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Market Failure and the Efficiency Case for State Intervention
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Micro - Government Intervention in Markets
In this course, Dr Toke Aidt (University of Cambridge) explores the microeconomics topic of government intervention. In the first module, we look at what markets look like when they efficiently allocate resources, how this can fail and the case for government intervention when this happens. After this, we explore what role the government plays in a market economy and some of the other reasons for state intervention. Then, we focus in on taxation. In the penultimate module, we explore the deadweight cost of taxation and the equity-efficiency trade off. In the final module, we look at how the government goes about regulating negative externalities.
Market Failure and the Efficiency Case for State Intervention
In this module, we look at what markets look like when they efficiently allocate resources, how this can fail and the case for government intervention when this happens. In particular, we will focus on: (i) a review of how efficient markets allocate resources, with use of a diagram to show consumer and producer surplus and an explanation of the term Pareto efficiency; and (ii) what happens when markets fail, including a discussion of the types of market distortions and a diagram to show what happens to consumer and produce surplus in a situation of market failure.
Hello. My name is Dr Kroger, right?
00:00:05And I'm an economist working at the Faculty of Economics
00:00:08in Cambridge and a fellow Jesus college in Cambridge.
00:00:11In this mini lecture,
00:00:16which is called market failure and the efficiency case for state Intervention,
00:00:18we're going to review the case,
00:00:22the essential case for why government should get involved in the economy.
00:00:24One of the fundamental insights of economics is that competitive markets that is,
00:00:29markets where all participants take prices has given when they make decisions,
00:00:34can allocate scarce resources efficiently in plain English.
00:00:38That means that when all trades are completed,
00:00:44it's not possible to find a new trade that would
00:00:47make somebody better off without making somebody else worse off.
00:00:49So economists call a situation like that parade
00:00:54so efficient after the Italian economist Wilfredo Pareto.
00:00:57Now this is really a profound insight.
00:01:03But before we start digging into what might go wrong
00:01:07and what a government then could do about it,
00:01:11let's look a little bit more at the details and developed two concepts which are
00:01:14going to be really helpful in thinking about
00:01:18the costs and benefits of state intervention.
00:01:21The concept of consumer and producer surplus
00:01:24so to do this, let us take a look at the market for some good.
00:01:30Generally, we're going to call it X,
00:01:34but you can think about it as gasoline to be specific.
00:01:36The price of gasoline is P,
00:01:41and the downward sloping red curve in the diagram is the demand curve.
00:01:44It shows how much consumers value the goods and therefore
00:01:50are willing to pay for each unit of gasoline.
00:01:55It's downward sloping because for the first units, the value it a lot
00:01:59and for subsequent units, the value
00:02:04extra gasoline less
00:02:07the blue upward sloping curve
00:02:10is the supply curve.
00:02:13It illustrates the marginal cost
00:02:15of producers of delivering gasoline to the market
00:02:18and its upward sloping.
00:02:23Generally speaking,
00:02:24because it's relatively cheap at the Martin to deliver the first couple of units,
00:02:25and as more and more units needs to be delivered, it becomes more expensive.
00:02:31The market equilibrium is where demand equals supply,
00:02:38and that happens at the price P star and at the quantity X star.
00:02:41This allocation
00:02:48is Pareto efficient.
00:02:49Now
00:02:51you might wonder, how do I know that?
00:02:52Well,
00:02:55consider the red area in the diagram. The area between the market price
00:02:56and the demand curve.
00:03:02Now the demand curve measures the consumer's willingness
00:03:05to pay for each unit of the good.
00:03:09So the difference between the demand curve
00:03:13and the price that they actually pay for it
00:03:15is the surplus that get out of consuming each unit.
00:03:18So if we add all that up, we get the red error,
00:03:22and that is the consumer surplus.
00:03:25It measures that benefit that the consumers get from consuming the good.
00:03:28Now
00:03:34take a look at the blue area in the figure
00:03:34that's the area between the market price
00:03:37and the supply curve.
00:03:40It measures
00:03:43the surplus
00:03:44that the producers get.
00:03:45Remember that the
00:03:48supply curve shows the marginal cost of producing the good.
00:03:49So if the producers get a higher price for the unit than the cost of supplying it,
00:03:54they get a surplus. So the difference between the supply curve and the market price
00:03:59is the produce a surplus.
00:04:04It
00:04:06shows us how much surplus
00:04:06the producers get
00:04:09now. At the market equilibrium.
00:04:12You would notice
00:04:14that this some of the consumer and the producer surplus
00:04:15is as large as it possible It can be.
00:04:18Therefore, the allocation is Pareto efficient.
00:04:22Now,
00:04:28if you're in doubt.
00:04:29Do you suppose? Not argument.
00:04:31So suppose
00:04:34that instead of trading
00:04:36the market
00:04:38equilibrium Volume X star,
00:04:40let's suppose that one extra unit is being traded as illustrated in the diagram,
00:04:43and it's so that the market price P star.
00:04:49In that case,
00:04:53you can see that the consumers are losing
00:04:54surplus because they have to pay more for the
00:04:57extra unit than they actually evaluate at the demand curve.
00:04:59And the producers,
00:05:03they are making a loss because the revenue they get from that unit is less
00:05:05than the cost of producing it.
00:05:10So if that unit was traded in the market, the total surplus would be less.
00:05:12And therefore we could make everybody better off by not producing that unit.
00:05:18So that demonstrates why the market equilibrium is efficient,
00:05:24operator efficient.
00:05:30So, in conclusion,
00:05:33the market allocation in a competitive market is efficient and therefore,
00:05:35from an efficiency point of view, there is no need for the government to do anything.
00:05:40The market does a very good job,
00:05:44but
00:05:49and this is a big boat.
00:05:50This wonder
00:05:53only works if there is no gravel
00:05:54in the machinery,
00:05:57and unfortunately,
00:05:59there are lots of reasons why
00:06:00this might not work in practise
00:06:02markets will typically fail.
00:06:04In delivering this desirable outcome,
00:06:07we can make a distinction between two
00:06:10categories of market failures or distortions,
00:06:12as we sometimes call it.
00:06:17One type is what I would call intrinsic market failure,
00:06:19and the other type is what I will call policy induced market failure.
00:06:24Now.
00:06:30Intrinsic market failures include things like
00:06:30market power and monopoly when the producers
00:06:33are not taking prices as given when they make decisions in the market.
00:06:36Information asymmetries is another market failure, externalities,
00:06:40missing markets and public goods.
00:06:45These are failures that arise from the fact that the market just
00:06:50doesn't quite work as intended and
00:06:53therefore do not allocate resources efficiently.
00:06:56Now,
00:07:01policy induced distortions and market failures are not intrinsic to the markets.
00:07:02Instead, they arise from the policy interventions
00:07:08introduced by the government
00:07:11and nonetheless the result.
00:07:14A misallocation of resources much in the
00:07:17same way as these intrinsic distortions due.
00:07:20Now let us look at a couple of examples to make this a little bit more concrete.
00:07:24Let us start by looking at an intrinsic market failure
00:07:31market power,
00:07:34so suppose that the producers
00:07:36in the market for gasoline
00:07:39have market power,
00:07:42maybe because there's only one gasoline station in
00:07:44the particular area that we're looking at.
00:07:47As a consequence of that, they can set the price
00:07:50above the competitive market price
00:07:54in the diagram. That's suppose that they are able to increase the price to P.
00:07:57M M for Monopoly
00:08:01now at that higher price.
00:08:05Uh, the consumers don't want to buy that much, obviously,
00:08:07so they scale back what they buy to the quantity X m.
00:08:11So the amount of gasoline trades in the market on the monopoly
00:08:17conditions is less than what would happen in the competitive market.
00:08:20But more importantly, let us look at what happens to consumer and producer surplus.
00:08:24The consumer surplus indicated in red is lower than
00:08:33it would have been in the competitive market.
00:08:39They produce us,
00:08:41they get some extra surplus so the blue area is
00:08:42bigger than it would have been in the competitive market.
00:08:45But and this is the key insight.
00:08:48The area marked up in orange
00:08:53is lost.
00:08:55So compared to the market allocation,
00:08:58the total surplus when we add up the red and the blue area in
00:09:01this diagram is less than what it would have been in the competitive market.
00:09:05So Monopoly, as an example of an intrinsic market failure,
00:09:12introduces a loss to the economy.
00:09:16It comes at a cost.
00:09:20Now it's relatively easy to see where this distortion is coming from,
00:09:23So take a look at the arrow in the diagram.
00:09:29If a little bit more
00:09:33gasoline
00:09:36were supplied to the market,
00:09:37then the consumers would value that
00:09:40and they would value it at the top of the arrow
00:09:42because that's where the demand curve is.
00:09:46And remember the demand curve show there's a valuation
00:09:48of the goods.
00:09:51The producers, on the other hand, would be willing to supply that extra units
00:09:54at the supply price at the supply curve,
00:09:59which is at the bottom of the arrow,
00:10:03we can see that there's a gap between the two, so getting an extra unit
00:10:06delivered to the market starting from the monopoly quantity
00:10:11would generate a social benefit because the
00:10:15consumers are willing to pay more for that
00:10:17unit to be delivered to the market than the producers required to supply it.
00:10:20So that is the fundamental source of the distortion that is created by this market,
00:10:27uh, power.
00:10:33So that was an example of a an intrinsic distortion or market failure.
00:10:36Now let's take a look at the policy induced distortion,
00:10:42so one example of that would be a maximum price.
00:10:46So if you take a look at the market diagram again,
00:10:50then the example would be a maximum price at P max,
00:10:53which means that the producers are not allowed to charge more than that price
00:10:58Of course, in recent times there's been a lot of debate about this in the market,
00:11:05not for gasoline, but in the market for gas.
00:11:09So what is the consequence of this price cap?
00:11:14Well, we can see if we calculate the consumer surplus,
00:11:17the difference between the consumers valuation of
00:11:20the units that are delivered to the market
00:11:23and the price that they have to pay, which is the maximum price.
00:11:26That's
00:11:30a lot lower, larger than it used to be.
00:11:31So the red area in the diagram is large.
00:11:34It produces because they can't charge more than the maximum price,
00:11:38get a bit of surplus,
00:11:41but we can see that the blue area is a bit smaller than it used to be.
00:11:43But
00:11:47we also see that we have the Orange area,
00:11:49the Orange area represents what is being lost.
00:11:52So again,
00:11:56the allocation with this price cap is not Pareto efficient.
00:11:57And the reason, of course, is that because the price cap is imposed,
00:12:02producers are not delivering that many units of the good gasoline to the market and,
00:12:08as a consequence, their consumers,
00:12:13who would happily have bought at a higher price but which are not able to do so.
00:12:15And as a consequence of that, we have a social laws
00:12:20Now.
00:12:25The government, of course, didn't introduce
00:12:27one would have thought this price cap to harm the economy.
00:12:29It's kind of collateral damage that we have that laws.
00:12:33The government would have done it because there is some benefit.
00:12:38Perhaps they wanted to help consumers by keeping prices low.
00:12:40But we can see from this that it comes at a cost.
00:12:45So
00:12:50in conclusion
00:12:51we learn two lessons from this.
00:12:53The first lesson is that the president of market failure gives the
00:12:56government and efficiency based rationale for
00:13:00wanting to intervene in the economy,
00:13:03to eliminate these intrinsic inefficiencies that arise from monopoly power,
00:13:05externalities and s symmetric information, and so on.
00:13:10The second insight is that government interventions into
00:13:16the economy introduces their own policy induced distortions,
00:13:21they create their own social losses,
00:13:26and these have to be traded off against the benefits that such interventions might
00:13:29might
00:13:36achieve.
00:13:37
Cite this Lecture
APA style
Aidt, T. (2023, January 23). Micro - Government Intervention in Markets - Market Failure and the Efficiency Case for State Intervention [Video]. MASSOLIT. https://massolit.io/courses/micro-government-intervention-in-markets/other-reasons-for-state-intervention
MLA style
Aidt, T. "Micro - Government Intervention in Markets – Market Failure and the Efficiency Case for State Intervention." MASSOLIT, uploaded by MASSOLIT, 23 Jan 2023, https://massolit.io/courses/micro-government-intervention-in-markets/other-reasons-for-state-intervention