October 17, 2023

Market Failures and Government

Intervention – Part 2
Managerial Economics

András Olivér Németh

nemeth.andras@uni-corvinus.hu

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Externalities
The consumption or production activity of one Consumption externality
economic agent influences the consumption - The utility of a consumer is affected by
and production possibilities of another agent somebody else’s smoking, loud music or
other than by affecting prices. nice garden.
- The utility of a consumer is affected by
There are positive and negative externalities the pollution of a nearby factory.

Production externality
- The production of an apple orchard is
positively affected by the production of
a nearby beekeeper.
- The production of a fishery is negatively
affected by the production of a nearby
steel mill.
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Externalities and social welfare

In the absence of external effects a competitive The case with no externalities:
market maximizes social welfare.
- Demand curve shows the subjective value of
additional units of the good for the consumers
(marginal benefit).
- Supply curve shows the cost of producing
additional units (marginal cost).
- At the intersection of the demand and supply
curves, marginal benefit equals marginal cost
(total welfare is maximized).
In the case of a positive externality the demand
curve doesn’t show the whole social marginal
benefit, in the case of a negative externality the
supply curve doesn’t show the whole social
marginal cost.
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Positive externality
In case of positive externalities the demand
curve doesn’t show the whole social marginal
benefit, because besides the benefit to
consumers, other members of the society
also enjoy some external benefit.
- Social marginal benefit is higher than the
private marginal benefit.
- Producers don’t take into account the external
benefit, only the private benefit of consumers
(the willingness to pay of consumers).
∗
The market equilibrium quantity (𝑄𝑝𝑟𝑖𝑣𝑎𝑡𝑒 ) is lower
∗
than the socially optimal quantity (𝑄𝑠𝑜𝑐𝑖𝑎𝑙 ).
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Negative externality
In case of negative externalities the supply
curve doesn’t show the whole social marginal
cost, because besides the costs of producers,
other members of the society also suffer from
some external cost.
- Social marginal cost is higher than the private
marginal cost.
- Producers don’t take into account the external
cost, only their private (production) cost.
∗
The market equilibrium quantity (𝑄𝑝𝑟𝑖𝑣𝑎𝑡𝑒 ) is
∗
higher than the socially optimal quantity (𝑄𝑠𝑜𝑐𝑖𝑎𝑙 ).

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A market solution to externalities

In some cases the market itself can resolve the problem of externalities.
- Let’s assume that rules allow us to have a party in our flat.
- Having the party has a value of 20 dollars for us (we would be willing to not have the party if
somebody pays us 20 dollars). The noise of the party causes an external cost of 40 dollars to our
neighbour (he would be willing to pay 40 dollars to avoid the noise).
- In this case it would be socially optimal not to have the party.
- A voluntary (market) transaction can lead us to this socially optimal situation: if the neighbour pays us
e.g. 30 dollars for not having the party, we are both better-off.
This works in the reverse situation as well:
- Let’s assume that according to the rules, the neighbour has the right to a quiet night.
- If having a party has a value of 40 dollars for us, while the noise of the party causes only an external
cost of 20 dollars to our neighbour, than it would be socially optimal to have the party.
- A voluntary (market) transaction makes this possible: if we pay e.g. 30 dollars to the neighbour for
allowing us to have the party, we are both better-off.
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The Coase theorem

Coase theorem: if the affected economic agents can negotiate without transaction costs and the initial
allocation of rights is clear, then voluntary transactions result in achieving the socially optimal situation.
- The outcome itself is independent from the initial allocation of rights.
- If our benefit from the party is higher than its external cost, then we will have the party even if initially the
neighbour has the right to a quiet night (we have to buy the right to have a party from him).
- The welfare of the participants depends on the initial allocation of rights.
- Naturally, it matters if the neighbour has to suffer the noise of the party, or receives a compensation for it.

Role of transaction costs: if there are significant transaction costs of negotiation (e.g., there are many
affected economic agents), then the market solutions can’t resolve the problem of externalities.

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Externalities
What can the government do?
Direct regulation Financial incentives (internalizing externalities)
- E.g., the government can regulate the quantity - Levying taxes on activities with negative
of pollution each company can emit. external effects (Pigovian tax)
- Inflexible solution – it works properly only if - The economic agents directly feel the external
the government knows the costs of decreasing costs they cause to others.
pollution for each company (an information the - Improving efficiency (in contrast to the case of
government doesn’t have). taxation in a perfect market)
- After reaching the threshold, the companies - Using subsidies in the case of activities with
have no incentives to decrease pollution further. positive external effects
Tradeable pollution permits
- Those polluters will buy the permits for whom
decreasing pollution would be the most costly.
- Decreasing pollution can be achieved with the
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Information asymmetry
One party has more information than the other. Adverse selection

It can lead to problems other than the better- Moral hazard

informed party gains at the expense of the worse-
informed party. Principal–agent problem

In all three cases the information asymmetry

leads to increased costs (efficiency loss).

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Adverse selection – The market for lemons

The price the consumers would be willing to offer
is between 1000 USD and 3000 USD.
- At this price the owners of the good cars are
not willing to sell.
- The buyers can only get lemons, therefore
they will only pay 1000 USD.

Let’s assume there’s a market for used cars. There will be no exchange of good cars (they are
- The owners know whether their car is a good „selected out” of the market) even if it would be
one (with a value of 3000 USD) or a lemon mutually beneficial.
(with a values of 1000 USD). - The exchanges won’t take place due to the
- The buyers don’t have this information, they information asymmetry.
only know that some of the cars are good, the
others are lemons.
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Moral hazard and principal–agent problem

Moral hazard Principal–agent problem

- If you are insured against something, - Agents should represent the interests of the
you have less incentives to do everything principal, but they can have independent
to avoid it. objectives.
- The probabilities are affected by your efforts. - The outcomes are affected by their efforts.
- The costs are borne by the insurance - The efforts can’t be observed directly.
company who have no (or only limited) - The principal has to take additional costs to
information about your efforts. provide incentives for the agent.

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Information asymmetry
What can the government do?
Mandatory provision of information Asymmetric information situations can easily
by the producer/seller arise in the public sector as well.
- E.g. used cars - Principal–agent problem
- E.g. medicines - Moral hazard

Public provision of information

- Licences
- E.g. medicines

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Government intervention
In the case of market failures the invisible hand of the market is not able to operate properly.
- A deadweight loss appears due to the price set above the marginal costs in the case of non-
competitive markets.
- Inability of the market to supply public goods (in a proper quantity).
- Suboptimal or supraoptimal production in the case of external effects.
- Information asymmetries cause inefficiencies through extra costs.

Government intervention can provide appropriate answers to market failures.

- Taxation, regulation, provision of public goods etc.

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Further economic functions of the government

Decreasing income inequalities:
- Although a properly operating market can maximize overall social welfare, the distribution of this
welfare can be very unequal.
- The government can decrease these inequalities through the tax and benefit system.

Moderating economic fluctuations (stabilization):

- Fluctuations are natural characteristics of a market economy, but they are socially costly.
- The government can „smooth” these fluctuations with the use of economic policy.

International economic policy: representation of national interest in global economic issues

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Problems of public choice

Although theoretically government intervention The theory of public choice shows that there
can correct market failures, the just as the are such problems with the joint decision-making
market, the government is also not perfect. of people that don’t appear in the case of
- There are not only market failures, but individual decisions.
government failures as well. - E.g., individual preferences can’t be always
aggregated properly (Condorcet paradox).
Government appears in the economic models as - Majority rule can’t take into account the
the promoter of social welfare, the representative intensity of individual preferences.
of the interests of the society. - Majority can accept such proposals that provide
- In reality, defining what is in the interest of the them some small gains, even if they cause
society is frequently not easy. significant costs for the minority.

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Condorcet’s voting paradox

Let’s assume that voters have three options Individual preference orderings are complete and
(A, B, and C) from which they have to choose. transitive (rational).
There are three types of voters with preferences
shown in the following table: Social preference ordering is not transitive!
- Society prefers option A to option B
Type 1 Type 2 Type 3
(65% of the voters favour A compared to B).
Share of voters 40% 35% 25% - Society prefers option B to option C
(75% of the voters favour B compared to C).
Best option A B C
- Transitivity would require that society should
Second best option B C A prefer option A to option C.
- However: society prefers option C to option A
Third best option C A B
(60% of the voters favour C compared to A).

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Arrow’s impossibility theorem

If there are at least three different options, there
is no such voting mechanism that meets all the
following requirements: Kenneth J. Arrow
- Unrestricted domain
- Sovereignty of decision makers
- Pareto principle There is no perfect way of aggregating individual
- Independence from irrelevant alternatives preferences.
- No dictatorship
If there are only two options, the majority rule
system meets the requirements.

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Political activity of voters

There are costs of… Why do people vote?
- Voting - It may have positive utility in itself
- Gathering information about politics - Altruism
- Filtering information about politics - Influencing others

The probability that our one vote matters

(therefore the expected benefit from voting)
is really low.

It may be rational not to vote.

It may be rational to be ignorant about political

questions.

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Government failures
Government intervention is frequently imperfect, because the government doesn’t have all the
information that would be necessary for an optimal policy answer.
- E.g., in the case of negative externalities, the government needs to be able to measure external costs
in order to set proper regulations or to levy the proper amount of Pigovian taxes. In many cases
external costs are hard to quantify.
- We have seen that the government should finance the provision of public goods, however this doesn’t
mean that the government knows how much of the public goods should it provide (e.g., what is the
optimal size of the army).
Political decision-makers don’t always make decisions with the objectives of maximizing social welfare,
they have their individual interests that affect their decisions.
- This is an appearance of the principal–agent problem, where the society is the principal, and the
government is its agent.
- E.g., making popular decisions that can hurt social welfare in the long run in order to win re-election.
- Corruption
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Thank you
for your attention!