Market Failure PDF

How the Free Market Creates Unfreedom Primarily taken from Stiglitz and Rosengard Welfare Economics 101 Pareto efficient The likelihood that a change makes some individuals better off without making anyone else worse off Limited in two ways: Highly individualistic Consid...

How the Free Market Creates Unfreedom Primarily taken from Stiglitz and Rosengard Welfare Economics 101 Pareto efficient The likelihood that a change makes some individuals better off without making anyone else worse off Limited in two ways: Highly individualistic Considers each’s welfare and not relative well-being to each other It is not explicitly concerned with inequality Rich can get richer, but poor are not made worse off Perception of individual matters Individuals are the best judge of their welfare Welfare Economics 101 If the economy is competitive, it is Pareto efficient Every Pareto efficient resource allocation can be obtained through a competitive market process with an appropriate initial redistribution of wealth Limits of the Free Market Under ideal conditions, the market ensures that the economy is Pareto efficient Still, several think that the “grass is always greener on the other side” Reorganized to make some people even more better off Current setups make some worse off: Overproduction leading to air and water pollution Underproduction for support for the arts, research into the nature of matter, or the causes of cancer Reality of some people having too little income to live on Market Failure The Case of Government Intervention Role of Government Welfare economics aims for Pareto efficiency Conditions under which Pareto efficiency is not attained are classified as market failures Government activity or intervention is necessary Six Forms of Market Failure Competition failure Public goods Externalities Incomplete markets Information failure / information asymmetry Unemployment, inflation, and disequilibrium Competition Failure Pareto efficiency requires perfect competition What does that need? Sufficient number of large firms (sellers) that believe they have no individual effects on the price of goods But, there are some markets that only have a few large firms Can you think of any? When there is only one or a few of these firms, what does it lead to? Competition Failure Monopoly When a single firm controls a market Oligopoly When only a few firms control a market Some or seeming competition is not enough Reasons for Competition Failure More efficient production by one firm Average cost of better firm declines as it produces more, leading to a competitive advantage of one (likely large firm) over others Natural monopoly A situation in which it is cheaper for a single firm to produce the entire output than for each of several firms to produce part of it Market only allows efficiency for a few High transportation or barriers to entry costs Imperfect information False scarcity – consumers may not be aware of competitors Reasons for Competition Failure Strategic control Cut prices significantly against a new competitor Some government actions or societal institutions Intellectual property– double-edged sword of innovation or dominance Patents Trademarks Copyrights Industrial Designs Geographical Indications Trade Secrets How should the government intervene? Natural monopoly, production and provision efficiency, or strategic control issues Shoulder set-up costs Provide open support to those in the same market Set price ceilings and price floors Imperfect information Make information available through various means Some government actions or societal institutions Intellectual property – set term limits Institute regulation Public Goods Two distinct qualities Non-rivalry: Goods or services that do not cost any more to have an additional person to enjoy the good or service Non-exclusive: It is generally difficult or impossible to exclude other from enjoying the good or service To better understand this, it is first important to know the Punnett Square of Rivalry and Exclusive Goods Public Goods Exclusive Yes No Private Common Pool (Air, fishing grounds, Yes (Cars, houses, pens, beaches, grazing groceries) land) Rival Club Public (Golf courses, (National defense, No swimming pools, R&D, farm to market wireless internet, roads, justice) cinemas) Public Goods What’s the problem? Private sector only sees their benefit: they will not necessarily shoulder the costs of others benefitting from their investment Cases: Lighthouses Roads Justice Basic education How should the government intervene? Invest or spend for public goods Bear the cost of free riders Stimulate the market to make it enticing for the private sector to enter Externalities The occurrence of unintended (sometimes willful ignorance) harm or benefit to others as a result of my production or use of a good or service Production externalities Positive – honey production; upcycling; fixing my house Negative – waste dumping; manufacturing noises and waste Consumption / Use externalities Positive – vaccination; food waste for mulch of others Negative – road congestion; smoking Externalities Why do they occur? Negative externalities Individuals do not bear the full cost of their actions, so they overproduce or overconsume Positive externalities Individuals do not enjoy the full benefits of their actions, so they underproduce or under-consume How should the government intervene? Incentivize positive externalities COVID Vaccination – provide free rice or cash Mandate as law; penalize those who do not abide Penalize negative externalities Pigouvian tax – tax placed on degree/amount of negative externality Regulation – place fines Other measures Subsidize lowered production of negative externality Subsidize abatement of negative externality Marketable permits Incomplete Markets Can you think of any good or service that may be too expensive to produce but people want to access at a relatively low price? Incomplete Markets Insurances Better now than they were before but still lacking Crop insurance Health insurance Loans Student loans Small business loans R&D funding Incomplete Markets While provided, they are often incomplete Undersupply of innovation While many new products come out, those that we truly need are often undersupplied Transaction costs It is costly and risky to innovate and offer a product with no assurance of buyers Information asymmetry and enforcement costs People hide information and that creates a lot of risk Insurance as an example Do I know enough about the customer? What do I hide from the agency? What if they don’t pay us, who shoulders the cost? Incomplete Markets The case of complementary markets Markets for two or more goods and services that need coordination Acting alone, they may not offer their goods and services Examples: Coffee and sugar Livestock, feed, and fertilizer Infrastructure development and roadwork How should the government intervene? Bear the costs Do large scale coordination Establish third-party arbitration bodies Regulating offices Laws backing enforcement Information Failure or Asymmetry Especially in our world today, information (or data) is key The economy works on information: Tells the market what people need and want Tells the people what are available and may be offered Information is sometimes/often withheld Markets can take advantage of this Underhanded selling (subconscious advertising, for example) People demand privacy People may want a better deal (insurance, for example) How should the government intervene? Set standards Law and regulation creation and enforcement Data privacy act Confidentiality agreements Data sharing agreements Optout clauses Informed consent clauses/statements/agreements Unemployment, Inflation, and Disequilibrium Basically, macroeconomic disturbances What market failures were found during COVID? Incomplete market – lack of vaccine market Public good – then private learning materials became public good necessities Externality – vaccine hesitancy and mask aversion Incomplete market – online selling platforms Information asymmetry – targeted scamming Market failures are interrelated to one another If everything is Pareto efficient, is government still necessary? Why the Market Can’t Be Left Alone A Pareto efficient economy says nothing about income distribution A competitive market can lead to inequality If you can’t afford it, too bad? Persons may not always act in their best interest People can still make ‘bad’ decisions even when they are fully informed People still smoke even if they know it’s bad for them Contraceptives and sexual protection What can Government do? Provide or require merit goods Goods and services that governments compel people to avail Seat belts Basic education Helmet for motorcyclists and cyclists Fire extinguisher Basic healthcare Social protection mechanisms (SSS, GSIS, PHILHEALTH) Is Government Intervention the answer? Not always, and not always in the long run Government ought to be under a public goods provision mindset Government intervention is not always perfect nor competitive Efficiency of certain services may not be their priority Synthesis Understanding market failures helps us understand how the economy works and why certain circumstances occur Perfection is a myth – on both ends: market and government Market failures still occur today Do the Principles of Welfare Economics Apply to the Development Sector? Do Market Failures Occur in Development Work?