Market Failure and the Efficiency Case for State Intervention

Hello. My name is Dr Kroger, right?

And I'm an economist working at the Faculty of Economics

in Cambridge and a fellow Jesus college in Cambridge.

In this mini lecture,

which is called market failure and the efficiency case for state Intervention,

we're going to review the case,

the essential case for why government should get involved in the economy.

One of the fundamental insights of economics is that competitive markets that is,

markets where all participants take prices has given when they make decisions,

can allocate scarce resources efficiently in plain English.

That means that when all trades are completed,

it's not possible to find a new trade that would

make somebody better off without making somebody else worse off.

So economists call a situation like that parade

so efficient after the Italian economist Wilfredo Pareto.

Now this is really a profound insight.

But before we start digging into what might go wrong

and what a government then could do about it,

let's look a little bit more at the details and developed two concepts which are

going to be really helpful in thinking about

the costs and benefits of state intervention.

The concept of consumer and producer surplus

so to do this, let us take a look at the market for some good.

Generally, we're going to call it X,

but you can think about it as gasoline to be specific.

The price of gasoline is P,

and the downward sloping red curve in the diagram is the demand curve.

It shows how much consumers value the goods and therefore

are willing to pay for each unit of gasoline.

It's downward sloping because for the first units, the value it a lot

and for subsequent units, the value

extra gasoline less

the blue upward sloping curve

is the supply curve.

It illustrates the marginal cost

of producers of delivering gasoline to the market

and its upward sloping.

Generally speaking,

because it's relatively cheap at the Martin to deliver the first couple of units,

and as more and more units needs to be delivered, it becomes more expensive.

The market equilibrium is where demand equals supply,

and that happens at the price P star and at the quantity X star.

This allocation

is Pareto efficient.

Now

you might wonder, how do I know that?

Well,

consider the red area in the diagram. The area between the market price

and the demand curve.

Now the demand curve measures the consumer's willingness

to pay for each unit of the good.

So the difference between the demand curve

and the price that they actually pay for it

is the surplus that get out of consuming each unit.

So if we add all that up, we get the red error,

and that is the consumer surplus.

It measures that benefit that the consumers get from consuming the good.

Now

take a look at the blue area in the figure

that's the area between the market price

and the supply curve.

It measures

the surplus

that the producers get.

Remember that the

supply curve shows the marginal cost of producing the good.

So if the producers get a higher price for the unit than the cost of supplying it,

they get a surplus. So the difference between the supply curve and the market price

is the produce a surplus.

It

shows us how much surplus

the producers get

now. At the market equilibrium.

You would notice

that this some of the consumer and the producer surplus

is as large as it possible It can be.

Therefore, the allocation is Pareto efficient.

Now,

if you're in doubt.

Do you suppose? Not argument.

So suppose

that instead of trading

the market

equilibrium Volume X star,

let's suppose that one extra unit is being traded as illustrated in the diagram,

and it's so that the market price P star.

In that case,

you can see that the consumers are losing

surplus because they have to pay more for the

extra unit than they actually evaluate at the demand curve.

And the producers,

they are making a loss because the revenue they get from that unit is less

than the cost of producing it.

So if that unit was traded in the market, the total surplus would be less.

And therefore we could make everybody better off by not producing that unit.

So that demonstrates why the market equilibrium is efficient,

operator efficient.

So, in conclusion,

the market allocation in a competitive market is efficient and therefore,

from an efficiency point of view, there is no need for the government to do anything.

The market does a very good job,

but

and this is a big boat.

This wonder

only works if there is no gravel

in the machinery,

and unfortunately,

there are lots of reasons why

this might not work in practise

markets will typically fail.

In delivering this desirable outcome,

we can make a distinction between two

categories of market failures or distortions,

as we sometimes call it.

One type is what I would call intrinsic market failure,

and the other type is what I will call policy induced market failure.

Now.

Intrinsic market failures include things like

market power and monopoly when the producers

are not taking prices as given when they make decisions in the market.

Information asymmetries is another market failure, externalities,

missing markets and public goods.

These are failures that arise from the fact that the market just

doesn't quite work as intended and

therefore do not allocate resources efficiently.

Now,

policy induced distortions and market failures are not intrinsic to the markets.

Instead, they arise from the policy interventions

introduced by the government

and nonetheless the result.

A misallocation of resources much in the

same way as these intrinsic distortions due.

Now let us look at a couple of examples to make this a little bit more concrete.

Let us start by looking at an intrinsic market failure

market power,

so suppose that the producers

in the market for gasoline

have market power,

maybe because there's only one gasoline station in

the particular area that we're looking at.

As a consequence of that, they can set the price

above the competitive market price

in the diagram. That's suppose that they are able to increase the price to P.

M M for Monopoly

now at that higher price.

Uh, the consumers don't want to buy that much, obviously,

so they scale back what they buy to the quantity X m.

So the amount of gasoline trades in the market on the monopoly

conditions is less than what would happen in the competitive market.

But more importantly, let us look at what happens to consumer and producer surplus.

The consumer surplus indicated in red is lower than

it would have been in the competitive market.

They produce us,

they get some extra surplus so the blue area is

bigger than it would have been in the competitive market.

But and this is the key insight.

The area marked up in orange

is lost.

So compared to the market allocation,

the total surplus when we add up the red and the blue area in

this diagram is less than what it would have been in the competitive market.

So Monopoly, as an example of an intrinsic market failure,

introduces a loss to the economy.

It comes at a cost.

Now it's relatively easy to see where this distortion is coming from,

So take a look at the arrow in the diagram.

If a little bit more

gasoline

were supplied to the market,

then the consumers would value that

and they would value it at the top of the arrow

because that's where the demand curve is.

And remember the demand curve show there's a valuation

of the goods.

The producers, on the other hand, would be willing to supply that extra units

at the supply price at the supply curve,

which is at the bottom of the arrow,

we can see that there's a gap between the two, so getting an extra unit

delivered to the market starting from the monopoly quantity

would generate a social benefit because the

consumers are willing to pay more for that

unit to be delivered to the market than the producers required to supply it.

So that is the fundamental source of the distortion that is created by this market,

uh, power.

So that was an example of a an intrinsic distortion or market failure.

Now let's take a look at the policy induced distortion,

so one example of that would be a maximum price.

So if you take a look at the market diagram again,

then the example would be a maximum price at P max,

which means that the producers are not allowed to charge more than that price

Of course, in recent times there's been a lot of debate about this in the market,

not for gasoline, but in the market for gas.

So what is the consequence of this price cap?

Well, we can see if we calculate the consumer surplus,

the difference between the consumers valuation of

the units that are delivered to the market

and the price that they have to pay, which is the maximum price.

That's

a lot lower, larger than it used to be.

So the red area in the diagram is large.

It produces because they can't charge more than the maximum price,

get a bit of surplus,

but we can see that the blue area is a bit smaller than it used to be.

But

we also see that we have the Orange area,

the Orange area represents what is being lost.

So again,

the allocation with this price cap is not Pareto efficient.

And the reason, of course, is that because the price cap is imposed,

producers are not delivering that many units of the good gasoline to the market and,

as a consequence, their consumers,

who would happily have bought at a higher price but which are not able to do so.

And as a consequence of that, we have a social laws

Now.

The government, of course, didn't introduce

one would have thought this price cap to harm the economy.

It's kind of collateral damage that we have that laws.

The government would have done it because there is some benefit.

Perhaps they wanted to help consumers by keeping prices low.

But we can see from this that it comes at a cost.

So

in conclusion

we learn two lessons from this.

The first lesson is that the president of market failure gives the

government and efficiency based rationale for

wanting to intervene in the economy,

to eliminate these intrinsic inefficiencies that arise from monopoly power,

externalities and s symmetric information, and so on.

The second insight is that government interventions into

the economy introduces their own policy induced distortions,

they create their own social losses,

and these have to be traded off against the benefits that such interventions might

might

achieve.