MARKET FAILURES POLITICS AND REGULATION Market failure equilibrium

MARKET FAILURES, POLITICS AND REGULATION Market failure: equilibrium price ≠ marginal utility of consumers or price ≠ marginal cost of output unit Market failure = inefficient allocation of resources Sources of market failures: 1. unequal income distribution; 2. monopoly power; 3. externalities; 4. public goods ; 5. imperfect information Economic regulation: limit entry into a particular industry and control both price and service quality. Source of it: natural monopoly but also other reasons The capture hypothesis: regulators serve the interests of regulated firms (who have „captured” them through the political process), not of consumers 1

IS CAPTURE HYPOTHESIS RIGHT? Turns on its head the idea that economic regulation protects the public interest from monopoly Some examples of industries that like being regulated: airlines and telephone companies. A case when a small group of firms prevail politically against the interests of many consumers. How is it possible? Because it is harder to organize a large number of people who care only a little about than a small, wealthy group that cares a lot Regulators are political like legislators but they do not react only to the political power of regulated firms 2

SOCIAL REGULATION Deals with externalities such as air pollution or asymmetric information An externality – action of a household or a firm directly affects other households or firms and these spillover effects not fully reflected in market prices The capture hypothesis not very helpful here Regulated firms not a small easily organized group Usually large groups involved: workers, green movements, consumers 3

Government and market failures Better access to public goods Externalities and optimal regulation Better information Less inequality in income distribution Protection of competition Stabilization of the economy 4

Public goods A private good- a good that if consumed by one person can not be consumed by another (a cake). A public good- a good that even if consumed by one person, is still available to others ( a clean river, national defense) The „free - rider” problem. No incentive to buy a piece of national defense – some one else shall do it Government decides how much of each public goods should be produced: Patents motivate private firms to invest in R&D Highway tickets motivate private firms to invest in highway construction 5

Tragedy of commons Based on the history of no limited use of commons Similar effects on open ocean resources (fishes), congested parks, rivers, congested beaches and highways A large number of consumers makes them no public anymore (excessive consumption) State may introduce paid entrance (tickets), limits to use some resources (fishes), increase the supply of some goods ( new highways) 6

Externalities Negative and positive externalities Pollution- private costs and social costs. Market price does not cover the social cost of pollution Positive externalities repainting the house, social benefits > private benefits Externalities caused by „missing markets” – consumption or production of goods with no prices Externalities - a form of public goods 7

Externalities control A pollution tax paid by firms that cannot reduce pollution not used in the US, but applied in Germany US experience – 1) engineering standards: firms obliged to use certain types of devices reducing pollution, 2) performance standards permitted limits of pollution Standards prevent firms to diminish costs of pollution reduction but do not motivate to higher pollution reduction, And… have side effects – no incentive to replace older cars polluting more Are standards easier and more practical to apply than taxes? Which one costs less? 8

Taxes versus engineering standards Some money could be saved by using pollution taxes But how to calculate a tax rate? Marginal cost and marginal benefit difficult to estimate Other solutions? Permits specifying a permissible level of pollution -as in performance standards, but firms are allowed to buy and sell permits(tradeable permits approach) Effects: minimization of cost reduction and a desired level of pollution reduction achieved 9

Imperfect information Asymmetry in buyers and sellers access to information: chemicals causing cancer at work place, unsafe toys The private costs , social costs, over production of goods involving risk Firms have no incentive to study long run health hazards to which workers or kids are exposed State intervention: higher wages payed in a high risk jobs, regulation concerning safety standards and working conditions, information labels on goods Should seat belts and air bags be obligatory? Are people making decisions they should be making? 10

Merit and demerit goods Merit goods: education, health care, some types of insurance People do not realize true personal benefits of those goods, usually have positive externalities Demerit goods: cigarettes, narcotics, the society wants to limit consumption of those goods, usually have negative externalities Do the people representing the society have better knowledge what anyone needs and what is good? Important question of value judgement 11

Regulatory failures Successful regulation needs a good understanding of causes and effects, costs and benefits of regulation A conflict over the value of regulation between those who argue for cost-effective regulation and those who argue that certain values (health, life) beyond economic calculation Regulatory reform: how to improve the quality of regulation Efforts of OECD and EU Commission 12

Deregulation Strong deregulation movement in the late 1970 s and early 80 s The role of economists: arguments that regulation did not serve the public interest Regulators own goals „stay in the business as long as possible” A strong support of competition in such industries as telecommunication, airlines, gas production Deregulation started in many countries: airlines the most favorite case Its effects (1970 -1984): costs per passenger mile have fallen substantially, per capita miles flown doubled 13

Should the state take care of equal income distribution? Income distribution produced by free market has no ethical claim to be fair Private markets can produce many different final distributions Modern governments engage in income redistribution Modern governments engage to ensure the right level of consumption of particular goods Income redistribution tools: taxes, social transfers 14

Government limits market power and protects competition The role of deregulation once again Effects of deregulation in airline transport, telecommunication: prices go down, productivity goes up, economy more innovative Privatization and nationalization- forms of regulation and deregulation Cartels and collusions illegal Regulation controlling fusions and firms takeover 15

Government makes economy more stabile Financing of R&D Changing structure of the economy through taxes and subsidies: agriculture versus industry, machine building versus raw materials industries Regional policy, the role of EU structural funds Modification of fluctuations of the business cycle Fiscal and monetary policy helps to keep the economy close to the full employment 16

Government failures versus market failures Which one is more harmful? 17