Chapter 9: Market Power and Market Failure

1. Chapter 9: Market Power and Market Failure • Purpose of chapter – a detailed examination of how Pareto Optimality can be distorted in a market economy by Market Power and Market Failure. • Leads to Distortions between shares of the Social Endowment and Social Product of members of a society.

2. Market Power • Market Power– the process of exploiting an advantage to give an individual some control in the market. -- Distributes a larger share of the social product (production) of the economy to the powerful. -- Makes the economy less efficient, producing less social product than under GCE.

3. Naturally Occurring Market Power • Naturally Occurring Market Power– market power resulting from either the consumer’s initial endowment (gifts, talents, attributes), or the natural competitive process of business. • Natural part of an economy.

4. Naturally Occurring Market Power in the Labor Market • Consider a labor market with a very high demand for a certain attribute. • Now consider individuals who have this attribute more than anyone else (and it doesn’t have to be a lot more). • The result – a large amount of market power for these individuals, and a very wage for them. • E.G. – Michael Jordan, Julia Roberts.

5. Naturally Occurring Market Power in Industry • Take an industry which undergoes great Economies of Scale – large purchases of physical capital, leading to a large region of downward sloping Average Cost (AC) • Significant increases in efficiency, lower average costs for high volume of production as a result. • Drives many other businesses out. • Creates Barriers to Entry – difficult for other businesses to enter to grab some of the positive economic profit.

6. The Extreme Case • Monopoly – industry characterized by one producer. • Producer has driven everyone else out through economies of scale, significant barriers to entry make it very difficult for firms to enter in. • Illegal in US (early 20th Century).

7. Naturally Occurring Market Power: Not Permanent • Consumers tend to lose attribute of being #1 in these highly competitive markets. • New technologies arise and produce superior products, bringing down original firms (e.g. IBM and Microsoft).

8. Artificially Occurring Market Power • Artificially Occurring Market Power – market power stemming from institutional restrictions or social perceptions. • “Most dangerous threat” to competitive economy (Adam Smith). • Can be long-term, not eroded naturally.

9. Rent-Seeking and Rent-Maintenance • Rent-Seeking – an attempt to seek market power by achieving an artificially created advantage. • Rent-Maintenance – an attempt to maintain market power by maintaining an artificially created advantage. • Application: Is this occurring through lobbying by special-interest groups in Congress?

10. Examples of Market Power • Key – protection or benefit of a segment of society at the expense of the competitive economy as a whole. -- patents for inventors -- tariffs and trade restrictions -- laws to keep industries out of villages (e.g. Wal-Mart) -- discrimination (institutional laws and social perceptions)

11. Discrimination and Gender Pay Inequity • Consider two labor markets, with the same labor demand and requiring roughly equal human capital. • One is “man-sphere” jobs (MS). • Other is “woman-sphere” jobs (WS). • Equilibrium wage in WS jobs (W*WS) < Equilibrium wage in MS jobs (W*MS).

12. Discrimination and Gender Pay Inequity • No discrimination (institutional or social perception)  migration from low-paying WS jobs to high-paying MS jobs. • Supply of labor decreases in WS market  W*WS. • Supply of labor increases in MS market  W*MS. • Continues until W*WS = W*MS.

13. Discrimination and Market Power • Discrimination – either prevents this adjustment from happening by law (institutional), or discourages it from happening (social perception). • Rent-Maintenance done by group imposing discrimination.

14. Market Failure • Market Failure – a market either doesn’t form when needed, or it doesn’t work smoothly and quickly to make necessary adjustments.

15. Market Failure and Public Goods • Public Good – a good which is non-partitionable (cannot be split up into pieces or degrees), and non-excludable (cannot exclude anyone from using it). • Examples – national defense, fire protection, police protection.

16. The Free Rider Problem • Free Rider Problem – since public goods are non-excludable, and non-partitionable, people can get full coverage for free. Therefore, everyone waits for someone else to pay for it. As a result, a market doesn’t form (market failure).

17. Market Failure and Externalities • Externality – when the actions of one economic unit (consumer, firm) affect another economic unit. • Positive Externality – affects in a positive way. • Negative Externality – affects in a negative way.

18. Externalities and (Lack of) Property Rights • Underlying reason for externalities – actions affect shared community resource where property rights can’t be assigned (e.g. air, water, environment). • Example – second-hand smoke from cigarettes.

19. Externalities – External Costs and Benefits • Negative Externality – imposes an external costto society, due to spillover harm on other members. • Positive Externality – produces an external benefitto society, due to spillover benefit on other members.

20. Marginal Private Benefit and Marginal Private Cost • Marginal Private Benefit (MPB) – the benefit to an individual person of doing one more unit of an activity (similar to marginal utility). • Marginal Private Cost (MPC) – the cost to an individual person of doing one more unit of an activity (all economic costs).

21. Marginal Social Benefit and Marginal Social Cost • Marginal Social Benefit (MSB) – the benefit to society of the person doing one more unit of an activity (similar to marginal utility). • Marginal Social Cost (MSC) – the cost to society of the person doing one more unit of an activity (all economic costs).

22. Characteristics of MPB, MPC, MSB, and MSC • All are measured in dollars ($). • MSB = MPB + EB, where EB are External Benefits associated with a positive externality involving the action. • MSC = MPC + EC, where EC are External Costs associated with a negative externality involving the action.

23. Negative Externality – A Graphical Representation • Negative externality implies that External Costs > 0 and MSC > MPC. • MSC curve represented by an upward shift of the MPC curve. • Socially optimal level of activity (LS) < Privately optimal level of activity (LP).

24. Negative Externality – Conclusion • Inefficiency due to Market Failure. • Too much undesirable activity, shifts social costs to bystanders.

25. Positive Externality – A Graphical Representation • Positive externality implies that External Benefits > 0 and MSB > MPB. • MSB curve represented by an upward shift of the MPB curve. • Socially optimal level of activity (LS) > Privately optimal level of activity (LP).

26. Positive Externality – Conclusion • Inefficiency due to Market Failure. • Too little desirable activity.

27. Negative Externalities and Firms • Inherent problem in production. • Examples -- acid rain and the environment. -- dumping chemicals in lakes, contaminating water supply -- noise pollution -- bars, adult places, and crime

28. Risk Externalities • Risk Externality – externality resulting from creating an unintended risk for innocent bystanders. • Example -- DWI. • Technology to reduce incidence of risk externality: breathalyzer/starter lock for car.

29. Market Power and Market Failure: The Next Step • Creates inefficiencies in society, deviation from GCE. • Very realistic and common. • What can government do to remedy these problems? • When should government not try to remedy these problems? • Topic of next chapter.