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Market Failure
When the two FTWE hold, role of public sector relegated to that of providing the institutional and
legal framework for market operations and possibly to redistributing income.
Otherwise, a prima facie case for non-market mechanisms that permit Pareto improvements might be
given.
Fundamental market failures: (1) non-competitive behaviour (2) externalities resulting from a lack of
property rights (3) externalities resulting from jointness in consumption and production including
public goods [and (4) informational externalities, discussed later in the course].
(1) violates perfect competition assumption; (2), (3) and (4) violate market completeness assumption.
While Alice is better off, the Bobs are worse off and the resulting allocation non-Pareto efficient. All
results apply to the production economy and more sophisticated instances of market power.
Russell Kueh
Policy responses
• Facilitate Bargaining (Coase Theorem)
• Quotas (Centralised)
• Pigouvian Taxes (Centralised)
Russell Kueh
Thus, with perfect information, price and quantity instruments are equally effective.
Policy responses
• Direct provision (quantity instrument)
• Pigouvian Subsidies (price instrument)
• Facilitating personalised markets
Direct provision and subsidies are the opposite case to that of quota and taxes: the quantity
instrument is to provide q0 directly, while the price instrument is to provide a unit subsidy equivalent
to the marginal externality at the Pareto efficient quantity, q0 i.e. MBb at q0.
Russell Kueh
Russell Kueh
This thought experiment works because consumers: (1) expect to be excluded from the benefits of
others’ provision (via heterogeneous experience) and (2) each pays a personalised price.
They all buy the same amount and are charged according to their MBs at that level.
No one is actually excluded, thus not violating the Pareto improvement argument above.
Preference Revelation
• Hope to design a mechanism that induces the consumers to reveal their preferences truthfully.
• Lectures present a Discrete Public Good and N Agent model, in which government is deciding
whether to provide a public good at a cost of C to be shared equally among N agents.
• If provided, agent i’s net benefit bi = φi – C/N; otherwise agent i’s net benefit is zero.
• i’s valuation and thus her bi is private information.
• Government wants to provide the public good if and only if social net benefit is non-negative i.e.
∑bi ≥ 0
Pivot Mechanism
• Each agent simultaneously report her net benefit
• Provided iff net benefit non-negative
Russell Kueh
• An agent i pays a tax iff she is pivotal, the amount of which equals the absolute value of the sum of
other agent’s announced net benefits
• It is a weakly dominant strategy for agent i to report her net benefit truthfully, satisfying
government’s objective of truth-induction
• This and other similar mechanisms generally work since they effectively require each agent to take
responsibility of the “net” externality that the agent’s decision imposes on others
• But the side payments involved in such mechanisms mean that the government runs a surplus that
it has to “burn”
• Refer to Market Failure lecture notes P.50 for algebraic representations and proofs
Many goods are neither purely rival nor purely public. ‘Mixed public goods’ are those subject to
congestion costs as the number of users increases e.g. parks, road, concerts, golf course etc.
At some point the addition of another user reduces the enjoyment of others, usually in terms of
‘quality’, but it is analytically useful to think of congestion as the altering of the ’amount’ of the good
per user.
It (interestingly) turns out that it is possible to provide optimal allocation of missed public goods via
a decentralised decision-making process.
Tiebout (1956) analyses the case where mixed public goods such as police protection, fire
proctection etc. are provided by local governments. He argues that if communities are geographically
isolated so that some form of exclusion can be effected against those non-locals, and if HHs are mobile
and can choose a community solely on the basis of the “local public good/ lump-sum tax” package
offered by each of the communities, then (with a few more technical assumptions) there will be an
optimal allocation of the local public goods achieved.
Buchanan (1965) offered a private sector version of the above mechanism with ‘clubs’ instead of
‘local governments’ and a ‘membership fee/facility’ package instead of a ‘local public good/tax’
package.
This result, that mixed public goods can be optimally provided by a decentralised mechanism, is
very important. It implies jointness per se does not lead to market failure (non-excludability and non-
rivalry required as well). And this result is quite general. The important assumptions are that
excludability is present and that costs rise eventually due to congestion.
In all cases of market failure, the MSB will differ from MSB, since market participants are motivated
by divergent MPC and MPB. Overconsumption or under-provision will occur where there are net
external costs or net external benefits, respectively.
The government may have a role to play – to involve itself in the actual allocation of resources. It
should be able (theoretically) to undertake mutually beneficial allocative actions (i.e. Pareto
improvements) that private agents cannot because of it’s monopoly on the legal use of coercive power.
It can extract involuntary payments and/or prohibit activities. This allows the public provision of non-
excludable public goods that suffer from the free-rider problem and which, therefore, would not be
provided privately.
Similarly, it can utilise corrective price instruments such as Pigouvian taxes/subsidies that eliminate
the divergence between private and social MC/MB, and/or utilise quantity instruments like quotas.
It is worth emphasising that this view of the benefits of governmental allocative functions is quite
distinct from the superficial view that the government ‘knows better’ and provides a coordinated and
planned way to resource allocation as opposed to the ‘invisible hand’ approach of private market.
Although the government sector may pursue ‘corrective’ policies in an economy which is not Pareto
optimal, it could also be a cause rather than a cure of market failure. Tax and transfer policies may
lead to a non-optimal allocation of resources in an economy that would otherwise be Pareto optimal:
non-lump-sum tax/subsidies alters the relative prices perceived by different agents, causing the Pareta
optimal conditions not to be satisfied (e.g. the mechanism whereby MRSs are equated by the same
relative price facing all—thereby achieving exchange efficiency—might break down).
A profound suggestion in this article is the two-stage evaluation of institutions. Extending the
previous argument, it is noted that while we expect all institutions to be better than they seem, they
need not be better to the same degree. There can be an institution (or student) that scores 75% without
repairs by private negotiation (or revision), but scores only 2% more at 77% after all possible repairs
(revisions) are done, while there can be one that scores only 60% without repairs (or revision) but 80%
after all improvements are exhausted.
The two-stage evaluation of institution precisely focuses on this issue of ‘repairability’: before
concluding overall efficiency, we must not only look at what outcomes the institution on its own would
yield, but also ask how far it can be repaired by private negotiation.
In the case of bureaucrats, we need to ask whether or not the clumsy (inefficient) compromise that
they are prepared to enforce is a good starting point for negotiation, compared, say, to one party’s
most-preferred outcome (in which case he certainly won’t trade).
Farrell (1987) suggests therefore that this use of bureaucrats—to ensure an equitable status quo for
bargaining—is more efficient than just letting the bureaucrat decide, or private property rights alone.