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Market failure



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Divergence between Social and Private costs and benefits

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Market failure

  2. 2. MARKET FAILURE • Perfect competition – important assumption of welfare economics. • The market, left to itself, allocates resources optimally. • Leads to Efficiency in use of resources, • Equity in distribution of resources. • Maximises welfare of all economic units. – There is equal distribution of income, – Atomistic economic units. – No imperfections in the market, – Preferences are denoted through price changes i.e. only through the market. – Private ownership of assets and income, 2Prabha Panth
  3. 3. • Not all these conditions may apply. • Market failure occurs when one or more of the efficiency conditions is not satisfied. • Causes of market failure: – Monopoly, – Externalities, – Public goods, – Uncertainties and imperfect information, – No market for goods or services, – Ethical considerations – Value Judgements 3Prabha Panth
  4. 4. Perfect competition in product and factor markets lead to: •  Private MC = Social Marginal cost •  Private MB = Social Marginal Benefit. • All exchanges take place in a well defined market • All goods and services are privately owned. • All utility comes only from material consumption. • All goods and services are priced, there are no free goods. 4 Prabha Panth
  5. 5. • Each good and service is provided individually and separately, and is consumed individually and separately. • All consumers have equal incomes and status. • All firms are of same size. No concentration of economic power. • If these conditions are not satisfied, then: PB/PA ≠ MRSx A,B≠ MRSY AB and w/i ≠ MRTSM K,L ≠ MRSN K,L But these assumptions do not exist in reality. Therefore there is always a divergence between Private and Social Costs and Benefits. These are discussed in the following pages: 5Prabha Panth
  6. 6. Externalities: unintended and uncompensated effects of actions of one unit felt by other units. • A consumer buys a commodity, where P = MU of that commodity. • A firm pays hires Labour, where w = MP of labour. • But there are many different types of consumption or production for which no price is paid. A) Positive Impacts: called External Economies or Benefits. For e.g. a person plants a tree in his compound, others get benefit of the shade. No payment for use of shade. B) Negative Impacts: called External Diseconomies or Costs. For e.g. effluents from a factory affect fishing in the river, or cause diseases to those who consume the water. No compensation paid to those who suffer from the pollution. Prabha Panth 6 1. Externalities
  7. 7. • Causes of Externalities: – Joint consumption/production, – No clearly defined property rights (common property). – Unequal income distribution, – No markets for these goods and services, not priced. Leads to divergence between Private and Social Costs/ Benefits. Does not lead to Pareto Optimality and Maximisation of Social Welfare. Prabha Panth 7
  8. 8. 1) External Diseconomy For a firm Marginal Private Cost, PMC = MR. But if the firm is emitting pollution, it leads to Social Costs (Diseconomy). E.g. poisons from a pesticide factory let off into a river. Fish die, people drinking that water are poisoned. But this cost is not included in the costs or P of the product. So Social cost > PMC. Pigou :- this extra cost should be added to PMC, for each unit of output produced. This gives the Social Marginal Cost curve, SMC = MPC + External Cost. If a tax equal to the external cost is added, SMC lies above PMC, and new equilibrium is at lower level of output, Now the P of the product covers the Social Cost. Output falls and the pollution is also reduced. Prabha Panth 8
  9. 9. 9 PMC = MR and rising, at E. Output is Q0 and Market P = P0. But pollution adds to social cost = EE1 = external costs. This is added to PMC to get SMC. If Q0 is still produced, society suffers = EE1. Actual cost to society = 0P1. Market P = P0 < SMC Utility falls, so MSC ≠ MSB. Pigou suggests Social tax = EE1 = FF1. Tax = SMC - PMC Then the firm is on SMC, and equilibrium is at F. Output falls to Q1, and pollution levels fall. Socially acceptable levels. Social cost FF1 = Pigovian tax, is included in the price P0. When SMC > PMC, then govt has to tax the good to reduce its consumption. SMC 0 Q0 Quantity of pesticide P0 Q1 D=AR=MR EF F1 E1 PMC P1 Cost Benefit PIGOVIAN TAX Figure 1 External Diseconomy
  10. 10. Prabha Panth 10 Cost Benefit 2. External Economies or Benefits: Q0 is education provided, which is less than the SMB (Social Marginal Benefit). E < E1. Since social benefits > private benefits, the market is under supplying the service. If SMB is included, then equilibrium is at F, with output = Q1. At F, PMC = SMB, but cost increases to P1. If govt gives subsidy of FF1 = P1P0, then education supply curve shifts left to S2. Equilibrium at F1. So where SMB > PMB, government has to give subsidy, to increase output at reduced cost/ price. Thus the market over supplies goods whose SMC > PMC, and under supplies when SMB > PMB. Hence the market is not efficient nor equitable. Govt intervention is required, no laissez faire. PMB 0 Q0 Education P0 Q1 SMB F E E1 F1 S1 = PMC = SMC P1 SUBSIDY Figure 2 External Economies S2
  11. 11. 2) Monopoly • Monopoly does not satisfy Pareto optimal conditions. 1) MCx < Px i.e. MRTS x,y ≠ MRS x,y MCy Py 2) Consumers take P as given, MRS < Px/Py Taking 1 and 2 together, MRTSxy < MRSxy (since MRTS = MCx/Mcy). In Monopoly P > MC, so MU≠ MC, even under private cost-benefit analysis. Prabha Panth 11
  12. 12. Prabha Panth 12 MC ARC=MRc E PM PC QCQM ARM MRM F 0 Fig.3 Monopoly vs. Perfect competition In fig.3, Monopoly equilibrium is at G, where MRM = MC and MC, with P = PM and Q = QM. But MC at G < PM. Shows exploitation by monopolist. If it was a Perfect Competition firm then, Pc = MC at F, Q = Qc. So Pc < PM, And Qc > QM. In the Edgeworth Box diagram, if both goods A and B are produced by monopolists, then: Pa ≠ MCa ≠ MUa Pb MCb MUb G In other imperfect markets also, none of the conditions of Pareto optimality are fulfilled. Social welfare cannot be maximised. P.C. is thus a crucial assumption of Pareto optimality, but the real markets in capitalist countries are not of Perfect competition.
  13. 13. 3. Public Goods • Public goods are those which one individual can consume without reducing its availability to another individual, and from which no one is excluded. There is Joint Consumption. – Non Rivalry in consumption: If one person consumes a good, others can also consume it. Availability of this good to others will not be reduced. E.g. defence, parks, street lights, roads. But Private goods are ‘rival’, one consumes it, others cannot consume it. The person who buys the good alone enjoys it. – Non Excludable: one person consumes a good, cannot stop others from consuming it. For e.g. if one person uses a road, he cannot stop others from using it. Prabha Panth 13
  14. 14. – Public goods cannot be priced. What is the price of defence, police, public roads? There is no market for Public Goods, where buyers and sellers meet and exchange. – No ownership: No one owns the public goods – they are common property. So there is over use or exploitation of public goods. – Taxes can be considered as payment for public goods. But taxes are not same as prices, where there is direct exchange for the good or service. – Free riders: there are people who don’t pay taxes, but enjoy the benefits of public goods. Prabha Panth 14
  15. 15. 4. Other imperfections Prabha Panth 15 AR = MR LRAC LRMC Q 0 R, C Decreasing Returns: Even with perfect competition, if there are decreasing returns, no equilibrium is possible. LRMC is always falling, and lies below MR. Figure 4. Uncertainty: if there is uncertainty regarding future prices, availability, or change in govt policy, then PC equilibrium cannot be established. Non existent and incomplete markets: as seen in the lesson on Market equilibrium, there could be non existent markets, or incomplete markets. In cases of Market Failure, it is the responsibility of the govt to provide these services to the public. The concept of Pareto Optimality, and the concept of the Free Market maximising Social and Private welfare, is then only a myth. In reality, govt intervention in a number of markets is inevitable for Social and even Private welfare (e.g. ban on smoking). Fig.4 Decreasing returns