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Chapter 9 The Economics Of Information & Market Failure

  1. CHAPTER 9 The Economics Of Information & Market Failure
  3. Learning Objectives What will you learn in this module?  What are the four important sources of market failure?  Explain why market power reduces social welfare?  What is deadweight loss created by monopoly? How public policy aimed at reducing deadweight loss?  Why externalities can lead competitive markets to provide socially inefficient quantity of goods and services?  Why competitive markets failed to provide socially efficient levels of public goods? 2-3
  4. Market Failure and efficiency • The socially efficient quantity in a market occurs where price equals marginal cost. This quantity maximizes the sum of consumer and producer surplus. • This socially efficient price and quantity arise naturally in a perfectly competitive market. 14-4
  5. Market Failure and efficiency • When a firm in a market produces an output that is less than the socially efficient level because it charges a price that exceeds marginal cost, the firm has market power. • The value to society of producing another unit is greater than the cost to produce another unit. • Government may intervene in the market in attempt to increase social welfare. 14-5
  6. A VIDEO ABOUT “Market Failure”
  7. Deadweight loss and Market failure • The figure shows monopolist’s demand, marginal cost and marginal revenue curves. The profit maximising output is Qm units and the units are sold at price Pm, consumers pay more for the last unit of output than its costs. Total social welfare is the region W, while the triangle area is the deadweight loss of the monopoly. 2-7
  8. A VIDEO ABOUT “Deadweight Loss” o
  9. Welfare and Deadweight Loss Under Monopoly 14-9 Price Quantity Demand MR MC 𝑄 𝑀 𝑃 𝑀 Deadweight loss Social welfare
  10. CHAPTER 9 The Economics Of Information & Market Failure
  11. IMPORTANT SOURCES OF MARKET FAILURE Market Control - Price Regulation
  12. Price Regulation • The presence of large scale economies may make it desirable for a single firm to service an entire market. • In these instances, government may permit a monopoly to exist, but regulate its price in effort to reduce the deadweight loss. 14-
  13. Regulating a Monopolist’s Price at the Socially Efficient Level Price Quantity Demand MR MC 𝑄 𝑀 𝑃 𝑀 𝑃 𝐶 Regulated price Effective demand 𝑄 𝐶
  14. Regulating monopoly price • Government can regulate monopoly’s price to reduce the deadweight loss. • An unregulated monopoly produces Qm units of output at price Pm. A competitive industry would produce Qc units, where MC intersects the demand curve • If government enforced a regulated price Pc then so the maximum price it can charge for units less than Qc is Pc. 2-
  15. Monopolist’s Break even point • The welfare loss of monopoly arising from monopoly can be analysed through its average total cost curve. • In the diagram monopoly produce at the break even point. • Unregulated monopoly would produce Qm units and charge Pm. Since price is equal to the total cost of production, the monopolist earns zero economic profits in the absence of regulation 2-
  16. Monopolist’s zero Economic profits Price Quantity Demand MR MC 𝑄 𝑀 𝑃 𝑀 𝑃 𝐶 Regulated price 𝑄 𝐶 ATC
  17. CHAPTER 9 The Economics Of Information & Market Failure
  19. Externalities • Externalities arises when costs borne by parties who are not involved in the production or consumption of the good. • Negative externalities exist when costs are borne by parties who are not involved in the production or consumption of a good or service. • The reason externalities cause a “market failure” is the absence of well-defined property rights. • The failure is often resolved when a government defines itself to be the owner of the environment, and uses its power to induce the socially efficient levels of output and pollution. 14-
  20. A VIDEO ABOUT “Negative Externalities and Market Failure” JUFor
  21. The Socially Efficient Equilibrium in the Presence of External Costs Output of steel Price of steel 𝑆 = 𝑖=1 𝑁 𝑀𝐶𝑖 (internal costs) 0 𝑄 𝑆 Demand 𝑃 𝐶 Marginal cost to society of producing steel (internal and external costs) 𝑃 𝑆 𝑄 𝐶 Marginal cost of pollution to society (external costs) A B Free market equilibrium C Socially efficient equilibrium
  22. Internalise the externalities • The supply curve is based on the private costs paid by the steel firms, if they are allowed to dump pollutant s into the water for free the market equilibrium is at point B • At this quantity, society pays marginal price of A, on top of the price of Pc paid to the steel firms • The cost of pollution is not internalised by the seller and buyer of steel products • The firms who take into account the pollution cost to society, their marginal cost curve would become vertical sum. 2-
  23. CHAPTER 9 The Economics Of Information & Market Failure
  25. Public Goods • A public good is another type of good that leads to a market failure. • A public good is: • A good that is nonrivalous and nonexclusionary in consumption, and therefore, benefit persons other than those who buy the goods. • Nonrivalous consumption: the consumption of the good by one person does not preclude other people from also consuming the good. • Nonexclusionary consumption: once provided, no one can be excluded from consuming the good. 14-
  26. A VIDEO ABOUT “Public Good” M8
  27. Public Goods and Inefficiencies • Public goods leads the market to provide inefficient quantities since everyone gets to consume a public good once it is available, but individuals have little incentive to purchase the good; they prefer others to pay for it. • When a group of individuals rely on the efforts or payments of others to provide a good, we say there is a free-rider problem. 14-
  28. CHAPTER 9 The Economics Of Information & Market Failure
  30. Incomplete Information • Efficiently functioning markets require participants to have reasonably good information about prices, quality, available technologies, and the risks associated with working particular jobs or consuming particular products. • Market inefficiencies result when participants have incomplete information. • One severe source of market failure is asymmetric information, where some market participants have better information than others. Then buyers may refuse to purchase from sellers 14-
  31. A VIDEO ABOUT “Asymmetric Information” vMnU
  32. Resource Allocation and Rent Seeking • Rent Seeking: selfishly motivated efforts to influence another party’s decision. • Monopolist’s rent seeking creates a loss of social welfare and inequality of income distribution. • Monopolists tend to earn higher incomes than average, the existence of the monopoly in the economy will tend to increase the inequality of income distribution. • Government policies can improve the allocation of resources to alleviate market failures and maximise overall welfare. 14-
  33. Government policy • Regulation presents a number of problems in the case of natural monopolies. • If a monopoly can avoid regulation, it can receive private gains. • Monopoly spends much more on lobbying activities and avoids legislation by engaging in rent-seeking activities. • Government enforcement cost will be very high. • These policies, however, generally benefit some parties at the expense of others due to ‘free rider’ problem. 2-
  34. What is Quota? • A quota is a government restriction that limits the quantity of imported goods that can legally enter the country. • The implications of quota policy: • Reduces competition in domestic market • Higher domestic prices • Higher profits for domestic firms • Lower consumer surplus for domestic consumers • Conclusion: Domestic producers benefit at the expense of domestic consumers and foreign producers 14-
  35. What is Tariffs? • A tariff is designed to limit foreign competition in the domestic market to benefit domestic producers, which accrue at the expense of domestic consumers and foreign producers. • Lump-sum tariff: fixed fee that foreign firms must pay the domestic government to be able to sell in the domestic market. • Excise (per-unit) tariff: the fee an importing firm must pay to the domestic government on each unit it brings into the country. 14-
  36. Conclusion • Market power, externalities, public goods, and incomplete information create a potential role for government in the marketplace to remedy market failures. • Government’s presence creates rent-seeking incentives, which may undermine its ability to improve matters. 14-
  37. RECAP On Key Terms and Concepts 2-37
  38. Key terms • Deadweight loss • Incomplete information • Free rider problem • Rent seeking • Negative externalities • Property rights • Public goods • Nonrival consumption • Social welfare • Inequality 2-