Section 4

Market Failure, Inequality

and Government
4.1 Market failure
4.2 Income distribution
4.3 Government failure

4.1
Market failure
4.1.1
4.1.2
4.1.3
4.1.4

Monopoly
Externalities
Public goods
Common resources

4.1.1

Monopoly

Single seller
no close
l
substitutes
b
barriers to entry
natural
legal (public franchise, government
p
)
licence,, patent)
can earn excess profits even in the long-run
price-searcher
but still faces downward-sloping demand
curve

Monopolist output and pricing

Choose output to maximise
total profits = total revenue - total costs
= TR - TC
by producing all units as long as
MR MC
where
MR = TR / q = marginal revenue
MC = TC / q
= marginal
i l costt
Once know the profit-max output, then the
price to be charged can be determined from
the demand curve.

Example
q
0
1
2
3
4
5
6

p TR=pq
20
0
18
18
16
32
14
42
12
48
10
50
8
48

MR
18
14
10
6
2
-2

TC
20
21
24
30
40
55
75

MC
1
3
6
10
15
20

Profit
-20
-3
8
12
8
-5
-27

for
q=3
q=4

profits are at a max and MRMC

MR<MC so producing 4th unit
reduces profits
thus setting p=$14 maximises profits

Marginal revenue is less than price

as p decreases sell more output but lose
revenue on units previously sold,
e.g. as p from $16 to $14, TR by $4 on
first 2 units but TR by $14 on new 3rd
unit sold so MR=$10
decrease
p from
$16 to
$14

$
price
16

TR loss on 1st 2 units = $4

14

TR gain on 3rd unit = $14

so MR = $10

10

MR
2

D
quantity

Comparison to a competitive industry

the monopolist charges a higher price
(pM) and produces a smaller quantity
(qM) compared to the competitive
industry (pC, qC)
price
MC
pM
pC

qM

MRM
qC

MB
quantity

the welfare loss is similar to that caused

by price ceilings, price floors and taxes
(part or all of the transfer may be
dissipated through rent-seeking which is
an additional deadweight loss)
price
S = MC

deadweight
loss

market
k
restriction
transfer
D = MB

MR

quantity
efficient quantity

Monopoly market restriction transfer

CS = - (2) - (3)
PS to competitive producers
= - (4) - (5) - (6)
PS to monopolist
= + (2) + (4) + (6)
normal PS for qM= + (6)
so excess PS for monopolist
= market restriction transfer
= + ((2)) + ((4))

p
pM
pC

1
2

5
D

6
qM qC

Blank slide

4.1.2

Externalities

side effects or spillovers outside of price

system
y
not captured
p
in markets
costs or benefits on third parties without
their consent
the market outcome, i.e. the amount
produced without intervention, depends
on p
private MC and MB
but the efficient amount to produce
depends on social MC and MB (i.e. MSC
and MSB) which are inclusive of external
costs or benefits on third parties

thus markets will produce too much or too

little and and there will be an inefficient
allocation of resources
externalities can be in production or
consumption and are 'positive' if third
parties get benefits or 'negative' if third
parties bear costs
the principle 'to get less of something tax
it and to get more subsidise it' can be
used
d tto correctt ffor externalities,
t
liti
i.e.
i
tax
t
goods with negative externalities and
subsidise goods with positive externalities

Negative externality in production

price
MSC

negative
externality
of x $ per
unit
produced

MC

10
6
9
8

p0
7

3 4
2 5

as discussed
below, a tax
of x $ per
unit reduces
q to q1

1
11
MB = MSB
q1

q0

quantity

quantity w/o intervention

efficient quantity

with no intervention, the market clearing

price is p0 and the quantity produced and
consumed is q0
the efficient quantity to produce and
consume is q1
at quantity q0
total net benefits to producers & consumers
= PS + CS
= (1)+(2)+(5)+(7)+(8)
+(3)+(4)+(9)+(10)
total externality costs to third parties
= (1)+(2)+(3)+(4)+(5)+(6)
total net benefits to everyone
= (7)+(8)+(9)+(10)-(6)

 at quantity q1 it can be calculated that

total net benefits to everyone
= (7)+(8)+(9)+(10)
so decreasing production from q0 to q1 has
t t l nett b
total
benefits
fit off +(6)
(6)
Alternative calculation of NB
Can also calculate the total net benefits of
decreasing production from q0 to q1
= Change
g in total value of output
p
+ savings in factor costs
+ savings in externality costs on third parties
= -[(4)+(5)+(11)] + [(11)] + [(4)+(5)+(6)]
= +(6)

if impose a production tax of x $ per unit

then the quantity produced is reduced from
q0 to q1 and the welfare effects are:
CS
= -(3)-(4)-(9)
PS
PS
= -(2)-(5)-(8)
(2) (5) (8)
Revenue
= +(2)+(3)+(8)+(9)
Externality costs = +(4)+(5)+(6)
so in total
Welfare
= + (6)
= efficiency gain

Negative externality in consumption

price
MC = MSC
negative
externality
of x $ per
unit
consumed

pb

tax of x $
so pb, ps
and q to q1

p0
ps

MSB
q1

q0

MB
quantity

efficient quantity

Positive externalities
Production

Consumption

price

price
MC
MSC

MC =
MSC

ps
subsidy

pb

ps
subsidy
pb
MSB

MB =
MSB
q0 q1

quantity

MB
q0 q1

quantity

Note on externalities:
1. Practical issues in implementation of
tax/subsidies:
((a)) What rate to tax/subsidise?
/
Total NB ($)
optimal rate

(7)+(8)+(9)+(10)
(7)+(8)+(9)+(10)-(6)

prohibitive rate
areas from the
earlier diagram
of a negative
production
externality

tax rate

0
rates where tax
reduces welfare

(b) Tax/subsidy needs to directed as

closely as possible to the source of
the distortion so dont create byy
product distortions which reduce
welfare, e.g. X cents per litre tax
on leaded petrol compared to tax
on cars.

10

2. Emissions trading to determine the 'price

of pollution':
a government issues licences or permits
that allow the holder to emit a certain
amount of pollution (e.g. carbon)
and limits the total amount of permits to
the desired level of pollution
but permits are tradeable and their price
is determined in a market
advantage is that everyone has
incentives to find the most efficient way
of reducing pollution

3. Coase Theorem on voluntary bargaining

and property rights:
distribution (who is better or worse off)
depends on who has property rights
but efficient solution obtained regardless
of property rights (e.g. if polluter has
property rights then harmed party will
pay to avoid and will choose most
efficient way
y to avoid))
thus externalities will be internalised
importance of small groups so low
transactions cost in negotiating contracts
enforcement etc.

11

4.1.3

Public goods

Characteristics
consumption by one person doesnt affect
the consumption of others (non-rivalry in
use), e.g. tv broadcast
cant confine benefit to selected persons
(non-excludability), e.g. national defence
Problems for the price system
once produced, everyone benefits whether
pay or not
no incentives for private provision

The free-rider problem in large groups

one persons contribution doesnt do much
and wont affect what others do
rational not to contribute
Thus voluntary co-operation wont work
Who should pay?
with private goods MB revealed in
purchasing decisions
if charge for public goods on basis of MB
all would be better off but no incentive to
reveal MB

12

The demand curve for public goods is

derived by vertically summing
individual demands:
$
15
10
MBTOTAL = MB 1 + MB2
MB2

5
q0

MB1
quantity

Efficient production of public good

produce the quantity at which
MC = MBTOTAL
= sum of MB of each quantity
$
MC

MBTOTAL
q0

quantity

efficient
quantity

13

 which is the quantity which maximises

Total Net Benefits (TNB)
$

TC Total
TC=
T t l Costs
C t
TB = Total Benefits

gradient=MB

Maximum
TNB =TB-TC

gradient=MC
q0

q1

efficient
quantity

TNB =0

quantity

Note on public provision

of public goods:
1. Political competition with self-interested
well-informed
well
informed voters will result in efficient
quantity.
2. But voter ignorance and well-informed
interest groups will result in a larger
quantity produced with the associated
deadweight losses.
losses

14

4.1.4

Common resources

Characteristics
resources with equal access by all users
the more they are used the more degraded
they become because of
congestion (e.g. road system, park)
or, for renewable resources, the unsustainability of use (e.g. fisheries,
forestry,
y, or environmental systems)
y
) so
that it doesn't replenish itself
thus one user's consumption creates a
negative externality on other users'
consumption of the same good

usually no cost to user, no property rights

and non-excludable so they get overused
at low levels of usage, they have the same
characteristics as public goods (nonexcludability
l d bilit and
d non-rivalry)
i l )b
butt att hi
higher
h
levels of usage they are rivalrous in use
("your consumption affects mine")
Solutions to overuse of common resources
property
p y rights
g
p
tax, pricing
transferable quotas

15

4.2
Income distribution
4.2.1 Redistribution and deadweight losses
4.2.2 The Income Distribution Frontier
(IDF
IDF)) and the tradeoff between
efficiency and equity
4.2.3 Efficiency of the income tax/transfer
system
4.2.4 What is fair?

4.2.1

Redistribution and
deadweight losses

Changes
g in the distribution of income and
economic welfare are brought about by:
(1) price controls in goods and factor
markets (section 2.1);
(2) taxes/subsidies on goods
(sections 2.2, 3.4, 3.5); and
(3) income tax/transfers (this section).

16

Note that all interventions

(i) result in gainers and losers and
(ii) have efficiency costs (when not correcting
a
failure)
a u ) and
a d implementation
p
a o costs.
os s
market
Want the least cost, most efficient method of
achieving increased equality.

(1) Price controls

In (a) goods markets (e.g. price
ceilings, floors) affect
- consumers
- producers and factors
(b) factor markets
(e.g. minimum wages)

D
q

Generally not good for achieving increased

equality
can be large efficiency costs or deadweight
losses which are worsened by search costs,
rent-seeking etc
and all gainers may not be low income and
all losers may not be high income

17

(2) Taxes/subsidies on goods

(e.g. sales taxes, tariffs, food subsidies)
In comparison to policies in (1) these
change buyer/seller prices so similar
efficiency costs in terms of the
deadweight loss triangle
but affect net government revenue
have the same problem in achieving
increased income equality, i.e. all gainers
may not be low income and all losers may
not be high income

(3) Income taxes/transfers

the best method to achieve an income
distribution objective is to work directly on
income
but still deadweight losses from income
taxes
pre-tax
wage, i.e.
cost to
employer

SL with tax (for a given

amount of income from
all other sources)

wage

SL w/o tax (for a given

amount of income from all
other sources)

w1 b = w1 s + t

post-tax
wage, i.e.
takehome
wage

w0
w1 s
DL
qL1

qL0

quantity of labour

18

 and deadweight losses from transfers

(personal benefit payments) because of
reduced incentives to supply labour
SL with a larger amount
of income from all other
sources

wage

SL with smaller amount

of income from all other
sources

w1
w0

DL
qL1

qL0

quantity of labour

and implementation
(collection/distribution) costs

4.2.2

The Income Distribution

Frontier (IDF
(IDF)
) and the
tradeoff between
efficiency and equity

Net income of
individual H
120
100
80

Initial distribution (no intervention)

a
c b

After intervention
b

20 25 40

Note the \
line ab is a
segment of
the IDF
105 120
Net income of individual L

19

Note on the IDF:

1. Although usually focus on income, better to
use economic welfare including consumer
surplus; income is an imperfect measure of
welfare.
2. Redistribution is not costless.
- Arthur Okun, Equality and Efficiency: The
Big Tradeoff (1975)
- when take away from someone (e.g. $20
from H)and give to someone else there is
a leaky bucket so only part of what was
taken is redistributed (e.g. $5 to L) and
the rest has leaked out and is lost
(e.g. $15 or 75%)

The Okun leak results from

- individuals responding to the
intervention and the resulting
deadweight losses, e.g. an income tax
makes
k leisure
l i
more attractive
tt
ti
than
th
work
- collection/distribution costs of
taxes/transfers
3. Important to find least costly
redistribution policies
- dont want to end up at points such as c
inside the IDF

20

4.2.3

Efficiency of income
tax/transfer system
Income Taxes

Disposible
Di
ibl or nett income
i
(Ynet) is
i income
i
(Y)
less income taxes (T). Thus
Ynet = Y - T
Dividing by Y
(Ynet / Y) = 1 - (T / Y)
or
MDI = 1 - MTR
where
MDI = marginal disposible income
MTR = marginal tax rate

Australian MTRs (effective July 2008)

Income per week ($)
MDI
MTR
0 115
1
0
116 653
0.85
0.15
654 1538
0.70
0.30
1539
3461
0 60
0.60
0 40
0.40
3462
0.55
0.45
M TRs
60

45

Effective
Jul-2008
Jul
2008

Effective
Jul-2000

30

AWE Sep-2000

15

AWE Sep-2008
0
200

400

600

800

1000

1200

1400

1600

1800

2000

21

Income Taxes and Transfers

Allowing for personal benefit payments (B)
then
Ynet = Y - T + B
Thus
us
Ynet / Y = 1 - (T - B) / Y
or
MDI = 1 - EMTR
where
MDI = marginal disposible income
EMTR = effective
ff
marginall tax rate
Because most benefits are reduced as income
increases, EMTRs for those on low-incomes
can be quite high creating poverty traps or
welfare traps.

Example: Benefits to Australian families have

included
Parenting Allowance
Family Payment
Childcare Subsidies
Childcare Cash Rebate
Low Income Rebate
Family Tax Initiative
Concession Cards (discounts in health,
education, etc)
These benefits are means-tested, i.e. subject
to income and assets tests.
Consequently, low-income families often have
very little incentive to privately earn income,
i.e. they face very large EMTRs.

22

EMTRs
Single Income Couple with Two Children
120
100
80
60
40
20
Private Income ($wk)
0
200

400

600

800

1000

1200

Source: G.Beer, 'State of Play of EMTRs', Aust Eco Review, Sep. 98

Proposals to Improve Tax/Transfer

Efficiency: Negative Income Taxes
Problems with existing tax/transfer system
complexity and implementation costs
high EMTRs and poverty traps
One proposal to overcome these problems
is a Negative Income Tax with tax
payable/receivable calculated by
T = T0 + t Y
where
t = constant MTR
T0 = the amount of tax paid when Y=0
Since T0 is negative, everyone has a
guaranteed minimum income, Ynet= -T0

23

Example:
T = -5000 + 0.25 Y
so that
Ynet = 5000 + 0.75 Y

Y
0
20
100

T
-5
0
20

Ynet
5
20
80

T/Y
0%
20%

Advantages
constant MTR
no poverty traps
p
progressive
g
((i.e. average
g tax rate ATR
(=T/Y) increases as income increases)
simplicity and low implementation costs

Disadvantages
estimates of a package that is budgetneutral and ensures that those on low
incomes are no worse off suggest that a
high MTR would be required
politically unpalatable since a commonlyheld view is that:
why should the rich get -T0 $ ?, and
why should both rich and poor have to
pay t $ per extra $ earned?
this view favours the existing system and
is predicted by the median voter theorem

24

The median voter theorem

states that if voters are arranged by
preferences on some issue then the party
that does what the middle voter wants will
be elected
predicts that voters will elect governments
that implement increasing MTRs because if
voters are arranged by income levels
- the bottom 50% earn less than 50% of
total income
- so the median voter has less than
average income
- and will benefit from higher MTRs on
top 50% (but not too high or else tax
receipts decrease)

4.2.4

What is fair?

Two broad groups of views: fairness depends

on
the outcomes or end-results (often equal
outcomes)
- Utilitarianism: the utility from an extra $
of income decreases as incomes
increase, so societies total utility
i
increases
if redistribute
di ib
iincome ffrom hi
high
h
to low
process by which people achieve their
incomes (equal opportunities)

25

An economists perspective poverty relief

as a public good:
"I am distressed by the sight of poverty;
I am benefitted by
y its alleviation;; but I
am benefitted equally whether I or
someone else pays for its alleviation;
the benefits of other peoples charity
therefore partly accrue to me. To put it
differently, we might all of us be willing
t contribute
to
t ib t tto the
th relief
li f off poverty,
t
provided, everyone else did."
(M. Friedman Capitalism and Freedom, 1962, p.191)

most people are concerned about those in

poverty and there is private charity
but poverty relief has the characteristics
of a public good (non-rivalry in use and
non-excludability) so that sub-optimal
amounts will be produced

26

4.3
Government failure
4 3 1 Public interest theory of government
4.3.1
4.3.2 Public choice theory of government

4.3.1

Public interest theory of

government

The government promotes the public good:

(1) Fix
Fi market
k t failures,
f il
i
i.e.
increase
i
efficiency
ffi i
through taxes/subsidies and other
interventions to ensure that MSC=MSB.
(2) Promote a fair and equitable income
distribution generally through tax/welfare
system.
system
(3) Stabilise the economy over business cycle
through aggregate demand management
policy.

27

But is this descriptive of behaviour or is it

prescriptive?
Will examine (3) in macroeconomics.
Have just had a brief overview of (2) in
section 4.2.
42
What about (1)? How efficient is the state
in achieving increased economic efficiency?
- Partly a problem of imperfect
information
e.g. in practice how much should
externalities be taxed/subsidised and
dealt with (section 4.1.2); how do we
know the optimal level of production of
public goods (section 4.1.3)?

- But more fundamentally, why are so

many interventions efficiency reducing
and not in the general public interest
(tariffs, price controls, etc.)?

28

4.3.2

Public choice theory of

government

Governments act in a political market

place, where voters, coalitions of voters in
special interest lobby groups, bureaucrats
and politicians act in accordance with their
self-interest.
Public choice theory provides economic
models of government behaviour.
The outcomes are generally not
economically efficient.
Example: the economic theory of
regulation, or more generally, theory of
intervention.

The starting point is the observation that:

"The state has one basic resource which
in pure principle is not shared with even
the mightiest of its citizens: the power to
coerce. The state can seize money
y by
y the
only method which is permitted by laws
of civilized society, by taxation. The state
can ordain the physical movements of
resources and the economic decisions of
households and firms without their
consent.
t These
Th
powers provide
id th
the
possibilities for the utilization of the
state by an industry to increase its
profitability""
profitability
(George Stigler, The Theory of Economic Regulation, Bell
Journal, 1975) emphasis added

29

 Thus the behaviour of the state is best

understood in terms of the incentives that
its existence provides for groups that can
effectively
y utilise its distributive powers.
p
In short, the state can supply intervention
and individuals demand intervention, it is
not imposed on them.
And because intervention can benefit
individuals,, they
y will expend
p
resources to
obtain intervention, i.e. rent seeking can
be a profitable activity.

According to the public interest theory, the

state should be interested in MSB and MSC.
But its behaviour appears to be driven by
marginal political benefits and costs (MPB
and
d MPC) measured
d by
b the
th additional
dditi
l
political support (votes etc) or loss of
support resulting from any policy action.
Total political support would increase by
undertaking interventions so long as
MPB MPC.
C
This gives a number of insights into the
behaviour of government regarding
protection for domestic producers of goods.

30

(1) Tariffs and protection are often

good politics.
MPB come from the gainers who are
producers and factors specific to the
industry.
There are large gains to this group
who are small in number and are
well aware of their gains.
MPC come from the losers who are
consumers and overseas producers.
There are small losses to most
individuals in this group and they
often aren't aware of their losses.

Thus goverments often come to the

conclusion (usually with help from
industry and union lobbyists) that
if they give protection to an industry
then MPB > MPC.

31

(2) More hidden forms of protection

are often good politics.
Taxes/subsidies are more transparent
than tariffs, quotas, etc.
Thus for a given MPB, governments
can reduce MPC if losses are less
obvious, i.e. more hidden.
Often get very complex schemes that
are only understood by the important
beneficiaries, e.g. textiles in Australia.

(3) Demanders (and suppliers) of

protection will present public
interest arguments for the
protection.
For a given MPB, can reduce MPC
when losers believe its good for them.

32