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8/4/2019 Market Failure & Role of Regulation
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Market Failure & Role of
Regulation
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Market Failure
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Market Failure
Definition:
Where the market mechanism fails toallocate resources efficiently
Social Efficiency
Allocative Efficiency
Technical Efficiency
Productive Efficiency
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Market Failure
Social Efficiency = where external costsand benefits are accounted for
Allocative Efficiency = where societyproduces goods and services at minimum
cost that are wanted by consumers Technical Efficiency = production of
goods and services using the minimumamount of resources
Productive Efficiency = production ofgoods and services at lowest factor cost
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Market Failure
Allocative efficiency:
Also referred to as
Pareto Efficient Allocation resourcescannot be readjusted to make oneconsumer better off without making
another worse off zero opportunity cost!
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Market Failure
Market Failure occurs where: Knowledge is not perfect - ignorance
Goods are differentiated
Resource immobility Market power
Services/goods would or could not be providedin sufficient quantity by the market
Existence of external costs and benefits
Inequality exists
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Market Failure
Imperfect Knowledge:
Consumers do not have adequate technicalknowledge
Advertising can mislead or mis-inform Producers unaware of all opportunities
Producers cannot accurately measureproductivity
Decisions often based on past experiencerather than future knowledge
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Market Failure
Goods/Services are differentiated
Branding
Designer labels - they cost three times as muchbut are they three times the quality?
Technology lack of understanding of the impact
Labelling and product information
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Market Failure
Resource Immobility Factors are not fully mobile
Labour immobility geographical andoccupational
Capital immobility Not the financial one.
Land cannot be moved to where it might beneeded!
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Market Failure
Market Power:
Existence of monopolies and oligopolies
Collusion
Price fixing Abnormal profits
Rigging of markets
Barriers to entry
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Market Failure
Inadequate Provision:
Merit Goods and Public Goods
Merit Goods Could be provided by the
market but consumers may not be able toafford or feel the need to purchase marketwould not provide them in the quantitiessociety needs
Sports facilities?
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Market Failure
Merit Goods
Education nurseries, schools,colleges, universities could all beprovided by the market but wouldeveryone be able to afford them?
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Market Failure
Public Goods
Markets would not provide such goods andservices at all!
Non-excludabilityPerson paying for thebenefit cannot prevent anyone else from alsobenefiting - the free rider problem. Buyinghouse near the main road.
Non-rivalry
Large external benefits relative to cost socially desirable but not profitable tosupply! Like govt. libraries
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Market Failure
De-Merit Goods
Goods and services provided by themarket which are not in our best interests!
Tobacco and alcohol Drugs
Gambling
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Market Failure
External Costs and Benefits
External or social costs
The cost of an economic decision to a third
party External benefits
The benefits to a third party as a result of adecision by another party
Examples in next pages
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Market Failure
External Costs Decision makers do not take into
account the cost imposed on society
and others as a result of theirdecision e.g. pollution, traffic congestion,
environmental degradation, depletion ofthe ozone layer, misuse of alcohol,
tobacco, anti-social behaviour, drugabuse, poor housing
The difference between the
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External CostsPrice
Quantity Bought and Sold
MSB
MPC
Rs 5
100
MSC = MPC + External Cost
Rs12
Social CostValue of the negativeexternality (Welfare Loss)Rs 7
80
Socially efficient output is whereMSC = MSB The Marginal Social
Benefit curve (MSB)represents the sum of the
benefits to consumers insociety as a whole theprivate and socialbenefits. The MarginalPrivate Cost (MPC) curverepresents the costs tosuppliers of producing agiven output.
The MPC does not take into account thecost to society of production. At anoutput level of 100, the private cost tothe supplier is Rs 5 per unit but thecost to society is higher than this (Rs12).
The true cost therefore is theMSC (the MPC plus the externalcost). Current output levelstherefore (100) represent someelement of market failure price does not accurately reflecthe true cost of production.
The difference between thevalue of the MSB and the MSCrepresents the welfare loss tosociety of 100 units beingproduced.
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Market Failure
External benefits by products of production and
decision making that raise the
welfare of a third party e.g. education and training, public
transport, health education andpreventative medicine, refuse collection,investment in housing maintenance, law
and order
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External Benefits
Price
Quantity Bought and Sold
MPB
MSC
Rs 5
100
Value of the positive
externality (Welfare Loss)
Socially efficient outputis whereMSC = MSB
MSB
Rs10
Rs 6.50
140
Social Benefits
There can be a positionwhere output is less than
would be sociallydesirable (education forexample?) In this case,the sum of the benefits tosociety is greater than theprivate benefit to theindividual.
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Market Failure
Inequality:
Poverty absolute and relative
Distribution of factor ownership
Distribution of income Wealth distribution
Discrimination
Housing
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Market Failure
Measures to correct market failure State provision Extension of property rights Taxation
Subsidies Regulation Prohibition Positive discrimination
Redistribution of income
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Emergence of Broad Framework of Study
Are we regulating or de-regulating?
Feedback Market failures -> Regulation
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Free MarketCompetitiveForces
MarketEfficiency
MarketFailure
Regulation
Regulation EquitableDistribution
Objective of Regulation
Market Efficiency and Equitable Distribution
What is a Regulation
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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 MarketCompetitiveForces
MarketEfficiency
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Perfectly Competitive Market
Free markets allocate Supply of goods to the
buyers who values themmost
Demand for goods to thesellers who can produce
them at least cost
Free market produces thequantity of goods thatmaximizes the sum of consumerand producer surplus
Competitive forces efficientlyallocate the scarce resources
Free MarketCompetitiveForces
MarketEfficiency
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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 ofthe 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
Free MarketCompetitiveForces
MarketEfficiency
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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 welfaremay not be maximized
This leads to a loss of economic efficiency
Market
FailureRegulation
M k t
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Brief History of Market Failure Preclassical economics primarily government regulation;
nineteenth century classical economics harmonization ofself interest and social interest; neoclassical economics presence of market failures and government to act as anefficient coordinating force
The concept of market failure initially appeared as a means ofexplaining in economic terms why the need for governmentexpenditures should arise normative judgement about therole of government
As it matured the market failure concept on an additionalcharacteristics diagnostic tool by which policy makerslearned how to objectively determine the exact scope andtype of intervention.
Market
FailureRegulation
Market
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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
Market
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Main causes of Market Failure
Externalities causing private and social costsand/or benefits to diverge
Public goods and Common Resources
Market dominance and abuse of monopoly power
Equity issues Markets can generate an
unacceptable distribution of income and socialexclusion
MarketFailure
Regulation
Market
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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
Market
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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 thesocial benefit > private benefit
Information failure may lead to under-consumption(individuals not fully aware of the benefits to themselvesof consuming a merit good)
MarketFailure
Regulation
Market
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Market Failure due to Externalities
Negative Externalities Positive Externalities
MarketFailure
Regulation
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
Market
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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 consuminga good or a service without paying for the costs ofprovision
Many goods have a public element but they are not purepublic goods congested motorway
MarketFailure
Regulation
MarketR l i
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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 right
to produce some good or service patents andcopyrights given by the government
Provide incentive for research and creativity activity offsetby the monopoly prices
Natural Monopoly - The costs of production make asingle producer more efficient than a larger number ofproducers
MarketFailure
Regulation
MarketR l ti
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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 that
the 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
MarketFailure
Regulation
MarketR l ti
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Market Failure due to Natural Monopoly
High fixed costs of entering anindustry which causes long runaverage costs to decline as outputexpands
The marginal cost of producing one
more unit is constant averagecost declines as output increasesover a much large range of outputlevels.
Telecommunications, electricity,water, railways etc. are somenatural monopolies
MarketFailure
Regulation
MarketRegulation
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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 amonopolist 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 approaches
marginal 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.
FailureRegulation
MarketRegulation
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Moral HazardsShirking 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
FailureRegulation
MarketRegulation
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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 correctfor perceived market failure
To employ the diagnostic approach, analysts attempt to identifyboth the precise type of problem that gives rise to the marketfailure
Policy analysts argue that existence of a market failure provides a
necessary, not a sufficient justification for public policyinterventions. A double market failure test is required.
Sufficiency is established when the gains from governmentintervention outwieghs the dangers of government intervention
FailureRegulation
MarketRegulation
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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
FailureRegulation
MarketRegulation
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Government Intervention to Correct Market Failure
FailureRegulation
Problem Intervention Evaluation
Zero provision of
public goodsDirect 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
AdvantagesLeaves space for market forces to interactProvision of revenue for the government
DisadvantagesDifficulty in valuating ECOvervaluation means output is below social
optimum, as with undervaluation means that output
is not sufficiently lowered (ie, societys welfare is not
always maximized)Effectiveness of tax dependent on PED
Legislation: laws and administrative rules are
passed to prohibit or regulate behaviour that
imposes an EC, 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
MarketRegulation
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Positive
Externalities
Financial intervention: subsidies made to the
producer or consumer
AdvantagesConsidered the most effective way of solving
underconsumption as it is easily implementedDisadvantagesLike taxes, the valuation of EB is difficultHigh government expenditure is requiredOkuns leaky bucket: each dollar transferred from a
richer to a poorer individual, results in less than adollar 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
FailureRegulation
MarketRegulation
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Government Intervention to Correct Market Failure
Non provision of
merit goodsThere is a need to produce merit goods (which are naturally underconsumed) at low prices or for free due
to four reasons1.Social justice: they should be provided according to need and not ability to pay2.Large positive externalities, for example in the provision of free health services helps to contain and
combat the spread of disease3.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 decisions4.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 monopolies1.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)
FailureRegulation
MarketF il
Regulation
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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 isconceived 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)
FailureRegulation
MarketF il
Regulation
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Some regulating act in India
Sectors Type of MarketFailure
Regulator Type of Regulation Relevant Statutes
Utilities Natural Monopoly,Externalities, PublicGood,
CERC, SERCs Licensing, Tarifffixation, QoSstandards, DisputeResolution
Electricity Act 2003
Oil & Gas Natural Monopoly,Externalities
Petroleum and NaturalGas Regulatory Board
Licensing, Tarifffixation, QoSstandards, DisputeResolution
Petroleum and NaturalGas Regulatory BoardAct 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
FailureRegulation
Regulation Equitable
Distribution
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Theorem of Welfare Economics First Theorem
If (1) households and firms act perfectly competitively, taking price asparametric, (2) there is a full set of markets, and (3) there is perfectinformation, then a competitive equilibrium, if it exists, is Paretoefficient
Second Theorem If household indifference maps and firm production sets are convex, if
there is a full set of markets, if there is perfect information, and iflump sum transfers and taxes may be carried out costlessly, then andPareto efficient allocation can be achieved as a competitive equilibriumwith appropriate lump sum transfers and taxes (The size of output isnot shrunk)
Ideally, this would be achieved through measures that did not destroythe efficiency properties, and much of welfare economics is based onthe assumption that non-discriminatory taxes and transfers can becarried out
Distribution
Regulation Equitable
Distribution
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Policies to reduce poverty
Minimum Wage Laws
Welfare
Negative Income Tax
In-kind transfers
Antipoverty programs and work incentives
Trade-off between equality and efficiency
Distribution
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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 the
consumers 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 oneset of factors alone
Involvement of disciplines other than economics (law,political science, sociology etc.)
Broad definition the use of public authority to setand apply rules and standards (Hood et al, 1999)
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 of
return on capital employed); provide an environment conducive for new firms to enter the
industry 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).
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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 of Competition 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 of Political 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 of PublicSector 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