Market Failure & Role of

Regulation
Ch 3 & 4
 Econ 2.4
Learning

What are examples of

market failure?

What is a government
Intervention?

How, when and why does the

government intervene in the market
 Market Failure can occur in a number
of ways…
1. Some products may be under produced or not at all. Thus
resources are under allocated to their production
2. Some good may be over produced. Thus resources are
over allocated to their production.
3. The production or consumption of some products affects
third parties with spill overs, these social costs are not
included in the private market price.

Market failure implies a loss of allocative efficiency

the potential total surplus in the market is not
maximised
A deadweight loss may exist
 Market Failure Examples
Pollution, air, water, soil

Traffic congestion

Deforestation and loss of

biodiversity

Health problems associated

with consumption of
tobacco, alcohol and illicit
drugs

Depleted fish stocks

Global Warming
Examples of goods which the market fails to provide in
adequate quantities

 Roading
 Health services
 Waste disposal
 Library services
 Education
 Train transport
 Affordable housing
ange of Government Interventions

Street lighting Unequal income distribution

Safety for cyclists
Passive smoking
Obesity Public transport Drink driving
Quality education
Recycling Affordable medicine
Cigarettes
Carbon Emissions

What tools does the government us

to solve these problems
Positive Externality of
Production

P$

MPC

MSC

MSB

Q
Job training and
education at work
Negative Externality of Production
P$

MSC

MPC

MSB

Q Nuclear Power Generation

Negative Externality of
Consumption
P$

MSC

MPB

MSB
Alcohol Consumption
Q
Positive Externality of
Consumption
P$

MSC

MSB

MPB

Q
Education at University
Graphing externalities
Roles of Government

 Legislative or Regulatory Role

 Allocative Role
 Distributive Role
 Stabilisation Role
 Activity
 Several market failures are obvious in many developed
countries.

 Affordable medicines – underprovided and overpriced by market

 Public transport – underprovided and overpriced by market
 Obesity and heart disease – negative externality on society

 You have a summary about “government measures to

compensate for market failure”, and also a list of the effects.

 Task: for the three market failures listed above can you
 Suggest a suitable government intervention
 Analyse the effects of this intervention on the market.
 Explain the overall effect on allocative efficiency and DWL
Framework
Competitive Market
Free Market
Forces Efficiency

Market
Regulation
Failure

Regulation Equitable
Distribution

Objective of Regulation – Market Efficiency and Equitable Distribution

 Market
Regulation
Failure

What is a Market Failure

 Market failure occurs when freely
functioning markets, operating without
government 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
Regulation
Failure

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
 Moral Hazards – ignorant party lacks information about performance of
the of the agreed upon transaction

 Equity issues – Markets can generate an unacceptable distribution of

income and social exclusion
EXTERNALITIES AND ENVIRONMENTAL
ECONOMICS

externality A cost or benefit resulting from some

activity or transaction that is imposed or bestowed
on parties outside the activity or transaction.
Sometimes called spillovers or neighborhood
effects.

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EXTERNALITIES AND ENVIRONMENTAL
ECONOMICS

MARGINAL SOCIAL COST AND

MARGINAL-COST PRICING
marginal social cost (MSC) The total cost to
society of producing an additional unit of a good
or service. MSC is equal to the sum of the
marginal costs of producing the product and the
correctly measured damage costs involved in the
process of production.

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EXTERNALITIES AND ENVIRONMENTAL
ECONOMICS

FIGURE 15.1 Profit-Maximizing Perfectly Competitive Firms

Will Produce Up to the Point That Price Equals
Marginal Cost (P = MC) 19 of 35
EXTERNALITIES AND ENVIRONMENTAL
ECONOMICS

Acid Rain and the Clean Air Act

Acid rain is an excellent example of an externality
and of the issues and conflicts in dealing with
externalities.

The case of acid rain highlights the fact that efficiency

analysis ignores the distribution of gains and losses.
That is, to establish efficiency we need only to
demonstrate that the total value of the gains exceeds
the total value of the losses.

Other Externalities

20 of 35
EXTERNALITIES AND ENVIRONMENTAL
ECONOMICS

marginal private cost (MPC) The amount

that a consumer pays to consume an
additional unit of a particular good.
marginal damage cost (MDC) The
additional harm done by increasing the level
of an externality-producing activity by one
unit. If producing product X pollutes the
water in a river, MDC is the additional cost
imposed by the added pollution that results
from increasing output by one unit of X per
period.

When economic decisions ignore external costs, whether those costs are borne by one
person or by society, those decisions are likely to be inefficient.
21 of 35
EXTERNALITIES AND ENVIRONMENTAL
ECONOMICS

Five approaches have been taken to

solving the problem of externalities:

(1) government-imposed taxes and

subsidies,

(2) private bargaining and negotiation,

(3) legal rules and procedures,

(4) sale or auctioning of rights to impose

externalities, and
(5) direct government regulation.
22 of 35
EXTERNALITIES AND ENVIRONMENTAL
ECONOMICS

Taxes and Subsidies

FIGURE 15.3 Tax Imposed on a Firm Equal to Marginal

Damage Cost
23 of 35
EXTERNALITIES AND ENVIRONMENTAL
ECONOMICS

Bargaining and Negotiation

Coase theorem Under certain

conditions, when externalities are
present, private
parties can arrive at the efficient
solution without government
involvement.

24 of 35
EXTERNALITIES AND ENVIRONMENTAL
ECONOMICS

Legal Rules and Procedures

injunction A court order forbidding

the continuation of behavior that leads
to damages.

liability rules Laws that require A to

compensate B for damages imposed.

25 of 35
EXTERNALITIES AND ENVIRONMENTAL
ECONOMICS

Selling or Auctioning Pollution Rights

Singapore is known for its

many laws designed to
reduce negative externalities.
Littering, chewing gum in
public, eating on a subway
car, failing to flush a toilet,
and
vandalizing public property
are all considered serious
offenses that are punishable
by imprisonment, fines,
and/or public chastisement.

26 of 35
EXTERNALITIES AND ENVIRONMENTAL
ECONOMICS

Direct Regulation of Externalities

Taxes, subsidies, legal rules, and public

auction are all methods of indirect regulation
designed to induce firms and households to
weigh the social costs of their actions against
their benefits.

Direct regulation of externalities takes place at

the federal, state, and local level.

27 of 35
PUBLIC (SOCIAL) GOODS

public goods (social or collective

goods) Goods that are
i. non-rival in consumption
ii. their benefits are non-excludable.

In an unregulated market economy with no government to see that they are produced,
public goods would at best be produced in insufficient quantity and at worst not produced
at all.
28 of 35
PUBLIC (SOCIAL) GOODS

THE CHARACTERISTICS OF PUBLIC

GOODS
nonrival in consumption A characteristic of
public goods: One person’s enjoyment of the
benefits of a public good does not interfere
with another’s consumption of it.

nonexcludable A characteristic of most

public goods: Once a good is produced, no
one can be excluded from enjoying its
benefits.

29 of 35
PUBLIC (SOCIAL) GOODS

free-rider problem A problem intrinsic to

public goods: Because people can enjoy the
benefits of public goods whether they pay for
them or not, they are usually unwilling to
pay for them.

drop-in-the-bucket problem A problem

intrinsic to public goods: The good or
service is usually so costly that its provision
generally does not depend on whether or
not any single person pays.

Consumers acting in their own self-interest have no incentive to contribute voluntarily to the
production of public goods. Some will feel a moral responsibility or social pressure to
contribute, and those people indeed may do so. Nevertheless, the economic incentive is
missing, and most people do not find room in their budgets for many voluntary payments.
30 of 35
 Competitive Market
Free Market
Forces Efficiency

Perfectly Competitive Market

 Free markets allocate
 Supply of goods to the buyers
who values them most
 Demand for goods to the
sellers who can produce them
at least cost

 Free market produces the

quantity of goods that maximizes
the sum of consumer and
producer surplus

 Competitive forces efficiently

allocate the scarce resources

(Arrow, Kenneth, and Debreu, Existence of an

equilibrium for a competitive economy, 1954 –
Formal proof under which the market equilibrium is
Pareto efficient)
 Market
Regulation
Failure

Market Failure due to Public Good

In the case of public goods and common resources, externalities arises because
something of value has no price attached to it.
“goods which will enjoy in common in the sense that each individual’s consumption
of such a good leads to no subtractions from any other individual’s consumption of
that good. For ex: fishing grounds, pastures, forests, water
 Market
Regulation
Failure

Market Failure due to Public Good

 Free market economy will fail to deliver the efficient quantity
of 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 of provision

 Many goods have a public element but they are not pure
public goods – congested motorway

 Common resources – non excludable but rival – example

fishing etc

 Because people are not charged for their use of common

resources, they tend to use them excessively (The Tragedy of
Commons)
 Market

Market Failure due to Market

Regulation
Failure

Power
 Monopoly – A price maker compared to price
taker 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 and
copyrights 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 of
producers
 Market
Regulation
Failure

Market Failure due to Market Power -

Monopoly
 In a competitive firm – price equals marginal
cost while in the case of monopolized market
price exceeds marginal cost

 Monopolist charges a higher price therefore

earning a higher profit

 Also there is a deadweight loss implying that

the monopolist produces less than the socially
efficient quantity of output.

 Monopolist chooses to produce and sell the

quantity of output at which the marginal
revenue and marginal cost curve intersect;
while the social planner would choose the
quantity at which the demand and marginal
cost curves intersect.

 The monopoly may also use some of its profit

paying for its monopoly profits paying for
these additional costs. Therefore the social
loss from monopoly includes both these costs
and the deadweight loss resulting from a price
above marginal cost
 Market
Regulation
Failure

Market Failure due to Natural

Monopoly
 High fixed costs of entering an
industry which causes long run
average costs to decline as output
expands

 The marginal cost of producing one

more unit is constant – average
cost declines as output increases
over a much large range of output
levels.

 Telecommunications, electricity,
water, railways etc. are some
natural monopolies

(Mankiw, 2007)
 Market
Regulation
Failure

Market Failure due to Information Asymmetry -

(Principal Agent problem)
 Buyers and Sellers will have
different information about
the product’s attributes

 In one instance when the

consumer is less informed –
there will be a producer
surplus but also a net loss to
society

 Adverse Selection, Moral

hazards are a result of
information asymmetry
Wiemer and Vining (1999)
 Market
Regulation
Failure

Adverse Selection – The Market for Lemons

 Finally the market for poor quality of cars only exist – Good products and
good customers are under represented while bad products and bad
customers are over represented
(Pindyck and Rubinfeld (2001)
 Market
Regulation
Failure

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 identify both

the precise type of problem that gives rise to the market failure

 Policy analysts argue that existence of a market failure provides a

necessary, not a sufficient justification for public policy
interventions. A double market failure test is required. (Weimer &
Vining, 1992).

 Sufficiency is established when the gains from government

intervention outwieghs the dangers of government intervention
 Market
Regulation
Failure

Government Intervention to Correct Market Failure

(1) Command and Control technique (including regulation)

(2) Government subsidy and other forms of financial

assistance (including research grants and tax
allowances/tax exemptions)

(3) Taxation (including indirect taxes designed to control

pollution)

(4) Policies to increase competition and reduce the

immobility of factors of production

(5) Provision and finance of public and merit goods

(6) Introduction/expansion of market based incentives to

change both consumer and producer behaviour

Government Intervention to Correct Market Failure
Problem Intervention
Zero provision of Direct provision of public goods
public goods
Negative Financial intervention: taxes (equal to the
externalities monetary value of the MEC) are imposed on
individuals or a firm, internalizing ECs
Legislation: laws and administrative rules are
passed to prohibit or regulate behaviour that
imposes an EC, e.g. pollution permits
Education, campaigns and advertisements solve
the problem of imperfect information by
allowing the external costs to be made known to
the consumer, discouraging demand
Market
Regulation
Failure
Evaluation
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
Enforcement is difficult and expensive
Benefits must outweigh the costs of implementation.
A lot of time may be needed for effects to be felt
 Market
Regulation
Failure

Government Intervention to Correct Market Failure

Positive Financial intervention: subsidies made to the Advantages

Externalities producer or consumer 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
Okun’s 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, Enforcement requires constant checking which may
compulsory education etc. translate to high costs.
 Market
Regulation
Failure

Government Intervention to Correct Market Failure

Non provision of There is a need to produce merit goods (which are naturally underconsumed) at low prices or for free
merit goods 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 Imposition of a lump-sum tax on a monopolist (shifts AC upwards), and supernormal profits are taken as
markets 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
Regulation
Failure

Government Intervention to Correct Market Failure

Natural Monopolies In the case of Natural Monopoly the essence of regulation is the explicit replacement
of competition with governmental orders with principal institutional device for
assuring 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 prescription
of major aspects of their structure and economic

There are four principal components of this regulation that in combination distinguish
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 an obligation to
serve all applicants under reasonable conditions.
(The principles of economic regulation, A.E.Kahn)
 Market
Regulation
Failure

Some regulating act in India

Sectors Type of Market Regulator Type of Relevant
Failure Regulation Statutes

Utilities Natural Central Electricity Licensing, Tariff Electricity Act 2003

Monopoly, Regulatory fixation, QoS
Externalities, Public Commission standards, Dispute
Good, (CERC), Science Resolution
and Engineering
Research Council
(SERCs)

Oil & Gas Natural Petroleum and Licensing, Tariff Petroleum and
Monopoly, fixation, QoS Natural Gas
Externalities Natural Gas (Quality of Service) Regulatory Board
Regulatory standards, Dispute Act 2006
Board Resolution Petroleum Act 1934
Petroleum and
Minerals Pipelines
Act, 1962

Tele Monopolistic, TRAI Licensing, Tariff TRAI Act 1997

Oligopoly fixation, QoS
Communications standards,
Interconnection,
Spectrum
Management
(Advisory)

Banking Information RBI Monetary policy Banking Act 1959

Asymmetry, Supervision &
Regulation
Consultation paper on Approach to Regulation Issues and Options, Planning Commission India