Research Review Seminar - II

Market Failure &

Role of Regulation

Jogendra Behera
8th February, 2008
RRS I – What is a
Regulation
 Emergence of Broad Framework of Study

 Are we regulating or de-regulating?

 Feedback – Market failures -> Regulation

Framework
Competitive Market
Free Market
Forces Efficiency

Market
Regulation
Failure

Regulation Equitable
Distribution

Objective of Regulation – Market Efficiency and Equitable Distribution

Types of Market
 Perfectly Competitive Market
 Goods/services offered are all same
 Numerous buyers and sellers and no single buyer or seller can
influence the market price - price takers

 Oligopoly
 Few sellers
 Each participant is aware of the actions of the others

 Monopolistic
 Goods/services are slightly differentiated
 Numerous sellers – each seller has some ability to influence the price

 Monopoly
 No substitute available for the goods/services offered
 Only one seller and this seller sets the price – price maker
 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)
The Invisible Hand
 Adam Smith stated in 1776, “ …while he intends only
his own gain…he is …led by an invisible hand to
promote an end which was no part of his intention…” –
that is to maximize the wealth of the nation

 The competitive market guides and controls the self

seeking activities of each individual to maximize the
wealth of the nation.

 Laissez faire – “Allow them to do” opposes state

economic interventionism (George Whatley, Principles
of Trade, 1774)
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

Brief History of Market
Failure
 Preclassical economics – primarily government regulation; nineteenth
century classical economics – harmonization of self interest and social
interest; neoclassical economics – presence of market failures and
government to act as an efficient coordinating force

 John Stuart Mill, Henry Sidgwick mark a turning point in the literature of
market failure

(Steven G. Medema, 2004)

 The concept of market failure initially appeared as a means of explaining

in economic terms why the need for government expenditures should arise
– normative judgement about the role of government

 As it matured the market failure concept on an additional characteristics –

diagnostic tool by which policy makers learned how to objectively
determine the exact scope and type of intervention (Weimer and Vining,
1992)
Definition of Market
Failure
 Market failure when the competitive outcome of
markets is not efficient from the point of view of
the economy as a whole

 This is usually because the benefits that the

market confers on individuals or firms carrying
out a particular activity diverge from the benefits
as a whole

 “a case in which a market fails to efficiently

provide or allocate goods and services” in
comparison to some ideal standard, such as the
perfect competition model”
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 (Akerlof – Lemon’s Problem);
 Moral Hazards – ignorant party lacks information about performance of
the of the agreed upon transaction (Peltzman argument on insured driver
taking more risks);

 Equity issues – Markets can generate an unacceptable distribution of

income and social exclusion
Market Failure due to
Externalities
 Externalities create divergence between private
and social costs and benefits

 Individual consumers and producers may fail to

take externalities into account when making
consumption and production decisions

 Consumers and suppliers are assumed to

consider their own private costs and benefits
Market Failure due to
Externalities
 Negative Externalities
 Over production of goods where the social costs > private
cost
 Over consumption of demerit goods where social benefit <
private benefit

 Positive Externalities
 Under consumption/provision of merit goods where the
social benefit > private benefit
 Information failure may lead to under-consumption
(individuals not fully aware of the benefits to themselves
of consuming a merit good)
Market Failure due to
Externalities

Negative Externalities Positive Externalities

Negative externalities lead markets to produce a larger quantity than socially

desirable; Positive externalities lead markets to produce a smaller quantity than
is socially desirable
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 …” (Samuleson, 1954)
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, Garret
Hardin 1968)
Market Failure due to
Market 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 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
demanded 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 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 Failure due to Oligopoly
 In reality a firm is neither perfectly competitive or monopoly in nature rather
somewhere between.

 Oligopoly is a market with only a few sellers:

 A key feature of oligopoly is the tension between co-operation and self-interest.
 The group of oligopolists is best off co-operating and acting like a monopolist –
producing small quantity of output and charging a price above marginal cost –
cartel or collusion
 However the self interest is hindrance to co-operate (example of two prisoners) –
dominant strategy leading to Nash equilibrium which is less than what monopolist
would make profit
 As the number of sellers in an oligopoly grows larger, an oligopolistic market looks
more like a competitive market. The price approaches marginal cost, and the
quantity produced approaches the socially efficient level

 Co-operation between oligopolists is undesirable from the standpoint of

society – to move the allocation of resources closer to social optimum, policy
makers should try to induce firms in an oligopoly to compete rather than co-
operate.
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)

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)
Moral Hazards – Shirking of
Workers

 The higher the current rate of unemployment, and the higher the wage
paid over the market wage, the more effective will be the threat of
dismissal

(Pindyck and Rubinfeld (2001)

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
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
externalities the 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
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
Government Intervention to Correct
Market Failure
Positive Financial intervention: subsidies made Advantages
Externalities to the 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 Enforcement requires constant checking

usage, compulsory education etc. which may translate to high costs.
 Government Intervention to Correct
Market Failure
Non provision of There is a need to produce merit goods (which are naturally underconsumed) at low
merit goods prices or for free 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

markets profits are taken as 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)
Government Intervention to Correct
Market Failure
Natural In the case of Natural Monopoly the essence of regulation is the explicit replacement of
Monopolies 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)
Some regulating act in
India
Sectors Type of Market Failure Regulator Type of Regulation Relevant Statutes

Utilities Natural Monopoly, CERC, SERCs Licensing, Tariff fixation, Electricity Act 2003
Externalities, Public Good, QoS standards, Dispute
Resolution

Oil & Gas Natural Monopoly, Petroleum and Natural Licensing, Tariff fixation, Petroleum and Natural
Externalities Gas Regulatory Board QoS standards, Dispute Gas Regulatory Board Act
Resolution 2006
Petroleum Act 1934
Petroleum and Minerals
Pipelines Act, 1962
Tele Communications Monopolistic, Oligopoly TRAI Licensing, Tariff fixation, TRAI Act 1997
QoS 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
Theorem of Welfare
Economics
 First Theorem
 If (1) households and firms act perfectly competitively, taking price 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

 Second Theorem
 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 and
Pareto efficient allocation can be achieved as a competitive equilibrium
with appropriate lump sum transfers and taxes (The size of output 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-discriminatory taxes and transfers can be
carried out

(Albert & Hahnel)

Political Philosophy of
redistributing income
 Utilitarianism

 Liberalism

 Libertarianism
Policies to reduce
poverty
 Minimum Wage Laws

 Welfare

 Negative Income Tax

 In-kind transfers

 Antipoverty programs and work incentives

Trade-off between equality and efficiency

(Mankiw, 2007)
Regulation - Summary
 The possibility of market failure underpin the economic
rationale for state regulation of market economies.

 Regulations can take different forms with different roles

 Health, safety regulations and environmental regulations can be

rationalized on the basis of imperfect information and externalities

 Economic regulation of public utilities can be explained by

economies of scale and scope and need to protect the consumers
from monopoly exploitation

 Aspects of fiscal policy can be rationalized on the basis in terms of

wealth and income redistribution

 Regulatory intervention for universal service obligations etc.

Regulation - Summary
 Regulation cannot be limited to economic issues – means to
ultimately achieve non-economic ends
 Intentions and outcomes are therefore defined by a combination
of economic, social, political and bureaucratic factors and cannot
be attributed to one set of factors alone
 Involvement of disciplines other than economics (law, political
science, sociology etc.)
 Broad definition – “ the use of public authority to set and apply
rules and standards” (Hood et al, 1999)
(Economic Regulation – A Preliminary literature review and summary of research questions –
Parker)
 As an effort by the state “to address social risk, market failure or
equity concerns through rule based direction of individual and
society” (Planning Commission consultation paper on Regulation)
Regulation - Summary
 Regulation is a complex balancing act between advancing the interests
of consumers, competitors and investors, while promoting a wider,
‘public interest’ agenda.
 minimum prices to benefit the consumer (maximize consumer surplus);
 ensure adequate profits are earned to finance the proper investment needs
of the industry (earn at least a normal rate of return on capital employed);
 provide an environment conducive for new firms to enter the industry and
expand competition (police anti-competitive behavior by the dominant
supplier);
 preserve or improve the quality of service (ensure higher profitability is not
achieved by cutting services to reduce costs);
 identify those parts of the business which are naturally monopolistic
(statutory monopolies that are not necessarily justified in terms of either
economies of scale or scope);
 take into consideration social and environmental issues (e.g. when
removing cross subsidization of services).

(Parker, 2000)
References
Books
1. Mankiw, N. Gregory. (2007). Principles of Economics. 3rd Indian Edition,

2. Friedman, D. (1990). Market Failures. Chapter 18. Price Theory. Southwestern

Publishing

3. Djolov, G. George. (2008). The Economics of Competition – The Race to Monopoly.

Jaico publishing house

4. Michael, A. & Hahnel, R,. A quiet revolution in welfare economics. Online book.

Journals
1. Dollery, B. and Worthington, A. (1996). The Evaluation of Public Policy.
Normative Economic Theories of Government Failure. Journal of Interdisciplinary
Economics 7(1):pp. 27-39.

2. Medema, G. Steven. (2004). Mill, Sidgwick, and the evolution of the theory of
market failure. History of Political Economy

3. Stigler, J. George. (1971). The theory of economic regulation. Bell Journal of

Economics 2(1), Page 3-21
References
4. Shleifer, Andrei. Understanding Regulation. European School of
Management, Vol 11, No. 4, 2005, pp 439 – 451

5. Hammond, J. Peter. (1997).The Efficiency Theorems and Market

Failure. Elements of General Equilibrium Analysis, Basil Blackwell

6. Parker, D. (1999). Regulation of privatized public utilities in the UK:

performance and governance. International Journal of Public Sector
Management. Vol 12, pp 213-236.

7. Dollery, B., & Wallis, J. (2001). The theory of market failure and
policy making in contemporary Local Government. Working Paper in
Economics

8. Consultation Paper(2006). Approach to Regulation: Issues and

Options. Planning Commission, Government of India
Thank You