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Market Failure & Role ofRegulation
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RRS I What is a Regulation
Emergence of Broad Framework of Study
Are we regulating or de-regulating?
Feedback Market failures -> Regulation
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Framework
Free MarketCompetitive
Forces
Market
Efficiency
Market
FailureRegulation
Regulation Equitable
Distribution
Objective of Regulation Market Efficiency and Equitable Distribution
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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 - 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 MarketCompetitive
Forces
Market
Efficiency
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Perfectly Competitive Market
Free markets allocate Supply of goods to the
buyers who values themmost
Demand for goods to the
sellers who can producethem at least cost
Free market produces thequantity of goods thatmaximizes the sum of consumerand producer surplus
Competitive forces efficientlyallocate the scarce resources
(Arrow, Kenneth, and Debreu, Existence of anequilibrium for a competitive economy, 1954 Formal proof under which the market equilibriumis Pareto efficient)
Free MarketCompetitive
Forces
Market
Efficiency
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The Invisible Hand
Adam Smith stated in 1776, while he intendsonly his own gainhe is led by an invisiblehandto promote an end which was no part of hisintention that is to maximize the wealth of
the nation
The competitive market guides and controls theself seeking activities of each individual tomaximize the wealth of the nation.
Laissez faire Allow them to do opposes stateeconomic interventionism (George Whatley,Principles of Trade, 1774)
Free MarketCompetitive
Forces
Market
Efficiency
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What is a Market Failure
Market failure occurs when freelyfunctioning markets, operating withoutgovernment intervention, 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
Market
FailureRegulation
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Brief History of Market Failure Preclassical economics primarily government regulation; nineteenth
century classical economics harmonization of self interest and socialinterest; neoclassical economics presence of market failures andgovernment to act as an efficient coordinating force
John Stuart Mill, Henry Sidgwick mark a turning point in the literature of
market failure
(Steven G. Medema, 2004)
The concept of market failure initially appeared as a means of explainingin 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 objectivelydetermine the exact scope and type of intervention (Weimer and Vining,1992)
Market
FailureRegulation
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Definition of Market Failure
Market failure when the competitive outcome ofmarkets is not efficient from the point of view ofthe economy as a whole
This is usually because the benefits that themarket confers on individuals or firms carryingout a particular activity diverge from the benefitsas a whole
a case in which a market fails to efficientlyprovide or allocate goods and services incomparison to some ideal standard, such as theperfect competition model
Market
FailureRegulation
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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 Lemons Problem);
Moral Hazards ignorant party lacks information about performance of
the of the agreed upon transaction (Peltzman argument on insureddriver taking more risks);
Equity issues Markets can generate an unacceptable distributionof income and social exclusion
Market
FailureRegulation
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Market Failure due to Externalities
Externalities create divergence between privateand social costs and benefits
Individual consumers and producers may fail totake externalities into account when makingconsumption and production decisions
Consumers and suppliers are assumed toconsider their own private costs and benefits
Market
FailureRegulation
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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 themselvesof consuming a merit good)
Market
FailureRegulation
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Market Failure due to Externalities
Negative Externalities Positive Externalities
Market
FailureRegulation
Negative externalities lead markets to produce a larger quantity than socially
desirable; Positive externalities lead markets to produce a smaller quantity than
is socially desirable
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Market Failure due to Public Good
Free market economy will fail to deliver the efficient quantityof 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 ofprovision
Many goods have a public element but they are not purepublic goods congested motorway
Common resources non excludable but rival examplefishing etc
Because people are not charged for their use of commonresources, they tend to use them excessively (The Tragedy ofCommons, Garret Hardin 1968)
Market
FailureRegulation
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Market Failure due to Market Power
Monopoly A price maker compared to pricetaker 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 rightto produce some good or service patents andcopyrights 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 ofproducers
Market
FailureRegulation
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Market Failure due to Market Power -
Monopoly In a competitive firm price equals marginal
cost while in the case of monopolized marketprice exceeds marginal cost
Monopolist charges a higher price thereforeearning a higher profit
Also there is a deadweight loss implying thatthe monopolist produces less than the sociallyefficient quantity of output.
Monopolist chooses to produce and sell thequantity of output at which the marginalrevenue and marginal cost curve intersect;while the social planner would choose thequantity at which the demanded marginal costcurves intersect.
The monopoly may also use some of its profitpaying for its monopoly profits paying forthese additional costs. Therefore the socialloss from monopoly includes both these costsand the deadweight loss resulting from a priceabove marginal cost
Market
FailureRegulation
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Market Failure due to Natural Monopoly High fixed costs of entering an
industry which causes long runaverage costs to decline as outputexpands
The marginal cost of producing onemore unit is constant averagecost declines as output increasesover a much large range of outputlevels.
Telecommunications, electricity,
water, railways etc. are somenatural monopolies
(Mankiw, 2007)
Market
FailureRegulation
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Market Failure due to Oligopoly In reality a firm is neither perfectly competitive or monopoly in
nature rather somewhere between.
Oligopoly is a market with only a few sellers: A key feature of oligopoly is the tension between co-operation and self-
interest. The group of oligopolists is best off co-operating and acting like a
monopolist producing small quantity of output and charging a priceabove marginal cost cartel or collusion
However the self interest is hindrance to co-operate (example of twoprisoners) dominant strategy leading to Nash equilibrium which is lessthan what monopolist would make profit
As the number of sellers in an oligopoly grows larger, an oligopolisticmarket looks more like a competitive market. The price approachesmarginal cost, and the quantity produced approaches the sociallyefficient level
Co-operation between oligopolists is undesirable from thestandpoint of society to move the allocation of resources closer tosocial optimum, policy makers should try to induce firms in anoligopoly to compete rather than co-operate.
Market
FailureRegulation
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Market Failure due to Information Asymmetry -
(Principal Agentproblem)
Buyers and Sellers will havedifferent information aboutthe products attributes
In one instance when theconsumer is less informed there will be a producersurplus but also a net loss tosociety
Adverse Selection, Moralhazards are a result ofinformation asymmetry
Market
FailureRegulation
Wiemer and Vining (1999)
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Adverse Selection The Market for Lemons
Finally the market for poor quality of cars only exist Good products andgood customers are under represented while bad products and badcustomers are over represented
(Pindyck and Rubinfeld (2001)
Market
FailureRegulation
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Moral Hazards Shirking of Workers
The higher the current rate of unemployment, and the higher the wagepaid over the market wage, the more effective will be the threat ofdismissal
Market
FailureRegulation
(Pindyck and Rubinfeld (2001)
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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, analysts attempt to identifyboth the precise type of problem that gives rise to the marketfailure
P
olicy analysts argue that existence of a market failure provides anecessary, not a sufficient justification for public policyinterventions. A double market failure test is required. (Weimer &Vining, 1992).
Sufficiency is established when the gains from governmentintervention outwieghs the dangers of government intervention
Market
FailureRegulation
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Government Intervention to Correct Market Failure
(1) Command and Control technique (including regulation)
(2) Government subsidy and other forms of financialassistance (including research grants and taxallowances/tax exemptions)
(3) Taxation (including indirect taxes designed to controlpollution)
(4) Policies to increase competition and reduce theimmobility of factors of production
(5) Provision and finance of public and merit goods
(6) Introduction/expansion of market based incentives tochange both consumer and producer behaviour
Market
FailureRegulation
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Government Intervention to Correct Market Failure
Market
FailureRegulation
Problem Intervention Evaluation
Zero provision of
public goods
Direct provision of public goods
Negative
externalities
Financial intervention: taxes (equal to the
monetary value of the MEC) are imposed on
individuals or a firm, 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, 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 thatimposes an EC, e.g. pollution permits
Enforcement is difficult and expensive
Education, campaigns and advertisements solve
the problem of imperfect information by
allowing the external costs to be made known to
the consumer, discouraging demand
Benefits must outweigh the costs of implementation.
A lot of time may be needed for effects to be felt
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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, the valuation of EB is difficult
High government expenditure is required
Okuns leaky bucket: each dollar transferred from a
richer to a poorer individual, results in less than a
dollar increase in income for the recipient. Leaks
arise as a result of administrative costs, changes in
work effort, attitudes etc. arising from the
redistribution
Legislation include regulation seatbelt usage,
compulsory education etc.
Enforcement requires constant checking which may
translate to high costs.
Government Intervention to Correct Market Failure
Market
FailureRegulation
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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.Social justice: they should be provided according to need and not ability to pay
2.Large positive externalities, for example in the provision of free health services helps to contain and
combat the spread of disease
3.Dependants are subject to their guardians decision which are not necessarily the best, therefore the
provision of services like free education and dental treatment is needed to protect dependants from
uninformed or bad decisions
4.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), and supernormal profits are taken as
tax. Governments may also regulate MC/AC pricing for monopolies.
Government may impose regulations to control a monopolies
1.Forbidding the formation of monopolies (e.g., antitrust laws)
2.Forbidding monopolistic behaviour (like predatory pricing)
3.Ensuring standards of provision.
4.Ensuring competition exists (e.g., deregulation)
Market
FailureRegulation
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Government Intervention to Correct Market Failure
Natural Monopolies In the case of Natural Monopoly the essence of regulation is the explicit replacementof competition with governmental orders with principal institutional device forassuring good performance.
In the case of natural monopoly the primary guarantor of acceptable performance is
conceived to be not competition or self restraint but direct governmental prescriptionof major aspects of their structure and economic
There are four principal components of this regulation that in combinationdistinguish the public utility from other sectors of the economy: control of entry,price fixing, prescription of quality and conditions of service, and an imposition of anobligation to serve all applicants under reasonable conditions.
(The principles of economic regulation, A.E.Kahn)
Market
FailureRegulation
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Some regulating act in India
Sectors Type of MarketFailure
Regulator Type of Regulation Relevant Statutes
Utilities Natural Monopoly,Externalities, Public
Good,
CERC, SERCs Licensing, Tarifffixation, QoS
standards, Dispute
Resolution
Electricity Act 2003
Oil & Gas Natural Monopoly,Externalities
Petroleum and NaturalGas Regulatory Board
Licensing, Tarifffixation, QoS
standards, Dispute
Resolution
Petroleum and NaturalGas Regulatory Board
Act 2006
Petroleum Act 1934
Petroleum and MineralsPipelines Act, 1962
Tele Communications Monopolistic,Oligopoly
TRAI Licensing, Tarifffixation, QoS
standards,Interconnection,Spectrum Management
(Advisory)
TRAI Act 1997
Banking InformationAsymmetry,
RBI Monetary policy
Supervision &Regulation
Banking Act 1959
Market
FailureRegulation
Consultation paper on Approach to Regulation Issues and Options, Planning Commission India
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Regulation - Summary The possibility of market failure underpin the economic
rationale for state regulation of market economies.
Regulations can take different forms with different roles
Health, safety regulations and environmental regulations canbe rationalized on the basis of imperfect information andexternalities
Economic regulation of public utilities can be explained byeconomies of scale and scope and need to protect theconsumers from monopoly exploitation
Aspects of fiscal policy can be rationalized on the basis interms of wealth and income redistribution
Regulatory intervention for universal service obligations etc.
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Regulation - Summary
Regulation cannot be limited to economic issues means to ultimately achieve non-economic ends
Intentions and outcomes are therefore defined by acombination of economic, social, political andbureaucratic factors and cannot be attributed to one
set of factors alone Involvement of disciplines other than economics (law,
political science, sociology etc.) Broad definition the use of public authority to set
and apply rules and standards (Hood et al, 1999)(Economic Regulation A Preliminary literature review and summary ofresearch questions Parker)
As an effort by the state to address social risk, marketfailure or equity concerns through rule based directionof individual and society (Planning Commissionconsultation paper on Regulation)
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Regulation - Summary
Regulation is a complex balancing act between advancing theinterests of consumers, competitors and investors, whilepromoting a wider, public interest agenda. minimum prices to benefit the consumer (maximize consumer
surplus); ensure adequate profits are earned to finance the proper
investment needs of the industry (earn at least a normal rate ofreturn on capital employed);
provide an environment conducive for new firms to enter theindustry and expand competition (police anti-competitivebehavior by the dominant supplier);
preserve or improve the quality of service (ensure higherprofitability is not achieved by cutting services to reduce costs);
identify those parts of the business which are naturally
monopolistic (statutory monopolies that are not necessarilyjustified in terms of either economies of scale or scope);
take into consideration social and environmental issues (e.g.when removing cross subsidization of services).
(Parker, 2000)
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ReferencesBooks
1. Mankiw, N. Gregory. (2007). Principles of Economics. 3rd Indian Edition,
2. Friedman, D. (1990). Market Failures. Chapter 18. Price Theory. SouthwesternPublishing
3. Djolov, G. George. (2008). The Economics ofCompetition The Race to Monopoly.
Jaico publishing house
4. Michael, A. & Hahnel, R,.A quiet revolution in welfare economics. Online book.
Journals1. Dollery, B. and Worthington, A. (1996). The Evaluation of Public Policy.Normative Economic Theories of Government Failure. Journal of InterdisciplinaryEconomics 7(1):pp. 27-39.
2. Medema, G. Steven. (2004). Mill, Sidgwick, and the evolution of the theory ofmarket failure. History ofPolitical Economy
3. Stigler, J. George. (1971). The theory of economic regulation. Bell Journal ofEconomics 2(1), Page 3-21
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References
4. Shleifer, Andrei. Understanding Regulation. European School ofManagement, Vol 11, No. 4, 2005, pp 439 451
5. Hammond, J. Peter. (1997).The Efficiency Theorems and MarketFailure. Elements of General Equilibrium Analysis, Basil Blackwell
6. Parker, D. (1999). Regulation of privatized public utilities in theUK: performance and governance. International Journal ofPublicSector Management. Vol 12, pp 213-236.
7. Dollery, B., & Wallis, J. (2001). The theory of market failure andpolicy making in contemporary Local Government. Working Paperin Economics
8. Consultation Paper(2006).Approach to Regulation: Issues andOptions. Planning Commission, Government of India
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Thank You
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