Topic 3: Market Failure. When competitive markets fail When a competitive market is left to operate freely the result will be an optimal level of output

Topic 3: Market Failure

When competitive markets fail When a competitive market is left to operate freely the result will be an optimal level of output and the most efficient allocations of resources. That is, the point of equilibrium will also be the point at which the greatest number of people achieves the highest level of living standards possible. Sometimes markets fail and as a result unregulated markets are unable to allocate resources efficiently or resources are allocated in such a way that national living standards or welfare is not maximised.

Government Intervention In Australias economy, the market generally makes good decisions about how resources are used. However, as we have seen, sometimes the free operation of the market system creates problems that reduce efficiency and undermine our living standards. When this occurs, the Australian government intervenes in the market. Typically there are several justifications for government intervention, influence or regulation of our market system.

Reasons for Government Intervention 1. The correction of various types of market failure. Markets do not always make good decisions when, for example, there is market power, asymmetric information, negative externalities, and the requirement to have affordable socially desirable goods and services for the community. The government attempts to correct these market failures by passing laws, and using particular indirect taxes and specific government outlays in budgets to reallocate resources more efficiently. In so doing, societys needs and wants are better satisfied and our living standards are improved.

Reasons for Government Intervention 2. Stabilisation of the level of economic activity. We know that most markets are quite unstable. At the microeconomic level, prices and output vary greatly over a period of time. This contributes to macroeconomic instability where the Australian market economy experiences economic booms and recessions. These reduce our living standards. As a result, the government attempts to moderate the severity of these fluctuations using special stabilisation policies to regulate the level of economic activity

Reasons for Government Intervention 3. Redistributing income more equitably. The price system (involving the forces of demand and supply) not only determines the price of particular commodities, goods and services, it also greatly affects the level of peoples wages (the price of labour) and contributes to income inequality where there are high and low income earners. As we shall see, governments reduce the level of income inequality generated by the free operation of the labour market. This involves using particular policies to redistribute some income from the rich to the poor

Government Intervention Unit 4 focuses of government intervention to improve economic stability and achieve a more equitable distribution of income. In unit 3 we will just focus on government intervention to deal with market failures.

Definition Market Failure Market Failure: is a situation where, because of imperfections in the working of the market mechanism, competitive markets do not achieve an efficient allocation of resources. It occurs when consumers or producers pursuit of self interest leads to a situation where resources are allocated in ways that do not maximize the economic welfare of all members of society and national living standards. (Consumer sovereignty, price system, profitability unsuccessful or inefficient at allocating resources into areas that increase the nations living standards)

Types of Market Failure There are four types of market failure we will examine: Public Goods Asymmetric Information Externalities Market Power

Public Goods Public goods: are both non-excludable and non-rival (non-depletable) in consumption. A person who does not pay for the good cannot be excluded from consuming it and one persons consumption does not lesson anothers ability to consume.

Public Goods Public goods: are both non-excludable and non-rival (non-depletable) in consumption. A person who does not pay for the good cannot be excluded from consuming it and one persons consumption does not lesson anothers ability to consume. Non-payers cannot not be excluded from consuming

Public Goods Public goods: are both non-excludable and non-rival (non-depletable) in consumption. A person who does not pay for the good cannot be excluded from consuming it and one persons consumption does not lesson anothers ability to consume. The consumption of the good by one person does not reduce the benefits received by another

Public Goods Public goods: are both non-excludable and non-rival (non-depletable) in consumption. A person who does not pay for the good cannot be excluded from consuming it and one persons consumption does not lesson anothers ability to consume. The existence of a public goods leads to the free rider problem, where a free rider is a person who receives the benefit from a public good but does not pay for it. The existence of free riders means the market will tend to under-allocate resources to those goods where the producer cannot charge all end users.

Examples of Public Goods

Government Intervention - Public Goods The government will intervene in those markets where it deems the provision of public goods to be important. The main method the government uses to put more resources into socially desirable production is through outlays or spending on health, education and so on. This change to resource allocation is done mostly through the annual budgets announced by federal, state and local governments. Outlays for desirable public sector production are paid largely from tax revenues.

Market Failure Asymmetric Information If a market is perfectly competitive then economic agents are assumed to be making fully informed rational decision based upon full information about factors such as prices, quantities, conditions and technologies. In certain circumstances consumers will not be able to ascertain all information about the good or service they are purchasing. In certain circumstances the seller will not have enough information to charge the correct price of offer the right service.

Definition Asymmetric Information Asymmetric information exists then there is an imbalance of knowledge between the buyer and seller. For example. the seller has more information than the buyer in a transaction, so rational choices and efficient decisions about resource allocation cannot be made. The market fails to work well.

Asymmetric Information and adverse selection Adverse selection is a problem that may arise in a market where the seller knows more about the product than the buyer does. The uninformed buyer may therefore purchase adversely. Example:

Asymmetric Information and moral hazard In some markets buyers have more information than the seller. Example:

Asymmetric Information and moral hazard Moral hazard occurs when economic agents adjust their behaviour to one that is less efficient or favourable from societys point of view. As a result they become less risk averse in their actions.

Asymmetric Information and government intervention 1. Government legislation and laws One approach is that the government could require full product disclosure by sellers of all relevant information needed for effective decision making by potential buyers through appropriate legislation, such as useful labelling on products like food). The government could make it illegal for sellers to withhold certain information; for example, laws about the responsibilities of company directors to accurately inform and update investors about business conditions and prospects that affect decision making, or product labelling requirements that warn users of potential hazards or dangers. The government has a range of consumer protection laws through the Trade Practices Act (1974) that prohibit a number of unfair practices, cover conditions and warranties and sets product safety standards and information.

Asymmetric Information and government intervention 2. Advertising and educational campaign The government could conduct an advertising campaign to educate and inform consumers of potential dangers of products so that effective choices can be made and resources allocated efficiently to maximise societys wellbeing. In addition, improving the speed and level of public access to the internet can help facilitate effective research, and better knowledge and understanding of the consequences of decisions made by consumers.

Asymmetric Information and government intervention 3. Private organisations and associations These provide useful information for potential consumers. Independent reviews by consumer groups such as Choice and an RACV car inspection can help the consumer to increase their level of information about a particular good or service. The internet has also provided consumers with a wealth of information to ascertain whether a product offered by suppliers meets their needs and is priced competitively.

Definition; Market Power Market power occurs when there are not enough buyers and sellers in the market and there is a lack of competition. As a result sellers can attempt to obtain higher profits by charging higher prices or forcing prices up by limiting supplies to the market. Generally in these markets the market price is not a competitive price.

Recall Market Structure Perfectly competitive Market Competition produces an equilibrium price in the market and this can lead to more products being shared There tends to be an efficient and effective allocation of resources and higher levels of production Due to consumer sovereignty wants are satisfied and living standards maximised.

Recall Market Structure Monopolistic Competition Prices tend to be higher as businesses try to gain an advantage in the market There can be wastage in resource allocation due to businesses trying to differentiate similar products Some firms can dominate leading to larger profits and wealth causing income inequality and lower living standards

Recall Market Structure Oligopoly/Duopoly There can be competition and cheaper prices but there can also be agreements to share the market, restrict production and fix similar prices. Can make agreements to engage in restrictive trade practices and reduce efficiency in the interests of more profit. Living standards can be reduced by the actions of self- interest exercised by these firms.

Recall Market Structure Monopoly Have economic power to act in their own interest and to set their prices in the market or restrict production so that they can charge higher prices They can set quotas, restrict production, discourage invention and innovation. Acting in their own interests tends to lead to inefficiencies and even to wasteful use of resources. Since acting in self interest can reduce living standards of other.

Market Power While highly concentrated markets are not always associated with inefficient outcomes, it is more likely to occur than in more competitive market structures. Monopolies and oligopolies have an incentive to restrict competition and output, lift prices (since firms are price makers rather than price takers), reduce efficiency in resource allocation and lower customer service. In some cases this can lead to greater profitability, especially if the demand for the product is inelastic. As a result there is an under-allocation of resources to the production of the product and some consumers will miss out.

Market Power Lack of competition in a market can also reduce the incentive for firms to innovate or increase their productivity. As a result firms with market power may become complacent as they can generate high profits without needing to modify current work practices.

Market Power Government Intervention Government deregulation of key markets Deregulation involves the removal or reduction of unnecessary government restrictions or rules that prevent competition. Over the past two decades there has been partial deregulation of some important markets including the labour, capital, waterfront, primary produce, telecommunications, electricity, water, milk and aviation markets. The hope is that the level of competition between sellers will be greater, creating increased efficiency and better living standards. Microeconomic reforms like these expose industries and workers to greater competition by removing unnecessary government restrictions and by breaking up both public- and private sector monopolies and oligopolies.

Market Power Government Intervention Trade Liberalisation Trade liberalisation involves removing restriction on international trade which give firms protection from international rivals. Trade liberalisation involves: By exposing businesses to greater competition the specific markets become bigger increasing consumer choice. As a result, local firms have had to improve product quality and cut production costs in an effort to lift their efficiency in resource allocation. Increasingly, our resources are allocated into areas where Australian industry has a comparative cost advantage. Living standards should rise as a result.

Market Power Government Intervention Laws designed to increase competition The main law designed to promote competition is the Trade Practices Act (1974). It gives the Government power to prevent anti-competitive behaviour. The competition policy is monitored and policed by the ACCC. The primary objectives of the ACCC are to improve competition and efficiency in markets and to foster adherence to fair trading practices and to provide participants full information

Market Power Government Intervention Laws designed to increase competition Aspects of the TPA that promote competition: The Act allows the Government to prevent mergers or acquisitions that will substantially lesson competition. The Act makes it illegal to fix, control or maintain prices The Act prevents the use of resale price maintenance contracts that specify a minimum price below which goods or services may not be resold. The Act prohibits predatory pricing which involves charging low prices in order to drive the competitor out of the market which then allows the business to increase their prices.

Market Failure - Externalities An externality arises when a person is engaged in a transaction (or activity) that affects the wellbeing of a third party who is not involved in the transaction (or activity). Externalities can be positive of negative. Externality is a cost or benefit borne by a third party, not involved in the transaction, as a result of the consumption or production of a good or service. A positive externality occurs when the third party receives a benefit as a result of the production or consumption of a good or service. A negative externality occurs when the third party is imposed a cost as a result of the production or consumption of a good or service.

Market Failure - Externalities Buyers and sellers tend to neglect the impact of the externality on their decision making which means the market outcome is not efficient. The market will tend to over-allocate resources to the production of those goods of services that create a negative externality. Whilst the market will tend to under-allocate resources to the production of those goods and services that create a positive externality.

Market Failure - Externalities Positive externalities of production: Positive Externalities of consumption:

Market Failure - Externalities Negative externalities of production: Negative Externalities of consumption:

Externalities Government Intervention When the existence of an externality causes an inefficient outcome the government can use its regulatory powers to regulate a market or use taxation system to influence the structure of relative prices.

Externalities Government Intervention 1. Legislative powers The government can use their powers to mandate certain activities or forbid certain activities For example in 1987, the Government banned Chloroflurocarbons (CFCs) because their use contributed to the hole in the ozone layer. Most state Governments have also banned smoking in enclosed areas such as pubs, restaurants and shopping centres.

Externalities Government Intervention 2.Use of Taxation System The government may choose to influence market outcome by indirectly the incentives of the consumer or producer via the market system. In the case of a negative externality the aim would be to force the producer or consumer to internalise the external cost that has been imposed on a third party. This can be done by imposing a tax on producers who cause a negative externality.

Externalities Government Intervention 2.Use of Taxation System The tax shifts the supply curve to the left for the good or service that is causing the negative externality. This will lead to a higher price for that good or service. The higher price will generally lead to a decrease in demand as the good or service now has a higher price relative to other substitutes which doe not cause the same external cost. The firm will notice the drop in demand and look at ways of reducing their external cost which may involve a change in the production process. As a result the market will move to a more efficient outcome.

Externalities Government Intervention 2.Use of Taxation System In the case of positive externalities the Government could subsidise activities that create external benefits in order to provide or encourage either greater production and/or consumption. Governments will generally subsidise education because an educated person gains private benefits and will also contribute to productivity growth and add to the productive capacity of the economy.

Externalities Government Intervention 2. Use of Taxation System 3. The government also provides funding and offers research grants for basic research in medicine, mathematics, other sciences and economics Without government support, there would be an under- allocation of human resources to the production of research and development because not all the gains can be appropriated by the producer of the R&D.

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Topic 3: Market Failure. When competitive markets fail When a competitive market is left to operate freely the result will be an optimal level of output