Market Failure & Role of Regulation 1[1]

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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


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)


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)


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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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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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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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.


Market

FailureRegulation


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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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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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Market Failure & Role of Regulation 1[1]