benefits of gambling. Some researchers point to the employment and tourism benefits that flow from the growth in demand for gambling services. There is also a fiscal dividend from this booming industry with a predicted $1bn per year of extra tax revenues flowing into the Treasury’s coffers.
But gambling also creates external costs. To mitigate the problem, Singapore sets up the NCPG.
The NCPG is a council comprising 16 members with expertise in psychiatry and psychology, social services, counselling, legal, rehabilitative as well as religious services. The Council’s first two-year term began on 31 August 2005, and it is now in its fifth term:
The Council’s main roles are:
- To provide advice and feedback to MSF on social concerns related to gambling, gambling problems and problem gambling.
- To support and implement effective programmes with regard to:
- Public education on problem gambling;
- Public communications and consultation of stakeholders with regard to gambling, gambling problems and problem gambling;
- Responsible gambling practices of legalised gambling operators;
- Research into problem gambling; and
- Prevention and treatment services for problem gamblers and their families.
- To execute casino exclusions in accordance with the Casino Control Act and within prevailing policies on casino social safeguards.
The usual approach to de-merit goods is to tax consumption, so that the private cost of consumption is increased and demand contracts.
Weighing the benefits and costs of Integrated Resorts in Singapore
Public Goods & Private Goods
Public goods provide an example of market failure resulting from missing markets. To understand this it is helpful first to discuss what is meant by a private good or service.
A private good or service has three main characteristics:
- Excludability: Consumers of private goods can be excluded from consuming the product by the seller if they are not willing or able to pay for it. For example a ticket to the theatre or a meal in a restaurant is clearly a private good. Another example is the increasing use of “pay-per-view”as a means of extracting payment from people wanting to watch exclusive coverage of sporting events on television or the payment required to travel on a toll-road or toll-bridge. Another example of a private good is the use of subscription-based services on the internet. Some newspapers provide the bulk of their news stories on the internet as a “quasi public good” such as The Guardian www.guardian.co.uk. Others are developing an alternative business model where users can only access premium services through password-protected parts of a web site that require payment from consumers – examples include The Economist www.economist.com and the Financial Times www.ft.com. Excludability gives the service provider (the seller) the chance to make a profit from producing and selling the product. As we shall see, with public goods, such excludability does not exist. When goods are excludable, the owners can exercise property rights.
- Rivalry: With a private good, one person’s consumption of a product reduces the amount left for others to consume and benefit from – because scarce resources are used up in producing and supplying the good or service. If you order and then enjoy a pizza from Pizza Hut, that pizza is no longer available to someone else. Likewise driving your car on a road uses up road space that is no longer available at that time to another motorist. The greater the volume of traffic on the roads, the higher the likelihood of traffic congestion which has the effect of reducing the average speed and increasing the average journey time for each road user.
- Rejectability: Private goods and services can be rejected – if you don’t like the soup on the college or school menu, you can use your money to buy something else! You can choose not to travel on Virgin Rail on a journey to the North West and go instead by coach, or you can choose not to buy a season ticket for your local soccer club and instead use the money to finance a subscription to a local health club. All private goods and services can be rejected by the final consumer should their tastes and preferences change.
Private and Public Goods – a question of exclusion
Le Shuttle is a private good – the service is excludable, rival in consumption and rejectable. But not all providers of public goods make a profit. EuroTunnel is facing large losses and even bigger debts!
Characteristics of Public Goods
As one might expect, the characteristics of pure public goods are the opposite of private goods:
- Non-excludability: The benefits derived from the provision of pure public goods cannot be confined to only those who have actually paid for it. In this sense, non-payers can enjoy the benefits of consumption at no financial cost to themselves – this is known as the “free-rider” problem and it means that people have a temptation to consume without paying!
- Non-rival consumption: Consumption of a public good by one person does not reduce the availability of a good to everyone else – therefore we all consume the same amount of public goods even though our tastes and preferences for these goods (and therefore our valuation of the benefit we derive from them) might differ
Examples of Public Goods
There are relatively few examples of pure public goods. Examples of public goods include flood control systems, some of the broadcasting services provided by the BBC, public water supplies, street lighting for roads and motorways, lighthouse protection for ships and also national defence services.
Example: Policing – a public good?
To what extent is our current system of policing an example of a public good? Some (but not all) aspects of policing might qualify as public goods. The general protection that the police services provide in deterring crime and investigating criminal acts serves as a public good. But resources used up in providing specific police services mean that fewer resources are available elsewhere. For example the use of police at sporting events or demonstrations and protests means that police resources have to be diverted from other policing duties. The police services must make important decisions about how best to allocate their manpower in order to provide the most effective policing service for the whole community.
Private protection services (including private security guards, privately bought security systems and detectives) are private goods because the service is excludable, rejectable and rival in consumption and people and businesses are often prepared to pay a high price for exclusive services. A good recent example of this has been the use of private security firms in post-war Iraq where up to 15,000 workers are said to have been working for private businesses protecting installations, coalition buildings and convoy protection.
Public goods and market failure
Pure public goods are not normally provided at all by the private sector because they would be unable to supply them for a profit. Thus the free market may fail totally to provide important pure public goods and under-provide quasi public goods (see below).
It is therefore up to the Government to decide what output of public goods is appropriate for society. To do this, it must estimate the social benefit from the consumption of public goods. Putting a monetary value on the benefit derived from street lighting and defence systems is problematic. The electoral system provides an opportunity to see the public choices of voters but elections are rarely won and lost purely on the grounds of government spending plans and the turnout at elections continues to fall.
The air waves – a public good or a quasi public good?
The airwaves used by mobile phone companies, radio stations and television companies are essentially owned by the government of a particular country.
Do they count as a pure public good? Normally the answer would be yes. One person’s use of the airwaves rarely reduces the extent to which other people can benefit from utilising them. But when demand for mobile phone services is high at peak times, the airwaves become crowded and as a result access to the networks can become slow. In this sense the airwaves can be treated a crowded non-pure public good.
The government also controls the issue of licences needed to operate mobile phone services using the airwaves in the UK. In 2000, they auctioned off five licences for 3rd generation mobile phone services and raised £22 billion in doing so.
Most public goods are non-pure public goods – these are also known as quasi-public goods. The main reason is that we can find ways and means of excluding some groups from consuming them!
A quasi-public good is a near-public good i.e. it has many but not all the characteristics of a public good. Quasi public goods are:
- Semi-non-rival: up to a point, extra consumers using a park, beach or road do not reduce the amount of the product available to other consumers. Eventually additional consumers reduce the benefits to other users. Beaches become crowded as do parks and other leisure facilities.
- Semi-non-excludable: it is possible but often difficult or expensive to exclude non-paying consumers. E.g. fencing a park or beach and charging an entrance fee; building toll booths to charge for road usage on congested routes
The diagram below is one way of illustrating the different characteristics of public and private goods.
One cause of market failure is the immobility of factors of production. There are two main types of factor immobility, occupational and geographical immobility.
Occupational immobility occurs when there are barriers to the mobility of factors of production between different sectors of the economy which leads to these factors remaining unemployed, or being used in ways that are not efficient.
Some capital inputs are occupationally mobile – a computer can be put to use in many different industries. And commercial buildings such as shops and offices can be altered to provide a base for many businesses. However some units of capital are specific to the industry they have been designed for – a printing press or a nuclear power station for example!
People often experience occupational immobility. For example, workers made redundant in the steel industry or in heavy engineering may find it difficult to find a new job. They may have specific skills that are not necessarily needed in growing industries which causes a mismatch between the skills on offer from the unemployed and those required by employers looking for workers. This problem is calledstructural unemployment. Clearly this leads to a waste of scarce resources and represents market failure.
Geographical immobility refers to barriers people moving from one area to another to find work. There are good reasons why geographical immobility might exist:
- Family and social ties.
- The financial costs involved in moving home including the costs of selling a house and removal expenses.
- Huge regional variations in house prices leading to a shortage of affordable housing in many areas
- Differences in the general cost of living between regions and also between countries.
Policies to Improve the Mobility of Labour
To reduce occupational immobility:
- Invest in training schemes for the unemployed to boost their human capital to equip them with new skills and skills that can be transferred from one occupation to another.
- Subsidise the provision of vocational training by private sector firms to raise the skills level
To reduce geographical immobility:
- Reforms to the housing market designed to improve the supply and reduce the cost of rented properties and to increase the supply of affordable properties.
- Encourage part-ownership / part-rented housing
- Specific subsidies for people moving into areas where there are shortages of labour – for example teachers and workers in the National Health Services.
Government Intervention in the Market
|In a free market economic system, scarce resources are allocated through the price mechanismwhere the preferences and spending decisions of consumers and the supply decisions of businesses come together to determine equilibrium prices. The free market works through price signals. When demand is high, the potential profit from supplying to a market rises, leading to an expansion in supply (output) to meet rising demand from consumers. Day to day, the free market mechanism remains a tremendously powerful device for determining how resources are allocated among competing ends.Intervention in the marketThe government may choose to intervene in the price mechanism largely on the grounds of wanting to change the allocation of resources and achieve what they perceive to be an improvement in economic and social welfare. All governments of every political persuasion intervene in the economy to influence the allocation of scarce resources among competing usesWhat are the main reasons for government intervention?
The main reasons for policy intervention are:
Options for government intervention in markets
There are many ways in which intervention can take place – some examples are given below
Government Legislation and Regulation
Parliament can pass laws that for example prohibit the sale of cigarettes to children, or ban smoking in the workplace. The laws of competition policy act against examples of price-fixing cartels or other forms of anti-competitive behaviour by firms within markets. Employment laws may offer some legal protection for workers by setting maximum working hours or by providing a price-floor in the labour market through the setting of a minimum wage.
The economy operates with a huge and growing amount of regulation. The government appointed regulators who can impose price controls in most of the main utilities such as telecommunications, electricity, gas and rail transport. Free market economists criticise the scale of regulation in the economy arguing that it creates an unnecessary burden of costs for businesses – with a huge amount of “red tape” damaging the competitiveness of businesses.
Regulation may be used to introduce fresh competition into a market – for example breaking up the existing monopoly power of a service provider. A good example of this is the attempt to introduce more competition for British Telecom. This is known as market liberalisation.
Direct State Provision of Goods and Services
Because of privatization, the state-owned sector of the economy is much smaller than it was twenty years ago.
State funding can also be used to provide merit goods and services and public goods directly to the population e.g. the government pays private sector firms to carry out operations for NHS patients to reduce waiting lists or it pays private businesses to operate prisons and maintain our road network.
Fiscal Policy Intervention
Fiscal policy can be used to alter the level of demand for different products and also the pattern of demand within the economy.
Intervention designed to close the information gap
Often market failure results from consumers suffering from a lack of information about the costs and benefits of the products available in the market place. Government action can have a role inimproving information to help consumers and producers value the ‘true’ cost and/or benefit of a good or service. Examples might include:
These programmes are really designed to change the “perceived” costs and benefits of consumption for the consumer. They don’t have any direct effect on market prices, but they seek to influence “demand” and therefore output and consumption in the long run. Of course it is difficult to identify accurately the effects of any single government information campaign, be it the campaign to raise awareness on the Aids issue or to encourage people to give up smoking. Increasingly adverts are becoming more hard-hitting in a bid to have an effect on consumers.
The effects of government intervention
One important point to bear in mind is that the effects of different forms of government intervention in markets are never neutral – financial support given by the government to one set of producers rather than another will always create “winners and losers”. Taxing one product more than another will similarly have different effects on different groups of consumers.
Government intervention does not always work in the way in which it was intended or the way in which economic theory predicts it should. Part of the fascination of studying Economics is that the “law of unintended consequences” often comes into play – events can affect a particular policy, and consumers and businesses rarely behave precisely in the way in which the government might want! We will consider this in more detail when we consider government failure.
Judging the effects of intervention – a useful check list
To help your evaluation of government intervention – it may be helpful to consider these questions:
Efficiency of a policy: i.e. does a particular intervention lead to a better use of scarce resources among competing ends? E.g. does it improve allocative, productive and dynamic efficiency? For example – would introducing indirect taxes on high fat foods be an efficient way of reducing some of the external costs linked to the growing problem of obesity?
Effectiveness of a policy: i.e. which government policy is most likely to meet a specific economic or social objective? For example which policies are likely to be most effective in reducing road congestion? Which policies are more effective in preventing firms from exploiting their monopoly power and damaging consumer welfare? Evaluation can also consider which policies are likely to have an impact in the short term when a quick response from consumers and producers is desired. And which policies will be most cost-effective in the longer term?
Equity effects of intervention: i.e. is a policy thought of as fair or does one group in society gain more than another? For example it is equitable for the government to offer educational maintenance allowances (payments) for 16-18 year olds in low income households to stay on in education after GCSEs? Would it be equitable for the government to increase the top rate of income tax to 50 per cent in a bid to make the distribution of income more equal?
Sustainability of a policy: i.e. does a policy reduce the ability of future generations to engage in economic activity? Inter-generational equity is an important issue in many current policy topics for example decisions on which sources of energy we rely on in future years.
An indirect tax is imposed on producers (suppliers) by the government. Examples include duties on cigarettes, alcohol and fuel and also GST
GST is a tax placed on the expenditure / a tax set as a percentage of the price of a good)
A tax increases the costs of production causing an inward shift in the supply curve
The vertical distance between the pre-tax and the post-tax supply curve shows the tax per unit
With an indirect tax, the supplier may be able to pass on some or all of this tax onto the consumer through a higher price
This is known as shifting the burden of the tax and the ability of businesses to do this depends on the price elasticity of demand and supply
- In the left hand diagram, demand is elastic so the producer must absorb most of the tax and accept a lower profit margin on each unit. When demand is elastic, the effect of a tax is to raise the price – but we see a bigger fall in quantity. Output has fallen from Q to Q1.
- In the right hand diagram demand for the product is inelastic and therefore the producer is able to pass on most of the tax to the consumer by raising price without losing much in the way of sales.
The table below shows the demand and supply schedules for a good:
Quantity Supplied (Pre-tax)
Quantity supplied (Post-tax)
|1||What is the initial equilibrium price and quantity?||Price = $6 Quantity = 400|
|2||The government imposes a tax of $3 per unit. The new supply schedule is shown in the right hand column of the table – less is now supplied at each and every market price|
|3||Find the new equilibrium price after the tax has been imposed||New price =$8|
|4||Calculate the total tax revenue going to the government||Tax revenue = $450|
|5||How have consumers been affected by this tax? There has been a fall in quantity traded and a rise in the price paid by consumers – this leads to a fall in economic welfare as measured by consumer surplus|
Who pays the tax? The burden of taxation
The Government would rather place indirect taxes on commodities where demand is inelastic because the tax causes only a small fall in the quantity consumed and as a result the total revenue from taxes will be greater. An example of this is the high level of duty on cigarettes and petrol.
- Specific taxes: A specific tax is where the tax per unit is a fixed amount – for example the duty on a pint of beer or the tax per packet of twenty cigarettes. Another example is air passenger duty
- Ad valorem taxes: Where the tax is a percentage of the cost of supply – e.g. GST currently levied at the standard rate of 7%. In the diagram below, an ad valorem tax has been imposed on producers. The equilibrium price rises from P1 to P2 whilst quantity falls from Q1 to Q2.
Note that the effect of an ad valorem tax is to cause a pivotal shift in the supply curve
This is because the tax is a percentage of the unit cost of supplying the product. So a good that could be supplied for a cost of $50 will now cost $58.75 when VAT of 17.5% is applied whereas a different good that costs $400 to supply will now cost $470 when the same rate of VAT is applied
The absolute amount of the tax will go up as the market price increases
Tobacco is an example of a product on which both specific and ad valorem taxes are applied.
What is a subsidy?
A subsidy is a payment by the government to suppliers that reduce their costs of production and encourages them to increase output
The subsidy causes the firm’s supply curve to shift to the right
The amount spent on the subsidy is equal to the subsidy per unit multiplied by total output
A direct subsidy to the consumer has the effect of boosting demand in a market
Different Types of Producer Subsidy
- A guaranteed payment on the factor cost of a product – e.g. a guaranteed minimum price offered to farmers such as under the old-style Common Agricultural Policy (CAP).
- An input subsidy which subsidises the cost of inputs used in production – e.g. an employment subsidy for taking on more workers.
- Government grants to cover losses made by a business – e.g. a grant given to cover losses in the railway industry or a loss-making airline.
- Bail-outs e.g. for financial organisations in the wake of the credit crunch
- Financial assistance (loans and grants) for businesses setting up in areas of high unemployment – e.g. as part of a regional policy designed to boost employment.
To what extent will a subsidy feed through to lower prices for consumers?
A subsidy has the effect of causing an outward shift in the market supply curve for a product
This depends on the price elasticity of demand for the product. The more inelastic the demand curve the greater the consumer’s gain from a subsidy. Indeed when demand is perfectly inelastic the consumer gains most of the benefit from the subsidy since all the subsidy is passed onto the consumer through a lower price. When demand is relatively elastic, the main effect of the subsidy is to increase the equilibrium quantity traded rather than lead to a much lower market price.
A subsidy might be justified if it encourages increased supply and consumption of products that yield high external benefits
Economic and Social Justifications for Subsidies
Why might the government be justified in providing financial assistance to producers in certain markets and industries? How valid are the arguments for government subsidies?
- To keep prices down and control inflation – in the last couple of years several countries have been offering fuel subsidies to consumers and businesses in the wake of the steep increase in world crude oil prices.
- To encourage consumption of merit goods and services which are said to generate positive externalities (increased social benefits). Examples might include subsidies for investment in environmental goods and services.
- Reduce the cost of capital investment projects – which might help to stimulate economic growth by increasing long-run aggregate supply.
- Subsidies to slow-down the process of long term decline in an industry e.g. fishing or mining
- Subsidies to boost demand for industries during a recession e.g. the car scrappage scheme
Economic Arguments against Subsidies
- The economic and social case for a subsidy should be judged carefully on the grounds of efficiencyand fairness
- Might the money used up in subsidy payments be better spent elsewhere?
- Government subsidies inevitably carry an opportunity cost and in the long run there might be better ways of providing financial support to producers and workers in specific industries.
Free market economists argue that subsidies distort the working of the free market mechanism and can lead to government failure where intervention leads to a worse distribution of resources.
- Distortion of the Market: Subsidies distort market prices – for example, export subsidiesdistort the trade in goods and services and can curtail the ability of ELDCs to compete in the markets of rich nations.
- Arbitrary Assistance: Decisions about who receives a subsidy can be arbitrary
- Financial Cost: Subsidies can become expensive – note the opportunity cost!
- Who pays and who benefits? The final cost of a subsidy usually falls on consumers (or tax-payers) who themselves may have derived no benefit from the subsidy.
- Encouraging inefficiency: Subsidy can artificially protect inefficient firms who need to restructure – i.e. it delays much needed reforms.
- Risk of Fraud: Ever-present risk of fraud when allocating subsidy payments.
- There are alternatives: It may be possible to achieve the objectives of subsidies by alternative means which have less distorting effects.
A failure of the free market and the price mechanism to deliver an allocatively efficient allocation of scarce resources is normally regarded as justification for government intervention.
This intervention is designed to correct for instances of market failure and achieve an improvement in economic and social welfare.
But what if intervention leads to further inefficiencies? What if government policies prove to be costly to implement but ineffective in achieving their desired outcomes? What happens if intervention distorts markets still further leading to a further loss of efficiency?
What is Government Failure?
Even with good intentions governments seldom get their policy application correct. They can tax, control and regulate but the outcome may be a deepening of the market failure or even worse a new failure may arise
Government failure may range from the trivial, when intervention is merely ineffective, but where harm is restricted to the cost of resources used up and wasted by the intervention, to cases where intervention produces new and more serious problems that did not exist before. The consequences of this can take many years to reverse.
Government failure in a non-market economy
The collapse of the Soviet Union in the late 1980s marked the failure of command economies as a means of allocating resources among competing uses. The essence of a command economy was that the state planning mechanism would decide what to produce and how to produce it and for whom to produce. Government failure occurred when the central planners produced products that were not wanted by consumers – a loss of allocative efficiency, since there was no price mechanism to signal changes in consumer preferences and demand.
Another fundamental failing of the pure command economy was that there was little incentive for workers to raise productivity; poor quality control; and little innovation by firms as no profit motive existed. Command economies also suffered massive environmental de-gradation because they did not posses structures for valuing the environment and giving consumers and producers the right incentives to protect their environmental heritage.
Causes of Government Failure
Government intervention can prove to be ineffective, inequitable and misplaced.
(a) Political self-interest
The pursuit of self-interest amongst politicians and civil servants can often lead to a misallocation of resources.
For example decisions about where to build new roads, by-passes, schools and hospitals may be decided with at least one eye to the political consequences.
The pressures of a looming election or the influence exerted by special interest groups can foster an environment in which inappropriate spending and tax decisions are made. – e.g. boosting welfare spending in the run up to an election, or bringing forward major items of capital spending on infrastructural projects without the projects being subjected to a full and proper cost-benefit analysisto determine the likely social costs and benefits. Critics of current government policy towards tobacco taxation and advertising, and the controversial issue of genetically modified foods argue that government departments are too sensitive to political lobbying from the major corporations.
(b) Policy myopia
Critics of government intervention in the economy argue that politicians have a tendency to look for short term solutions or “quick fixes” to difficult economic problems rather than making considered analysis of long term considerations.
For example, a decision to build more roads and by-passes might simply add to the problems of traffic congestion in the long run encouraging an increase in the total number of cars on the roads.
The risk is that myopic decision-making will only provide short term relief to particular problems but does little to address structural economic problems.
Critics of government subsidies to particular industries also claim that they distort the proper functioning of markets and lead to inefficiencies in the economy. For example short term financial support to coal producers to keep open loss-making coal pits might prove to be a waste of scarce resources if the industry concerned has little realistic prospect of achieving a viable rate of return in the long run given the strength of global competition.
(c) Regulatory capture
This is when the industries under the control of a regulatory body (i.e. a government agency) appear to operate in favour of the vested interest of producers rather can consumers
Some economists argue that regulators can prevent the ability of the market to operate freely. We might find examples of this in agriculture, telecommunications, the main household utilities and in transport regulation.
For example, to what extent has the system of agricultural support known as the Common Agricultural Policy operated too much in the interests of farmers and the farming industry in general? And as a result, has the CAP worked against the long-term interest of consumers, the environment and developing countries who claim that they are being unfairly treated in world markets by the effects of import tariffs on food and export subsidies to loss-making European farmers?
(d) Government intervention and disincentive effects
Free market economists who fear government failure at every turn argue that attempts to reduce income and wealth inequalities can worsen incentives and productivity. They would argue against the National Minimum Wage because they believe that it artificially raises wages above their true free-market level and can lead to real-wage unemployment. They would argue against raising the higher rates of income taxbecause it is deemed to have a negative effect on the incentives of wealth-creators in the economy and generally acts as a disincentive to work longer hours or take a better paid job.
(e) Government intervention and evasion
A decision by the government to raise taxes on de-merit goods such as cigarettes might lead to an increase in attempted tax avoidance, tax evasion, smuggling and the development of grey markets where trade takes place between consumers and suppliers without paying tax
Case Study: The Unintended Economic Effects of a Tariff
In 2005 the US government slapped anti-dumping tariffs on the imports of Chinese furniture. At the time, imports accounted for 58% of the market for beds and similar items.
What happened next was probably not in the plans of US lawmakers and the local furniture manufacturers who supported the tariffs. Although imports from China did fall sharply, a number of Chinese manufacturers moved their plants to different countries, Vietnam being the main choice. The result was that as of 2010, imports now account for 70% of the total market!
(f) Policy decisions based on imperfect information
- How does the government establish what citizens want it to do in their name? Can the government ever really know the true revealed preferences of so many people?
- Often a government will choose to go ahead with a project or policy without having the full amount of information required for a proper cost-benefit analysis. The result can be misguided policies and damaging long-term consequences.
- How does the government know how many extra houses need to be built in the UK over the next twenty years? Is building thousands of extra homes in an already congested South-east the right option? Are there better solutions? There have been plenty of instances of government housing policy having failed in previous decades!
(g) The Law of Unintended Consequences
- The law of unintended consequences is that actions of consumer and producers — and especially of government—always have effects that are unanticipated or “unintended.”Particularly when people do not always act in the way that the economics textbooks would predict
- The law of unintended consequences is often used to criticise the effects of government legislation, taxation and regulation. People find ways to circumvent laws; shadow markets develop to undermine an official policy; people act in unexpected ways because or ignorance and / or error. Unintended consequences can add hugely to the financial costs of some government programmes so that they make them extremely expensive when set against their original goals and objectives.
(h) Costs of administration and enforcement
Government intervention can prove costly to administer and enforce. The estimated social benefits of a particular policy might be largely swamped by the administrative costs of introducing it.
Key points about government failure
- Free market economists are distrustful of intervention. They believe that the price mechanismshould be given freedom to operate
- Often we can accuse the government of policy failure only with the benefit of hindsight
- Limited information – no government has the resources and information available to it to make fully-informed, objective judgements. That is the nature of politics.
- Government failure is most likely to occur when decisions are made in the vested interest of special interest groups, at the expense of other groups (the result is a loss of equity)
Competition & Monopoly in Markets
A market structure describes the characteristics of a market which can affect the behaviour of businesses and also affect the welfare of consumers. Some of the main aspects of market structure are listed below:
- The number of firms in the market
- The market share of the largest firms
- The nature of production costs in the short and long run e.g. the ability of businesses to exploiteconomies of scale
- The extent of product differentiation i.e. to what extent do the businesses try to make their products different from those of competing firms?
- The price and cross price elasticity of demand for different products
- The number and the power of buyers of the industry’s main products
- The turnover of customers – this is a measure of the number of consumers who switch suppliers each year and it is affected by the strength of brand loyalty and the effects of marketing. For example, have you changed your bank account or your mobile phone service provider in the last year? What might stop you doing this?
What is a monopoly?
- A pure monopolist in an industry is a single seller. It is rare for a firm to have a pure monopoly – except when the industry is state-owned and has a legally protected monopoly.
- A working monopoly: A working monopoly is any firm with greater than 25% of the industries’ total sales. In practice, there are many markets where businesses enjoy some degree of monopoly power even if they do not have a twenty-five per cent market share.
- An oligopolistic industry is characterised by the existence of a few dominant firms, each has market power and which seeks to protect and improves its position over time.
- In a duopoly, the majority of sales are taken by two dominant firms.
How monopolies can develop
Monopoly power can come from the successful organic (internal) growth of a business or throughmergers and acquisitions (also known as the integration of firms).
This is where two firms join at the same stage of production in one industry. For example two car manufacturers may decide to merge, or a leading bank successfully takes-over another bank.
This is where a firm integrates with different stages of production e.g. by buying its suppliers or controlling the main retail outlets. A good example is the oil industry where many of the leading companies are explorers, producers and refiners of crude oil and have their own retail networks for the sale of petrol and diesel and other products.
- Forward vertical integration occurs when a business merges with another business further forward in the supply chain
- Backward vertical integration occurs when a firm merges with another business at a previous stage of the supply chain
The Internal Expansion of a Business
Firms can generate higher sales and increased market share and exploiting possible economies of scale. This is internal rather than external growth and therefore tends to be a slower means of expansion contrasted to mergers and acquisitions.
Barriers to Entry
Barriers to entry are the means by which potential competitors are blocked. Monopolies can then enjoy higher profits in the longer-term. There are several different types of entry barrier – these are summarised below:
- Patents: Patents are legal property rights to prevent the entry of rivals. They are generally valid for 17-20 years and give the owner an exclusive right to prevent others from using patented products, inventions, or processes. Owners can sell licences to other businesses to produce versions of their patented product.
- Advertising and marketing: Developing consumer loyalty by establishing branded products can make successful entry into the market by new firms much more expensive. Advertising can also cause an outward shift of the demand curve and make demand less sensitive to price
- Brand proliferation: In many industries multi-product firms engaging in brand proliferation can give a false appearance of competition. This is common in markets such as detergents, confectionery and household goods – it is non-price competition.
Monopoly, market failure and government intervention
Should the government intervene to break up or control the monopoly power of firms in market?
The main case against a monopoly is that it can earn higher profits at the expense of allocative efficiency. The monopolist will seek to extract a price from consumers that is above the cost of resources used in making the product. And higher prices mean that consumers’ needs and wants are not being satisfied, as the product is being under-consumed. Under conditions of monopoly, consumer sovereignty has been partially replaced by producer sovereignty.
In the two diagrams above we contrast a market where demand is price inelastic (i.e. Ped <1) with one where demand is more sensitive to price changes (i.e. Ped>1). The former is associated with a monopoly where consumers have few close substitutes to choose from. When demand is inelastic, the level ofconsumer surplus is high, raising the possibility that the monopolist can reduce output and raise price above cost thereby operating with a higher profit margin (measured as the difference between price and average cost per unit).
If a monopoly reduces output from the equilibrium at Q1 to Q2 then it can sell this at a price P2. This results in a transfer of consumer surplus into extra producer surplus. But because price is now about the cost of supplying extra units, there is a loss of allocative efficiency. This is shown in the diagram by the shaded area which is not transferred to the producer, merely lost completely because output is lower than it would otherwise be in a competitive market.
Higher costs – loss of productive efficiency:
- Another possible cost of monopoly power is that businesses may allow the lack of real competition to cause a rise in costs and a loss of productive efficiency.
- When competition is tough, businesses must keep firm control of their costs because otherwise, they risk losing market share.
- Some economists go further and say that monopolists may be even less efficient because, if they believe that they have a protected market, they may be less inclined to spend money on research and improved management.
- These inefficiencies can lead to a waste of scarce resources.
Evaluation – Potential Economic Benefits of Monopoly
The possible benefits of monopoly power suggest that the government and the competition authorities should be careful about intervening directly in markets and try to break up a monopoly. Market power can bring advantages both to the firms themselves and also to consumers and these should be included in any evaluation of a particular market or industry.
- Research and development spending: Huge corporations enjoying big profits are well placed to fund capital investment and research and development projects. The positive spill-over effects of research can be seen in more innovation. This is particularly the case in industries such as telecommunications and pharmaceuticals. This can lead to gains in dynamic efficiency and social benefits.
- Exploitation of economies of scale: Because monopoly producers often supply on a large scale, they may achieve economies of scale – leading to a fall in average costs.
- Monopolies and international competitiveness: The British economy needs multinational companies operating on a scale large enough to compete in global markets. A firm may enjoy domestic monopoly power, but still face competition in overseas markets.
Here is a good way to remember some of the issues we have covered regarding monopoly, efficiency and economic welfare
Service – does the lack of competition affect the quality of service to consumers? Prices –how high are prices compared to competitive / contestable market Efficiency – productive, allocative and dynamic Welfare – what are the overall welfare outcomes? Is there a net loss of welfare in markets dominated by businesses with monopoly power?
Many markets have firms with monopoly power but they seem to work perfectly well from the point of view of the consumer. Although there is a consensus among many economists that competition is a force for good in the long-run, we should be careful not simply to assume that monopoly power is bad and competition is good. There are persuasive arguments on both sides.