gsb728 lecture note topic 3a

Economics for Management

GSB728

Topic 5:

Government and the Market

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Note: This lecture note was prepared based on the teaching material provided

by the publisher of the textbook Principles of Economics.

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Learning Objectives

1. Social efficiency – Is this something that the free market will achieve?

2. Market failures – Why do markets not always give the best outcomes?

3. Government intervention – What can the government do when markets fail?

4. The environment: A case study in market failure – How can economists contribute to the environment debate?

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Social Efficiency• Social goals requiring intervention:

– Equity: a fair distribution of resources.• Problems of defining ‘fairness’

– Social efficiency: allocative efficiency.• Marginal social benefits (MSB).

• Marginal social costs (MSC).

– MSB > MSC Socially efficient to produce

(or consume) more.

– MSC > MSB Socially efficient to produce

(or consume) less.

• Social efficiency achieved where MSB = MSC.4

Social Efficiency (contd.)

– General market equilibrium:• Socially efficient?• Is intervention required?

• Perfect competition with no externalities leads to a socially efficient outcome:

– MU = MSB = P = MC = MSC

– Therefore MSB = MSC

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Market Failures

• A market failure is a socially inefficient outcome.

• Externalities:

– External costs of production:• MSC > MC

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7

0

DP

MSCCosts and benefits

QuantityQ1Q2

Production Costs Externalised

Cost externalised

Social optimum Firm optimum

$MC = S

Source: Sloman et al. (2014).

– External benefits of production:• MSC < MC

Market Failures (contd.)

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0

DP

Q1

Costs and benefits MC = S

Q2

Production Benefits Externalised

Quantity

$

MSC

Social optimum

Firm optimum

External benefit

$

9Source: Sloman et al. (2014).

– External costs of consumption:• MSB < MB

• Principle of diminishing marginal utility.


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Q1

MB = MU

0

DP

Costs and benefits

External cost

MSB

Q2

Social optimum

External Costs of Consumption

Quantity

$

Firm optimum

Source: Sloman et al. (2014). 11

– External benefits of consumption:• MSB > MB


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Q2

0

DP

Costs and benefits

External benefit

MSB

Q1

External Benefits of Consumption

Quantity

$

Firm optimum


Social optimum

MB = MU

• Public goods:

– Non-rivalry.

– Non-excludability.

– Free-rider problem.


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Types of Goods According to Excludability and Rivalry

15Source: Stiglitz et al. (2014).

• Monopoly power:

– Demand curve faced by monopoly.

– Production at less than the social optimum.

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MC1

Q1

MC

MRAR

0

P1

$

A Monopolist Producing Less ThanSocial Optimum

Quantity

Monopoly price

Monopoly output


0

P1

MC1

MC = MSC

Q1

MRD = AR = MSB

Q2

$

Quantity

A Perfectly Competitive Firm Produces at the Social Optimum

P2

Perfectly competitiveprice and output

where MSB = MSC


• Deadweight loss under monopoly:• Consumer surplus.

• Producer surplus.

• Total (private) surplus.

– The effect of monopoly on total surplus:

• Deadweight welfare loss.

– Comparison between perfect competition and monopoly.


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0

$

Ppc

Qpc

D = AR = MR

Consumersurplus

Producersurplus

Perfect Competition

Quantity

MC = SIndustry equilibrium under

perfect competition - interestsof consumers and producers

are reconciled.


0

$

Pm

Qpc

D = AR

MC = S

Deadweight loss under monopoly

QuantityQm

MR

Producersurplus

Consumer surplus Industry equilibrium

under monopoly

‘Deadweight’ welfareloss.

Producer surplus ismaximised at the expense

of consumer.


– Possible advantages from monopoly:• Economies of scale.• Research and development.

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• Ignorance and uncertainty:• The problem of asymmetric information.

• The need for government monitoring.

• Incentives for agents.

• Poor economic decision making by people:• Merit goods.


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• The use of taxes and subsidies to correct market failures.

– Correcting distortions due to externalities:

• The optimum size of a tax:

– Tax = Marginal external cost.

– Subsidy = Marginal external benefit.

Government Intervention

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Q1

0

MC = S

DP

Cos

ts a

nd b

enef

its

Quantity

Using Taxes to Correct a Market Distortion (I)

$


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0

MC = S

DP

MSC

Costs and benefits

External cost

Q1Q2

Social optimum

Quantity

Using Taxes to Correct a Market Distortion (II)

$

Firm optimum


MC

Q1

0

P

Costs

Optimum tax = MSC – MC

MC = SMSC = MC1 = S1

D = MR

Q

Using Taxes to Correct a Market Distortion (III)

$

Tax

Social optimum

Q2

Firm optimum

E2 E1

Imposition of tax increasesmarginal cost of production:output contracts to social

optimum.


• Disadvantages of taxes and subsidies:

– Infeasible to use different tax and subsidy rates.

– Lack of knowledge.

Government Intervention (contd.)

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MB = MSB

L2 L1

P2

MSC

Emission levelP1 = 0

Emissions Charge

$ Costs and benefits

Tax


• Laws prohibiting undesirable behaviour:– Advantages of legal restrictions:

• Simple to understand.

• Safer when size of problem is potentially great.

• Quick to implement.

• A good way of dealing with imperfect information.

– Disadvantages of legal restrictions:• Inspectors are required.


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• Regulation of monopolies and restrictive practices:• Australian Competition and Consumer Commission

(ACCC) – Trade Practices Act.

– Anti-competitive practices:• Price fixing and market sharing.• Predatory pricing.• Resale price maintenance (supplier sets minimum

prices at which a good can be resold).• Some mergers.


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• Provision of information (to avoid poor decision-making due to ignorance).– Information on jobs (helps the labour market to

work better).

– Consumer information (e.g.: information helps them to know the negative effects associated with the consumption of certain goods such as cigarettes and fast food).

– Information to firms (statistics on prices, costs and employment, among others, that can help them to plan with greater certainty).


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• Direct provision of goods and services:

– The provision of public goods:• Examples: Streets, footpaths, legal system and

national defence.

– The need to evaluate costs and benefits of publicly provided goods:

• Cost-benefit analysis (if the social benefits of a project (e.g.: new road) exceed the social costs, then it would be socially efficient to implement it).


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The Environment: A Case Study in Market Failure

• The environmental problem:

– Global and local environmental problems.

• Market failures:

– The environment as a common resource.

– Externalities.

– Ignorance.

– Inter-generational problems.

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• Policy alternatives:

– Charging for use of the environment (as a resource or a dump).

• Environmental charges:

– Emissions charges.

– User charges for rubbish collection.

– Optimal charge = External cost.

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The Environment: A Case Study in Market Failure (contd.)

– Environmental ‘green’ taxes and subsidies:

• Imposed on goods that generate external environmental costs or benefits (also used to reduce pollution).

• Limitations: Identifying the socially efficient tax rate.

Demand inelasticity.

Problems with international trade.

Effects on employment.

Redistributive effects.36


– Laws and regulations:

– Education.

– Tradable permits:• Each firm is given a permit to pollute up to a

certain level. When less than the permitted pollution is generated, the firm is given a credit that can be sold to other firm polluting more than its original limit.

• Simple solution to achieve pollution reduction.

• Firms have financial incentive to cut pollution.

• How should be the tradable permits allocated? 37


• How much can we rely on governments?

• Governments must have the will to protect the environment.

• Depends on attitudes of various interest groups.

• Must be able to identify problems and appropriate solutions.

• When these problems are global!!

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ReferencesMorales, L. E., Simons, P. and Valle de Souza, S.

(2014). GSB728: Economics for Management [Topic Notes]. Armidale, Australia: University of New England, Graduate School of Business.

Sloman, J., Norris, K and Garratt, D. (2014). Principles of Economics (4th ed.). French Forest, Australia: Pearson.

Stiglitz, J., Walsh, C., Gow, J., Guest, R., Richmond, B. and Tani, M. (2014). Principles of Economics: First Australian Edition. Wiley.

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