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Market Market failure failure and and the the rationale rationale for for government intervention government intervention Introduction
Theorems of welfare economics Market failure Public goods Externalities Increasing returns to scale Risk and uncertainty Tax distortions Income redistribution
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Theorems Theorems of of welfare welfare economics economics (tools (tools of of normative normative analysis) analysis)
The standard justification of state intervention takes as its starting point the behavior of the economy in the absence of the government, that is, in the hypothetical situation of a free market economy. The standard approach to identifying situations where state intervention may lead to Pareto improvements is via the basic theorems of welfare economics.
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Figure: Figure: Basic Basic theorems theorems of of welfare welfare economics economics
E = Initial endowment; P1 = Initial price rate 1st theorem: Under market price ratio P1, there is an excess demand in X and excess supply in Y. Price ratio will rise from P1 to competitive price P* with competitive equilibrium allocation C (a Pareto optimum allocation). 2nd theorem: With lump-sum transfer from E to E, a Pareto allocation C can be supported by a competitive mechanism with P*.
P*
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Non-free entry
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Externality Public goods Merit goods: Some commodities (eg, fine art) ought to be provided even if the members of society do not demand them.
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Screening Screening
The provision of information has the attributes of a public good, especially the joint consumption property. Thus, information on product safety and health hazards is often publicly provided (e.g. the Food and Drug Administration). Similarly, the education system provides, in addition to its training role, an informational function known as screening. That is, by attaching levels of achievement to persons coming out of the education system (e.g. degrees, diplomas, grades), information is being provided to prospective employers regarding the potential productivity of the person. Presumably, the practice of licensing various professions or trades plays a similar screening role, however imperfect it is. The dissemination of information can, for our purposes, be considered as a particular type of public good.
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The The rationale rationale for for government government intervention intervention
Even if we accept the basic theorem on the efficiency of the competitive economy as a valuable reference point, there remain important reasons for government intervention: These may be summarized under the following: (1) public goods, (2) externalities (3) increasing returns to scale (failure of perfect competition), (4) absence of futures and insurance markets, (5) failure to attain full equilibrium, (6) merit wants, and (7) distribution.
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Externality Externality
When the activity of one agent directly affects the welfare of another in a way that is not transmitted by market prices, the effect is called an externality. Externalities arise as an unintended byproduct of agent behavior. The private benefit to the agent is presumably relatively large compared to the private cost, large enough to provide enough incentive for agent to undertake the activity in the first place. With public goods, on the other hand, the benefits to any single individual would be relatively small compared with the cost of providing the services of the good.
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Tax Tax distortions distortions and and market market inefficiency inefficiency
The existence of taxes prevents a Pareto optimum from being achieved, and this implies that market prices need not accurately reflect marginal social value. Optimal taxation: The levying of distortionary taxes may be unavoidable but the government will have some control over the amount of inefficiency. The government should pursue some sorts of taxes imposing the least efficiency losses on the economy.
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Evaluating Evaluating the the framework framework of of the the welfare welfare economics economics
The great advantage of welfare economics is that it provides a coherent framework for thinking about the appropriateness of various government interventions. However, there are some controversies surrounding the theory: The conventional social welfare function is highly individualistic, with a focus on peoples utilities. However, other societal goals are possible-- to maximize the power of the state. Individuals preferences are ill formed or corrupt, a theory that shows how to maximize their utility is irrelevant-Merit goods.
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Evaluating Evaluating the the welfare welfare economics economics _ _cont cont
Another possible problem with the welfare economics framework is its concern with results. Perhaps a society should be judged by the processes used to arrive at the allocation, not the actual results. Are people free to enter contracts? Are public process democratic? If this view is taken, welfare economics loses its normative significance.
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