Government Policy and Market Failures

1. Government Policy and Market Failures By Danish A. Khan, Department of Management Sciences, C.I.I.T., Islamabad.

2. What is the meaning of market failure? • Market failurescan be viewed as scenarios where individuals' pursuit of pure self-interestleads to results from the allocation of goods and services that are not efficient – that can be improved upon from the societal point of view. [There exists another conceivable outcome where an individual may be made better-off without making someone else worse-off]

3. Types of Market Failures • Productive and Allocative Inefficiency. • Monopoly Power. • Markets May Fail to Form, Resulting in a Failure to Meet a Need or Want Because of Obstructions. • Not Enough Merit Goods i.e. Education and Healthcare. • De-merit Goods and Negative Externalities.

4. Unstable i.e. Volatile Markets. • Income Inequalities. • Information Failures. • Property Rights.

5. Remedies to Overcome Market Failures 1. Correcting Inefficiencies 2. Curbing Monopolies 3. Taxes on Negative Externalities 4. Subsidies on Positive Externalities 5. Laws and Regulations 6. Changes in Property Rights 7. Pollution Permits

6. 1. Correcting Inefficiencies • Productive efficiency is concerned with producing goods and services with the optimal combination of inputs to produce maximum output for the minimum cost. • Productive inefficiency also occur when a firm is not producing at its lowest (unit) cost. • Allocative inefficiency occurs when goods and services are not distributed according to consumer preferences. • An economy could produce goods people don’t need this would be allocative inefficiency. • Maximum technical efficiency occurs when output is maximized from a given quantity of inputs.

7. 2. Curbing Monopolies • Deregulating the markets. • Merger policy. • Price capping or windfall taxes. • Breaking up existing monopolies.

8. 3. Taxes on Negative Externalities • Taxes on negative externalities are intended to make consumers / producers pay the full social cost of the good. This reduces consumption and creates a more socially efficient outcome. • Without a tax, there will be overconsumption (Q1 where D=S) because people ignore the external costs.

9. Points to Ponder when Taxing Negative Externalities • Difficult to measure the cost of negative externality. • If Demand is inelastic then higher taxes will not reduce demand much. • Taxes will cause inequality. • Cost of administration. • Possibility of evasion.

10. May be difficult to decide who is causing pollution? • Provides incentives to reduce the negative externality such as pollution. • Social efficiency. • Taxes raise revenue for the government which can be spent on alternatives.

11. 4. Subsidies for Positive Externalities • Subsidies involves the government paying part of the cost to the firm. This reduces the price of the good and should encourage more consumption. A subsidy shifts the supply curve to the right. Diagram Showing Market Failure when there is a Positive Externality

12. Points to Ponder when Subsidizing Positive Externalities • The cost will have to be met through taxation. The most efficient way to raise revenue for subsidizing positive externalities would be to tax goods with negative externalities. • Difficult to estimate the extent of the positive externality, therefore the government may have poor information about the service and how much to subsidize. • There is a danger that government subsidies may encourage firms to be inefficient and they come to rely on subsidy rather than improve efficiency.

13. Enables greater social efficiency. • If you subsidize public transport, it will encourage people to drive less, and reduce their negative externalities. • In the long term, subsidies for a good will help change preferences. It will encourage firms to develop more products with positive externalities. Examples of Goods with Positive Externalities in Societies: • Health care • Collecting refuse and litter • Education

14. 5. Laws and Regulations • To overcome market failure, the government may place laws and regulations which prohibitcertain behavior and actions. • Laws prohibiting undesirable behavior • Legal age for smoking. • Prohibition on certain classes of drugs – cocaine, heroin. • Showing violence in movies. • Non-operation of restaurants during Ramadan day-time etc.

15. Advantage of Legal Restrictions • Simple and easy to understand. • When the danger is great it may be better to ban it all together, e.g. heroin. • When a decision needs to be taken quickly, a tax may be too cumbersome. • A legal ban sends a clear signal that this action is wrong. • It is fairer than taxes.

16. Disadvantages of Legal Restrictions • There is little incentive for a firm to develop more efficient mechanisms. • It may be socially inefficient to ban everything. • Raising the legal age may encourage people to break the law. • Taxes may be a better way of collecting money for government to spend on alternatives to simply banning. • Prohibition can encourage the underground economy.

17. 6. Property Rights • Property ownership prohibits externalities. View the following case • Two property owners own land on a mountainside. Property Owner A's land is upstream from Owner B and there is significant, damaging runoff from Owner A's land to Owner B's land. • If a cause of action exists (i.e. B could sue A for damages and win) and the property damage equals $100 while the cost of building a wall to stop the runoff equals $50, the wall will exist. Owner A will build the wall, or pay Owner B between $1 and $50 to tolerate the runoff.

18. Points to Ponder • 1. Difficult to give property rights for things like air, seas and rivers. • 2. Impractical for people to sue. e.g. could people in Scandinavia sue people in UK for acid rain? • 3. It is unfair e.g. if the Chemical firm had property rights and the fishermen won’t. • 4. It is difficult to give property rights to future generations, the environment, animals, the sky.

19. 7. Pollution Permits Pros & Cons • Pollution Permits involve giving firms a legal right to pollute a certain amount per year. • If the firm produces less pollution it can sell its pollution permits to other firms. • if it produces more pollution it has to buy permits off other firms. Therefore there will be a market for pollution permits. • IF firms pollute a lot there will be low supply and high demand therefore the price will be high for permits. Therefore there is an incentive for firms to cut pollution.

20. It is difficult to know how many permits to give out. The government may be too generous or too tight. • Difficult to measure pollution levels. There is potential for hiding pollution levels. • Administration costs of implementing the scheme. • Industry which pollutes more than their quotas can simply buy permits off other people.

21. Policy Failure • A policy is successful if it achieves the goals that proponents set out to achieve and attracts no criticism of any significance and/or support is virtually universal. • Policy failure occurs when government policies do not correct for market failures.

22. Government Failure • Government failure refers to when the government intervenes in the economy to fix a problem, but only ends up creating more problems. • It harms social welfare and/or makes the market less efficient. • In order for government failure to occur, there first has to be a market failure. • The government will then decide whether and how to intervene. If the government intervenes and only makes the problems worse, then it has failed.

23. Why do Policies Fail? • The aims and goals of policy are not clear. • Rigorous analysis and use of evidence in measurement of implementation are lacking. • No room or scope for iteration and adaptation. • Inadequate human and material resources. • Lack of continuity in government policies. • Governance issues, centralization and Corruption.

24. Q/A