Prepared by Rijan Dhakal

Unit 6: Market Efficiency & Role of Government

A. Market and Efficiency

Market refers to interaction between buyers and sellers for a particular product. Efficiency
is defined as a situation in which resources are optimally allocated and utilized.
Competitive market is said to be the most efficient market as compared to other market
structures because both productive efficiency (P = minimum AC) and allocative efficiency
(P = MC) are achieved in it. In short, competitive market ensures the maximization of
welfare (i.e. maximization of total surplus). Similarly, we can state that market is efficient
if marginal benefit of consumption (MB) equals to marginal cost of production (MC).
Market efficiency can be measured through different parameters. One of the most popular
criteria of measuring efficiency is the total surplus (sum of consumer and producer
surpluses). Consumer surplus is defined as the willingness to pay (marginal benefit) minus
the actual price of a product. It is the area in between demand curve and actual price. On
the other hand, producer surplus is defined as the actual price minus cost of producing a
product (MC). It is the area in between price and supply curve. If the market is competitive
or if there is no government intervention in the market, the interaction of demand and
supply curves provides maximum total surplus.
P
S/MC

A e
Pe
B

D/MB
O Q
Qe

In the above figure, the area below the demand curve and above the equilibrium price
denotes consumer surplus represented by A. Similarly, the area below the equilibrium
price and above the supply curve represents producer surplus which is shown by B. Thus,
Total surplus = Consumer Surplus + Producer Surplus
=A+B
The total surplus (A + B) in the figure is maximum as MB and MC are equal to each other
at equilibrium point e.

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B. Effect of Government Policies in Market Equilibrium and

Efficiency
1. Effect of Tax
If government interferes the free market system through the imposition of tax on
commodity, the total surplus declines thereby creating deadweight loss in the
economy. Whether the tax is imposed on buyers or sellers of a particular product,
the equilibrium quantity in the market is reduced with buyers paying more and
sellers receiving less. The effect of tax can be presented below through diagrammatic
illustration:
P

Tax burden
on buyers Size of tax (t) S

Price A
DWL
buyers pay (PB)
B C e
Pe
E
D
Price(P )
sellers receive S
F
Tax burden D
on sellers
O Q
QT Qe

From above figure,

Pre-tax Scenario
C.S. =A+B+C
P.S. =D+E+F
T.S. = C.S + P.S
=A+B+C+D+E+F

Post-tax Scenario
C.S. = A
P.S. = F
Tax Revenue = B + D
Decline in C.S. = (A + B + C) – A = B + C
Decline in P.S. = (D + E + F) – F = D + E

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DWL = Decline in C.S. + Decline in P.S. – Tax Revenue

= (B + C) + (D + E) – (B + D)
 DWL = (C + E)
Thus, the imposition of tax on product by the government creates deadweight loss in the
economy.
2. Effect of Price Control Policies
Price control polices of the government in the form of price ceiling and price floor
have adverse effects in the market. The objective of the government for
implementing price control policies is to support the targeted group. But these
policies can create the situations of shortage and surplus leading to inefficient
market outcomes.
i. Price Ceiling
Price ceiling is a legal maximum price fixed by the government for a particular
product produced by the firms. If the price ceiling is below the equilibrium price,
demand exceeds supply so that the market faces the situation of shortage. If the price
ceiling persists in the long-run, shortage will be more acute so that there will be
every possibility of black markets. In this case, price ceiling below the equilibrium
price is a binding constraint which implies that it has adverse market outcome in the
form of shortage.
P

e
Pe

PC

O Q
QS Qe QD

Shortage

In the above figure, the price ceiling is PC which is below the equilibrium price Pe.
Due to price ceiling imposed by the government, producers are not able to sell the
product at any price higher than PC. At price ceiling PC, demand for the product is
QD and supply of the product is QS creating shortage equal to QS.QD.

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ii. Price Floor

Price floor is a legal minimum price fixed by the government for a particular product
produced by the firms. Due to price floor, supply exceeds demand thereby creating
surplus and leading to market inefficiency. If price floor is fixed above the
equilibrium price, it creates surplus or overproduction in the economy. In this case,
price floor above the equilibrium price is a binding constraint which implies that it
has adverse market outcome in the form of surplus.
P

Pf
e
Pe

O Q
QD Qe QS

Surplus

In the figure, the price floor is fixed at Pf which is above the equilibrium price Pe.
Due to price floor imposed by the government, producers are not able to sell their
product at any price lower than Pf. At price floor Pf, supply of product is QS and the
demand for product is QD so that there is a surplus of QD. QS. In cases of minimum
wage law fixed by the government, there is maximum possibility of the situation of
labor surplus (or, unemployment) in the economy.

C. Market Failure: Concept and Causes/Sources

Competitive market system helps to achieve the state of maximum social welfare such that
any reallocation of resources can't make some people better-off without making someone
worse-off. This maximum social welfare is also known as economic efficiency. However
under some circumstances, the market system can't lead to this optimum situation of
economic efficiency. Those circumstances due to which market fails to achieve economic
efficiency or maximum social welfare have been called market failure. To put it differently,
any distortion observed in the market mechanism is known as market failure. The end
result of market failure is mismatch between producers’ output and socially optimum
output (i.e. over or under production).

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Causes and Sources of Market Failure

There are four main causes and sources of market failure:

i. Market Power ii. Presence of Externalities
iii. Existence of Public Goods iv. Incomplete Information

i. Market Power
Market power is the ability of firms to influence price and output in the market. In perfect
competition, there is no market power enjoyed by the firms and buyers as they are price
takers. On the other hand, there is highest degree of market power under the monopolistic
market situation. Monopoly enjoys the highest degree of market power. Similarly, firms
under imperfect competition like monopolistic competition and oligopoly also enjoy
market power to some extent.
We can take the example of monopoly which enjoys extreme market power. Due to market
power, it is said to be one of the barriers to prevent economic efficiency. Under perfect
competition, a firm sets the price of its product equal to the marginal cost. When price
equals marginal cost (MC), economic efficiency exists because the firm operates at the point
where there is no surplus of capacity i.e. resources are fully utilized. But under monopoly,
a firm operates by creating surplus thereby making price greater than its MC.
C,R,P

MC
DWL
P1 e2
P2
e1 AR

MR
O Q
Q1 Q2
Underproduction

In the figure, a monopolist is in equilibrium at e1 where P > MC and it sells Q1 level of

output at price P1. If perfect competition existed, the firm would provide Q2 level of output
shown by point e2 where P = MC and the equilibrium price would be P2. The level of output
Q2 defined by point e2 under perfect competition is socially desirable output. The existence
of monopoly creates underproduction denoted by Q1Q2 level of output. Less than socially

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optimum output is produced under monopoly or any type of imperfect markets like
oligopoly, monopolistic competition etc. Due to less than socially desirable output
produced under the firms having market power, there is creation of deadweight loss
(DWL) in the economy. Deadweight loss is the decline in total surplus due to market
distortions like existence of market power or government intervention in the economy.

ii. Presence of Externalities

The existence of externalities is an important factor which prevents the achievement of

maximum social welfare or economic efficiency. Externalities refer to the beneficial and
detrimental (losses) effect of an economic unit (firm/consumer) on others for which there
are no provision of compensation. In other words, externalities are the external effects of
an economic agent on others for which there is no provision of compensation.

There are two types of externalities discussed below:

a. Positive Externalities (External Economies)
Positive externalities are said to exist if an economic agent while performing its
economic activities impose beneficial effects in the society for which it does not
receive any payment. In other words, when an economic unit creates benefits for
others for which it does not receive any payment, there exist external economies or
positive externalities. Due to positive externalities, market fails because it faces
underproduction. In this situation, Social Marginal Cost (SMC) is smaller than
Private Marginal Cost (PMC) by the amount of positive externalities created by the
firm.

i.e. SMC = PMC – Positive externalities

P,C
S
D S'
SMC = PMC – Positive
E Externalities
T
S
D1
S'
O Q
Q M
Less than socially optimum output/Underproduction

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In the figure, SS represents the supply curve for the product of the industry which
has been obtained by summing of the private marginal cost curves of firms. Due to
the existence of positive externalities, social marginal cost will be smaller than the
private marginal costs. Therefore the supply curve S'S' of the product reflecting
social cost will be lower than the supply curve SS based on private marginal costs.
The supply curve reflecting social cost is lower because it takes into account positive
externalities generated by the production in the industry, while private cost does not
take into account these positive externalities. It is observed from the figure that the
given demand curve DD1 and the supply curve SS based upon the private cost of
production, intersect at point E and thus determine OQ as the actual amount of
output produced. But the socially optimum output is OM at which the supply curve
S'S' reflecting social cost intersects the given demand curve. Thus, the product is
being produced in smaller quantity than the socially optimum output OM. The
existence of positive externalities results into under production by the amount QM.
b. Negative Externalities (External Diseconomies)
Negative externalities are said to exist if an economic agent while performing its
economic activities inflicts detrimental effects on others for which it does not pay. In
other words, when an economic unit creates losses on others for which it does not
make any payment, there exist external diseconomies or negative externalities. In
this situation, the Social Marginal Cost (SMC) is greater than Private Marginal Cost
(PMC) by the amount of negative externalities so that overproduction takes place.
i.e. SMC = PMC + Negative externalities

P,C SMC = PMC + Negative Externalities

S'
D S

S' D1
S
O Q
R Q

More than socially optimum output/ overproduction

When there exist negative externalities in production, private marginal cost will be
lower than the social marginal cost, since the former will not take into account costs
or harms imposed on others. Therefore, when external diseconomies are present,

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equating price with marginal cost will result in over-production of the product, that
is, more than socially optimum output will be produced. It is observed that the
supply curve SS based on private marginal costs intersects the demand curve at
point E and thus determines OQ amount of output. Supply S'S' which takes into
account negative externalities and therefore reflects social cost lies at a higher level
and intersects the demand curve at point L and therefore socially optimum output
will be OR. Thus, it follows when negative externalities are present, equating price
with private marginal cost will result in over-production of the product, that is, more
than socially optimum output will be produced.

iii. Existence of Public Goods

The important source of market failure is the existence of public goods. It should be noted
that public goods are not necessarily produced by the public sector. It is due to the
possession of certain properties that some goods are called public goods and has nothing
to do with whether they are produced in the public sector or private sector. Public goods
have the following two essential characteristics:
 Non-rivalry in consumption (property of a good whereby a person can be
prevented from consumption.)
 Non-excludability in consumption (property of a good whereby a person’s use
diminishes other person’s use.)
Examples of public goods: street light, national defense etc.
Due to non-excludability in consumption, public goods provide positive externalities
thereby creating less than socially optimum output in the economy if they are supplied by
the private sector. This problem associated with the provision of public goods can be termed
as Free Riders’ Problem. A free rider is a person who enjoys benefits from goods and
services but avoids paying for it.
Solution to Free riders’ Problem:
 Government should provide public goods.
 Nominal price should be charged for public goods (i.e. they should not be available free
of charge.)

iv. Incomplete Information

Incomplete information or information failure is defined as a situation in which economic
agents like consumers and producers lack complete knowledge regarding the goods and
services in the market. Incomplete information can occur in two basic situations. Firstly, it
exists when some or all of the participants in an economic exchange do not have perfect
knowledge. Secondly, it occurs when one participant in an economic exchange knows more
than the other, a situation referred to as the problem of asymmetric or unbalanced
information.

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In both cases of incomplete information, there is likely to be a misallocation of scarce

resources, with consumers paying too much or too little, and firms producing too much or
too little. Incomplete information is common and it appears to exist in numerous market
exchanges resulting into inefficient market outcomes termed as market failure.

D. Types of Market Failure

There are two types of market failure which are discussed below:
a. Structural Failure
Structural failure is the situation where perfectly competitive environment is not
present. For example, existence of monopoly or oligopoly denotes structural failure.
Under this situation, government has to regulate the behavior of monopoly or
oligopoly if they are exploiting consumers by charging undesirable price and
enjoying abnormally high profits. There are three major instruments employed by
the government in response to structural failures: Price Regulation, Utility
Regulation and Anti-trust law.
b. Incentive Failure
Incentive failure refers to the situation of the existence of externalities positive or
negative in the economy. In this situation, government responds the market
economy by encouraging positive externalities and discouraging negative
externalities. The major instruments to prevent market failure by incentive are tax
and subsidies, operating control and patent right.

E. Government Response to Market Failure

The responses of government to market failure can be analyzed below:
Government Response to Market Failure

Regulatory Responses to Structural Failure Regulatory Responses to Incentive Failure

Price Regulation under Monopoly Tax and Subsidies

Public Utility Regulation Operating Control

Anti-trust Law Patent Right

Regulation of Environmental Pollution

1. Regulatory Responses to Structural Failure

Structural failure is the situation where perfectly competitive environment is not present.
For example, existence of monopoly or oligopoly denotes structural failure. Under this
situation, government has to regulate the behaviour of monopoly or oligopoly if they are
exploiting consumers by charging undesirable price and enjoying abnormally high profits.

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There are following three major instruments employed by the government in response to
structural failures:
a. Price Regulation under Monopoly
b. Public Utility Regulation
c. Anti-trust Law

a. Price Regulation under Monopoly

Monopoly is said to be one of the barriers to prevent economic efficiency. Under
perfect competition, a firm sets price of its product equal to the marginal cost (MC).
When price (P) is equal to marginal cost, economic efficiency exists because the firm
operates in the point where there is no surplus of capacity. But under monopoly, a
firm operates by creating surplus thereby making P > MC. This situation leads to
underproduction in the economy.
Under this type of market failure due to monopoly, government uses either of the
following two methods:
i. Setting the price equal to marginal cost
ii. Setting the price equal to average cost
C,R,P

MC
AC

P1
P2
e2 e
3
P3
e1 AR

MR
O Q
Q1 Q2 Q 3
In the figure, a simple monopoly is considered where the average cost (AC) curve is
U-shaped. The equilibrium of the monopolist takes place at point e1 where Q1 level of
output is produced at price P1. Since, P > MC at the equilibrium defined by point e1,
underproduction exists in case of monopoly. The government can regulate this firm
by setting price equal to MC which is shown by point e2 where it must sell Q2 level of
output at price P2 (i.e. P2 < P1). The another method which the government can
implement is setting the price equal to AC which is shown by the point e3 where the
firm must sell Q3 level of output at price P3.

b. Public Utility Regulation

If a monopolist exploits consumers by charging abnormally high prices while

producing mass consumption goods, it is the responsibility of government to

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regulate it. Public utilities are those goods which are enjoyed by high mass so that
their price elasticity is less than unity (ep < 1). This implies that consumers must
purchase these goods irrespective of any price charged by the firms. The government
uses either of the following two tools in order to regulate these firms:
i. Setting the price equal to marginal cost
ii. Setting the price equal to average cost

Let us assume a situation of natural monopoly. Natural monopoly is defined as

situation where there is single seller for selling a particular product and long-run
average cost and marginal cost are falling as output expands. This implies that a
natural monopolist is able to enjoy large amount of economies of scale so that its
long-run average cost declines as output expands. In other words, a natural
monopoly is said to exist if it alone is capable of supplying the output according to
the market demand through its single plant.

C,R,P

P1 a
e1 e2
P2 LAC
P3 e3 LMC
AR
MR
O Q
Q1 Q2 Q3

In the figure, the LAC and LMC curves are continuously falling as output expands
because of natural monopoly. The firm is in equilibrium at point e1 where it sets
price P1 for Q1 level of output. If government regulates by compelling the firm to set
price equal to average cost, the firm would sell Q2 level of output at price P2. On the
other hand, if the government regulates the firm by making it set price equal to MC,
it would sell Q3 level of output at price P3 so that this price P3 is less than the AC
implying losses to the firm. In this case, the government should provide the loss
compensating subsidy to the firm but it is not always desirable because in order to
provide subsidy, the government must increase its total tax revenue which becomes
an unpopular policy for the people.

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c. Anti-trust law
The law implemented by the government against trust is known as anti-trust law.
Trust is defined as an organized form of two or more firms intended to exploit
consumers by setting common and high price. In this context, anti-trust law restricts
business practices that are considered unfair or monopolistic. The objective of this
law is to avoid monopoly of single firm or an industry to protect customers against
high price and low supply. The economic case for anti-trust law is based on
efficiency. Monopoly can lead to an inefficient use of resources as compared to the
competitive result. Furthermore, there are clear cases in which firms have tried to
act as monopolists charging higher prices with restricted outputs. In this way,
monopoly could lead to excess profits, underproduction and waste of scarce
resources. The main philosophy of anti-trust policy is that by creating the
environment of competition, economic efficiency can be enhanced. USA is the first
country to implement anti-trust law in 1890. The popular acts used in USA are
Sherman Act, Clayton Act, Robinson-Patman Act and Federal Trade Commission
Act.
In conclusion, antitrust law has made following practices illegal:
 Monopolies or attempt of monopolies.
 Use of unfair methods of competition.
 Enter trying contracts. Trying contracts make buyers purchase other items to
get the product they want.
 Engage in the particular form of price discrimination.
 Degradation of quality of products.
There are two approaches to anti-trust law:
a. Market Performance Approach
This approach includes the industry's rate of technological change, efficiency
and profit, the conduct of individual firm and so on. If firms have contributed
significantly in the economy, they should not be treated as violators of anti-
trust law.
b. Market Structure Approach
This approach is based on a popular philosophy, "an industry which does not
have competitive structure will not have competitive behavior"
(Stigler).Market structure means the number and size of buyers and sellers,
the easiness of the entrance of new firms and the extent of product
differentiation. According to this approach, government should look to the
market structure in order to find the undesirable monopolistic features and
need of anti-trust policy to correct the market structure.

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2. Regulatory Responses to Incentive Failure (Promotional Roles)

Incentive failure refers to the situation of the existence of externalities positive or negative
in the economy. In this situation, government responds the market economy by
encouraging positive externalities and discouraging negative externalities. The major
instruments of regulatory response to incentive failure are:
a. Tax and Subsidies
b. Operating Control
c. Patent Right
d. Regulation of Environmental Pollution

a. Tax and Subsidies

Subsidies are provided to those firms who create positive externalities. Market
mechanism does not have the tool to encourage positive externalities so that
government should actively intervene the market in order to promote positive
externalities by providing compensation to the firms in the form of subsidies. A
subsidy is a payment made to the supplier or producer by someone other than the
buyer that helps to cover the cost of goods and services. The provision of subsidy by
the government helps to create positive impact on the firms so that underproduction
can be avoided.
P
SM
SS

e1
P1
e2
P2
Subsidy
a

DM

O Q
Q1 Q2

In the figure, the market demand curve DM and the market supply curve SM intersect
each other at point e1 where P1 price and Q1 level of output are determined. If
subsidy is provided (e1a), the supply curve shifts to the right as SS so that a new
equilibrium takes place at e2 where P2 price and Q2 level of output are determined.
The level of output Q2 is socially efficient output.
On the other hand, taxes are opposite of subsidies. Taxation is used to control the
negative externalities created by the market. Market itself does not have any
mechanism to prevent negative externalities. In this situation, government role is

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inevitable to discourage negative externalities so that overproduction can be

minimized or avoided for this government uses tax policy to limit the undesirable
activities of firms. Pollution tax, fines or penalties are the common examples of tax
policies which are desired to discourage negative externalities.
P
ST
SM
a
e2
P2 Tax
P1 e1

DM

O Q
Q2 Q1
The initial equilibrium is shown by point e1 where the market demand curve DM and
the market supply curve SM intersect each other so that P1 and Q1 price and output
are determined respectively. In this situation overproduction exists due to negative
externalities. If the government imposes tax (e1a) to the firms, the supply curve shifts
to the left as ST so that new equilibrium takes place at e2. In the new equilibrium
situation, less output Q2 is supplied at higher price P2.
b. Operating Control
Operating right grant is a legal permission granted by the government to the private
sectors in operating business firms. It is a common method to provide firm with an
incentive to promote services in the public interest. Government controls media such
as radio, television, broadcasting rights to provide quality services to the public. The
regulation of commercial banks and financial institutions by central bank by
providing operating grant is also an example of this method. Operating right grants
are intended to protect the rights of consumers by providing quality services. The
firms should fulfill specified criteria and conditions to operate these services, if not,
license is cancelled.
Operating control is one of the most popular methods of correcting market failure
due to negative externalities. There are various forms of operating control which are
discussed below:
i. Control over Environmental Pollution
Environmental pollution is a negative externality created by private business
firms involved in production activities. Government uses its different tools to
correct the negative externality. For example, government sets limit for
automobile emissions, fuel efficiency, and safety standard to control
environmental pollution.

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ii. Control on Food Products

Firms involved in the production and sales of food products, drugs, and other
substance could harm consumers by producing and/or supplying low-
quality or substandard items. So it is essential to regulate such production
activities. The act designed by the government to control the quality of food
forces the private business to maintain the standard mentioned in the act.
iii. Industrial Work Conditions
Government controls the working environment of a factory by using labor
laws and health regulation including the provisions relating noise levels,
noxious gases and chemicals, and safety standards.
iv. Wage and Price Control
Government also regulates wage through minimum wage law and price is
also regulated to control inflation. Wage and price control policy of the
government limits the freedom of the firm to determine wage and price.
v. Control in the Operation of Financial Institutions
Government attempts to control the loan advancing activities of commercial
banks by setting the minimum required reserve ratio under which every
commercial bank is required to keep certain percent of the deposit in cash.
Banks cannot advance loan by undermining that required reserve ratio.
vi. Control in Transportation
Government also regulates the operation of airplanes and vehicles. For
example, the government can fix the limit of the weight of luggage/baggage
in airplanes, (normally up to 15 kg it is free, and beyond that passengers have
to pay additional charges), prohibition on carrying passengers on the roof of
passenger buses.

c. Patent Right
Patent Right is a special or exclusive right granted by the government to an
individual or firm in order to promote a public objective instrument. A bulk amount
of time, money and effort are needed for research and invention. If there is
duplication of the product, idea, process or technology developed by one firm, there
will be rarely new research and invention. Patent rights are therefore granted to
recognize research efforts of the firms and to inspire for the investment of further
research.
Introduction of new goods and new processes are due to innovation, inventions,
research and new ideas. A patent right is an exclusive right provided by the
government to the firm to enjoy monopoly power for a limited time period so that
research and development are promoted in the economy.

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If social cost is less than social benefit, patent right can be provided. Patent system
is a regulatory effort to get the benefit of both right to research and development and
competition. The government by granting limited right to earn monopoly profit
through patent stimulates research and economic growth, but by limiting patent
monopoly, it encourages the competitors to make similar research and development.
Arguments for Patent Right
i. Exclusive Rights: Provides the patent holder with the exclusive right to use,
sell, and license the invention.
ii. Competitive Advantage: Offers a competitive edge by preventing others from
using the patented invention.
iii. Market Position: Enhances market position by securing a unique product or
process.
iv. Return on Investment: Encourages investment in research and development
by ensuring a potential return.
v. Revenue Generation: Potential for generating revenue through licensing or
selling the patent.
vi. Attracting Investors: Increases attractiveness to investors due to protected
innovation.
vii. Innovation Encouragement: Promotes innovation by providing a reward for
creativity and research efforts.
viii. Monopoly Period: Grants a temporary monopoly on the use of the invention.

Arguments against Patent Right

i. High Cost: High costs associated with filing, maintaining, and defending
patents.
ii. Limited Duration: Protection is temporary.
iii. Enforcement: Legal enforcement can be complex and expensive.
iv. Innovation Hindrance: Can hinder further innovation by blocking the use of
patented technology.
v. Administrative Burden: Significant administrative effort required for filing
and maintaining patents.
vi. Complexity: Complex and time-consuming process to obtain a patent.
vii. Possibility of Invalidity: Patents can be challenged and potentially
invalidated, leading to uncertainty.

d. Regulation of Environmental Pollution (Optimal Level of Pollution Control)

The history of environmental pollution is as old as industries. Though many factors

are responsible for environmental pollution, the dominant factor has become

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industries. Pollution created by industries give birth to the negative externalities

such that PMC < SMC, hence market fails.
Since, pollution can't be made zero, there is a need of regulation by the government
so that optimal level of pollution can be determined.

Cost of Pollution Curve

As firms discharge pollution, the social cost of pollution increases. Cost of pollution
curve denotes the social cost of pollution imposed by the firms by discharging
pollution while performing their economic activities. It is an upward sloping curve
from left to right indicating that as more pollution is estimated by the private sectors,
the higher will be the social cost.
Y

SMC (Cost of pollution from

Cost of pollution

social view point)

O X
Quantity of pollution emitted

In the figure cost of pollution curve from social view point is upward sloping from
left to right. This is because if there is no regulation of pollution by government, the
social marginal cost (SMC) increases as the firms emit more pollution.

Cost of Pollution Control Curve

This curve represents the cost of firms when they are involved in controlling the
pollution they emit while performing economic activities. It is an upward sloping
curve from right to left indicating that less the quantity of pollution emitted by the
firms, higher will be the cost in order to control pollution.
Y
PMC (Cost of pollution control
Cost of pollution control

from firm's view point)

O X
Quantity of pollution emitted

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In the figure, the cost of pollution control curve from firm's point of view is upward
sloping from right to left. If government regulates the firms to control pollution, their
cost of controlling pollution will increase.
The optimal level of pollution is determined when these two curves intersect each
other shown by the figure that follows:
Y

PMC SMC
PMC, SMC

PMC > SMC

SMC > PMC

e

O X
Q1 Qe Q2
Quantity of pollution emitted

When the cost of pollution control curve and cost of pollution curve intersect each
other at point e, PMC and SMC are equal such that Qe is the optimal level of pollution
desired by the society. At Q1 level of pollution, SMC is less than PMC so that market
fails. At Q2 level of pollution, PMC is less than SMC so that market failure exists. The
quantity of pollution moves to Qe from either Q1 or Q2 so that PMC = SMC at e. In
the situation of Q1 level of pollution which is more desirable than Qe, the government
can encourage firms by providing subsidies to control pollution. If the level of
pollution is more than the optimal level (as Q2), the government imposes pollution
tax to the firms to discourage the emission of pollution.

F. Problems of Regulation

The major problems or issues of regulation can be explained below:

i. Cost of Regulation
Regulatory policies bring both benefits and costs in the economy. Due to regulation,
firms have to bear additional cost resulting into lower production and higher price.
Similarly government has to bear increased cost for increasing the scope of
regulation. In this context, the cost of regulation can be more than the benefits
received.
ii. Lack of Information
Due to lack of clear and accurate information regarding the cost and benefits from
policies of regulation, government faces problem in implementing them. Similarly,
the government may not have complete information about the causes and effects of
market failure so that it may be unable to make right decision on regulation.

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iii. Regulatory Lag

Regulatory lag is the gap between need and implementation of regulatory policies.
Regulatory lag creates problem in implementation of policies effectively.
iv. Behaviour of Regulating Agency
Regulating agency is the authoritative body to impose controls on economic
activities. If the behaviour and attitude of regulators are guided by their self-interest,
there arises problems of implementing fair policies of regulation which ultimately
brings economic injustice.
v. Lobbying Cost
Due to the existence of special interest groups in the economy, they try to influence
the regulators in different ways. These influencing power of special interest groups
create economic in efficiency due to misallocation of resources in the economy.

G. Effects of Regulation on Efficiency

 Government attempts to promote economic efficiency by preventing market failures

caused from various sources like monopoly, externalities, incomplete information and
public goods. However the regulation on these sources of market failure has adverse
effects on economic efficiency.
Examples:
 Taxes are imposed to correct the negative externalities of economic agents. If tax rate is
not determined at optimal level, it can create excess burden to tax payers which finally
brings inefficiencies in the market.
 Similarly, subsidies are provided to those economic agents and sectors which provide
positive externalities. But subsidies may create inefficiencies in the allocation of resources
as they are provided to the specific sectors of the economy.
 Government regulation of natural monopoly can create the problem on efficiency. It is
very difficult to control monopoly price as it distorts the incentives of the firms.
 Operating controls can create adverse effects in the economy if they are not properly
defined and implemented.
 Regulation in the form of patent right creates limited monopoly which prevents other
companies from entry in the market.

H. Regulation of International Competition

Regulation of international competition is also known as protection or trade restriction. Trade

restriction or regulation is the government intervention in international trade (exports and
imports). The main objective of trade restriction or regulation by the government is to protect
domestic producers from foreign competition.

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There are two forms of government regulation – Import tariff and Import Quota. Import tariff is a
tax on imported item. On the other hand, Quota is a limit on the quantity of imported item. Tariff
works through price and quota works through quantity.

The following figure illustrates the effects of tariff and quota.

SD

PD
PT E F World Price + Tariff
PW
World Price
G H
DD
Q
O A C D B

The domestic supply curve is represented by SD while the domestic demand curve is given
by DD. These two curves intersect each other at point N. The price that is determined at
point N is known as pre-trade price (PT). If trade is free, the international price that would
prevail is assumed to be PW. At the international price PW, a country produces OA but
consumes OB and the country, therefore, imports AB.
i. Effects of Tariff
Now, if a country imposes a tariff on its import, the price of the product will rise to
PT by the amount of tariff. There are four effects of tariff.
a. Consumption effect: Decrease in consumption form OB to OD.
b. Output effect: increase in production and supply from OA to OC.
c. Import reducing effect: import decreases from AB to CD.
d. Revenue effect: Government enjoys tariff revenue equal to the area EFGH.
If a tariff results into price PD, imports will drop to zero. Such a situation is called
prohibitive tariff.
ii. Effects of Quota
Quotas are similar to tariff. If an import quota of CD amount is imposed, price
would rise to PT because the total supply (domestic output plus imports) equals total
demand at that price. As a result of this quota, domestic production, consumption,
and imports would be the same as those of the tariffs.

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Thus, the output effect, consumption effect and import restrictive effect of tariff and
quotas are exactly the same. The only difference is the area of revenue. We have
already seen that tariff raises revenue for the government while quotas generate no
government revenue. All the benefits of quotas go to the producers and to the lucky
importers who manage to get the scarce and valuable import permits. In such a
situation, quotas differ from tariff. However, if import licences are auctioned off to
the importers, then government would earn revenue from the auction. Under these
circumstances, quotas and tariff are equivalent.

I. Government Failure: Theory of Public Choice

Public choice theory deals with the inefficiency of providing public goods and services by
the government. This theory is developed on the basis of the study of taxation and public
spending. This theory is considered to reduce the gap between economics and political
science. The main argument of public choice theory is that government fails to do right.
This theory states that politicians, bureaucrats, citizens, and states are guided by their self-
interest and use the power and authority of government for their own benefits.
The first contributor to the theory of public choice was James M. Buchanan. Prior to public
choice theory, economists used to accept government as "unquestionable controller with
perfect information and unlimited power." Similarly they used to advocate government as
a 'bureaucratic god'. However, bureaucrats and politicians are also human beings who are
guided by their self-interest so that inefficient outcomes are generated.
The basic principle of Public Choice Theory is that human beings are rational in the sense
that they always attempt to maximize their own benefits. Thus, the supporters of public
choice theory strongly claim that self-interested and self-motivated activities and decisions
of government might create socially inefficient outcomes.
Bases of Public Choice Theory
The promoters/supporters of the public choice theory have developed their arguments on
different bases. The important bases are introduced here.
i. Voters' Ignorance
According to public choice theorists, voters are much less informed about political
decisions. This lack of information is often referred to as rational ignorance. One of the
reasons is that it is generally much more expensive for individuals to gather information
about public choices.
ii. Politicians
Politicians often respond to the desires of small, well-organized, well-informed, and
well-funded special-interest groups. Faced with rational ignorance on the part of the
majority of voters, politicians often support policies that greatly benefit small, vocal
interest groups at the expense of the mostly silent and uniformed majority.

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iii. Special Interest Groups

These pressure groups or organized lobbies seek to elect politicians who support their
cause, and they actively support the passage of laws and regulations that further their
interests.
iv. Bureaucrats
Bureaus are the government agencies that carry out the policies enacted by government.
They do so by receiving annual lump-sum appropriations to cover the costs of
providing the services that they are directed to provide. According to public-choice
theory, bureaucrats are not simply passive executors of adopted policies, but seek to
influence such policies in order to promote their own personal interests.
Suggestions for Corrections
Public choice theory points out the case of government failure-a term similar to the market
failure scenarios familiar from the traditional economic theory. The conclusion of the
public choice theory is that self-interest guides all individual behaviour and the behaviour
of the government also; governments are inefficient and corrupt because people use
government to engage in (carry out) their own agendas. So free market systems are
supposed more efficient and more just. According to them, that government is the best
which does the least. In order to avoid government failure, perfectly competitive
environment should be created where market efficiency is at maximum. For perfectly
competitive environment, privatization policy should be effective.

J. Government Policies toward the Control of Pollution

When negative externality due to pollution causes a market to reach an inefficient
allocation of resources, the government can respond in one of two ways. Command–and–
control policies regulate behavior directly. Market-based policies provide incentives so that
private decision makers will choose to solve the problem on their own.
[

a. Command–and–Control Policies: Regulation

The government can remedy an externality by making certain behavior either required or
forbidden. For example, it is a crime to dump poisonous chemicals into the water supply.
In this case, the external costs to society far exceed the benefits to the polluter. The
government therefore institutes a command–and–control policy that prohibits this act
altogether.

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b. Market–Based Policies: Corrective Taxes and Tradable Pollution

Permits

i. Corrective Taxes
The government can internalize the externality by taxing activities that have negative
externalities. Taxes enacted to deal with the effects of negative externalities are called
corrective taxes. They are also called Pigovian taxes after economist Arthur Pigou.
An ideal corrective tax would equal the external cost from an activity with negative
externalities.
ii. Tradable Pollution Permits
Tradable pollution permits allow the voluntary transfer of the right to pollute from
one firm to another. A firm that can reduce pollution at a low cost may prefer to sell
its permit to a firm that can reduce pollution only at a high cost. A tradable pollution
permit is a permit issued by a government or regulatory authority that allows the
holder to emit a specified amount of a pollutant. These permits are limited in
number, corresponding to a regulatory cap on total emissions.

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