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Ch4. Market failure and the rationale for government intervention

Ch4. Market failure and the rationale for government intervention

• Introduction• Theorems of welfare economics• Market failure• Public goods• Externalities• Increasing returns to scale• Risk and uncertainty• Tax distortions• Income redistribution

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Theorems of welfare economics (tools of normative analysis)

Theorems of welfare economics (tools of normative analysis)

• The standard justification of state intervention takes as its starting point the behavior of the economy in the absence of thegovernment, that is, in the hypothetical situation of a free market economy.

• The standard approach to identifying situations where state intervention may lead to Pareto improvements is via the basic theorems of welfare economics.

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First theorems of welfare economicsFirst theorems of welfare economics

• First Theorem: If (1) households and firms act perfectly competitively, taking prices as parametric, (2) there is a full set of markets, and (3) there is perfect information, then a competitive equilibrium, if it exists, is Pareto-efficient.

• Remark: The condition of full set of markets rules out, for example, externalities.

• State intervention is not necessary on efficiency grounds. One of the primary activities of the government is indeed redistribution.

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Second theorems of welfare economicsSecond theorems of welfare economics

• If household indifference maps and firm production sets are convex, if there is a full set of markets, if there is perfect information, and if lump-sum transfers and taxes may be carried out costlessly, then any Pareto-efficient allocation can be achieved as a competitive equilibrium with appropriate lump-sum transfers and taxes(The size of total outputs is not shrunk, i.e. Edgeworth Box is not shrunk).

• Ideally, this would be achieved through measures that did not destroy the efficiency properties, and much of welfare economics is based on the assumption that non-distortionary (“lump-sum”) taxes and transfers can be carried out.

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Figure: Basic theorems of welfare economicsFigure: Basic theorems of welfare economics

• E = Initial endowment; P1 = Initial price rate

• 1st theorem: Under market price ratio P1, there is an excess demand in X and excess supply in Y. Price ratio will rise from P1to competitive price P* with competitive equilibrium allocation C (a Pareto optimum allocation).

• 2nd theorem: With lump-sum transfer from E to E’, a Pareto allocation C’ can be supported by a competitive mechanism with P*’.

P*’

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Market failureMarket failure• The conditions of Pareto optimal required, including the

specification of technology, preference and competition, are much more stringent than those in the real world.

• Welfare theorems will be violated when there are market failures. An economy may fail to generate an efficient allocation of resources (market failure) for two general reasons:

• Information failures (asymmetric information)– Poverty insurance

• Externalities– No market for clean air that forces polluter to pay for it.

• Public goods– Free rider

• Market failure is a necessary but not a sufficient condition forgovernment intervention.

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Market powerMarket power

• Monopoly• Increasing returns to scale• Imperfect and asymmetric information

– Nobel winners due to the contribution on the asymmetric information: George Akerlof, Michael Spence and Joseph Stiglitz

• The number of agents is small– Game theory: the transaction process and

interaction; cooperate and non-cooperate game• Non-free entry

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Nonexistence of marketsNonexistence of markets• Asymmetric information (principal-agent problem)

– The phenomenon of asymmetric information, known as the principal-agent problem: individuals who wish to take out, say insurance against future possible states of the world possess information that insurers do not. The insured persons (the agents) can exploit this informational advantage in dealing with the insurers (the principals) in various way.

– Two ways in which the principal-agent problem manifests itself in market breakdown are known as the moral hazard problem and the adverse selection problem.

• Externality• Public goods• Merit goods: Some commodities (eg, fine art) ought to be provided

even if the members of society do not demand them.

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Moral hazard problemMoral hazard problem• Moral hazard occurs when the insured can, through actions

unobservable to the insurer, influence either the probability of a loss occurring, or the magnitude of the loss. For example, a person can influence the probability of an accident by the degree of preventive action taken. If the quantity of preventive action is not observable to the insurer, market failure can result as shown byPauly (1974) and Marshall (1976). Alternatively, the standard example of how the insured influences the size of the loss is medical insurance.

• In the event that illness occurs, the insured can overuse medical services. This sort of moral hazard has been investigated by Arrow (1963), Pauly (1968), Zeckhauser (1970), and Feldstein and Friedman (1977). Perfect contingency markets cannot develop in the presence of moral hazard.

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Adverse selection problemAdverse selection problem• Adverse selection occurs when there are several different types of

insured persons, distinguished from one another by the probabilities of a bad state of nature occurring. Thus, some persons might be high risk and others low risk, and the insurerscannot tell one from the other. Automobile insurers cannot tell careful from careless drivers except imperfectly through such indicators as age, sex, and family status. As Rothschild and Stiglitz(1976) have shown, an equilibrium may not exist in the presence of adverse selection and, even if it does, it may not be efficient.

• A problem related to adverse selection is the simple lack of information by market participants. The derivation of the Pareto-optimality of competitive markets assumed that individuals and firms had complete knowledge regarding the availability and attributes of all goods and factors. Such will not always be thecase. Consumers may not know the implications of various products for their health or safety, nor will they have full information on the relative merits of various competing consumer items. Firms do not always know the quality of the labor force they are hiring.

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ScreeningScreening

• The provision of information has the attributes of a public good, especially the joint consumption property. Thus, information on product safety and health hazards is often publicly provided (e.g. the Food and Drug Administration). Similarly, the education system provides, in addition to its training role, an informational function known as screening. That is, by attaching levels of achievement to persons coming out of the education system (e.g. degrees, diplomas, grades), information is being provided to prospective employers regarding the potential productivity of the person. Presumably, the practice of licensing various professions or trades plays a similar screening role, however imperfect it is. The dissemination of information can, for our purposes, be considered as a particular type of public good.

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The rationale for government interventionThe rationale for government intervention

• Even if we accept the basic theorem on the efficiency of the competitive economy as a valuable reference point, there remain important reasons for government intervention:

• These may be summarized under the following: (1) public goods, (2) externalities (3) increasing returns to scale (failure of perfect competition), (4) absence of futures and insurance markets, (5) failure to attain full equilibrium, (6) merit wants, and (7) distribution.

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Pubic goodsPubic goods

• Non-rivalness in consumption• Non-exludable-free rider problem• Pure public goods• For a pure public good provision, any pricing scheme

which excludes individual is inefficient.• Congestion and Impure public goods• Location and nearness

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ExternalityExternality

• When the activity of one agent directly affects the welfare of another in a way that is not transmitted by market prices, the effect is called an externality.

• Externalities arise as an unintended byproduct of agent behavior. The private benefit to the agent is presumably relatively large compared to the private cost, large enough to provide enough incentive for agent to undertake the activity in the first place. With public goods, on the other hand, the benefits to any single individual would be relatively small compared with the cost of providing the services of the good.

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Increasing returns to scaleIncreasing returns to scale

• In this case, the competitive analysis of market behavior breaks down for two reasons:– The industry would end up as a monopoly.– The private sector could not profitably sustain marginal

cost pricing.• The government’s actions:

– Do nothing, the society suffers the welfare loss, but gains whatever innovative advantages the monopoly might have due to its size.

– Regulate the monopoly by prescribing its price (P=AC) or rate of return.

– To operate the monopoly as a public enterprise.

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Risk and uncertaintyRisk and uncertainty

• To achieve a Pareto efficient allocation is very difficult in a world of uncertainty.

• Arrow (1970) demonstrated an competitive pricing mechanism to obtain a risk efficient allocation: It will not be able to increase the expected utility of one person without at the same time reducing the expected utility of someone else. Assume:– Each individual is able to attach subjective probabilities to each of

the states of the world happening, and that the probabilities all sum to unity. There exist markets for “claims” to each type of commodity or factor in each possible future state of the world. These markets are often called contingency markets.

– Individuals behave so as to max their expected utility.

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Risk and uncertainty_cont.Risk and uncertainty_cont.

• Market failure results because in the real world a complete set of such contingency markets does not exist. It is true that somecommodities have future markets, and insurance policies allow one to purchase claims against certain contingencies (e.g. accidents, death) in the future. But, in general, relatively fewcommodities have anything near complete markets for future claims contingent on the state of the world. The stock market, which is the prime vehicle for trading in the risk of individualenterprises, is not a perfect futures market.

• There are at least two important reasons why perfect contingency markets have not developed: one is that the transaction costs of establishing such markets might be high relative to the number of traders. The other reason is the phenomenon of asymmetric information (principal-agent problem).

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Tax distortions and market inefficiencyTax distortions and market inefficiency

• The existence of taxes prevents a Pareto optimum from being achieved, and this implies that market prices need not accurately reflect marginal social value.

• Optimal taxation: The levying of distortionary taxes may be unavoidable but the government will have some control over the amount of inefficiency. The government should pursue some sorts of taxes imposing the least efficiency losses on the economy.

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Income redistributionIncome redistribution

• The trade-off b\w efficiency and equity: The more progressive the schedule is, the more income redistribution is attained; but the greater are the distorting effects of the tax on efficiency.

• Pareto-optimal income redistribution: Hochman and Rogers (1969) postulated that the income transfer is a form of externality. Income redistribution is necessary to achieve an efficient allocation.

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Figure: Pareto-optimal income redistributionFigure: Pareto-optimal income redistribution

• The existence of utility interdependence effectively narrows the locus of Pareto-optimal allocations to PAPB

on the grand utility possibility curve.

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Evaluating the framework of the welfare economicsEvaluating the framework of the welfare economics

• The great advantage of welfare economics is that it provides a coherent framework for thinking about the appropriateness of various government interventions. However, there are some controversies surrounding the theory:

• The conventional social welfare function is highly individualistic, with a focus on people’s utilities. However, other societal goals are possible-- to maximize the power of the state.

• Individuals’ preferences are ill formed or corrupt, a theory that shows how to maximize their utility is irrelevant--Merit goods.

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Evaluating the welfare economics _contEvaluating the welfare economics _cont

• Another possible problem with the welfare economics framework is its concern with results.

• Perhaps a society should be judged by the processesused to arrive at the allocation, not the actual results.

• Are people free to enter contracts? Are public process democratic? If this view is taken, welfare economics loses its normative significance.