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Elemental Economics

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Competitiveness of Nations

Cultural Econometrics

Cultural Economics

Elemental Economics

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Dr. Harry Hillman Chartrand, PhD

Cultural Economist & Publisher

Compiler Press


215 Lake Crescent

Saskatoon, Saskatchewan

Canada, S7H 3A1

Curriculum Vitae


Launched  1998




6.0 Market Failure


0. Overview

The necessary conditions for Perfect Competition are so strict that it does not, in fact, exist in the real world.  It is an ideal, an ideological benchmark against which outcomes under Imperfect Competition can be assessed.  This includes, to a degree, Oligopoly where the Standard Model comes to its geometric end with Sweezy's Kinked Demand Curve.   Since the 1940s constrained profit maximization under Oligopoly has mutated into Game Theory which operates outside the geometric elegance of the Standard Model. 

Nonetheless, if one uses Perfect Competition as the benchmark then outcomes under Imperfect Competition represent Market Failure.  There are, however, other forms of Market Failure.  These include Externalities, i.e., costs and benefits external to market price, and Public Goods, i.e., socially valuable goods and services that firms cannot profitably produce or that the Public does not want them to produce, e.g., national defense.  In what follows the nature of and alternative policy solutions to different forms of Market Failure are examined.  Finally, the nature and limitations of Public Choice Theory will be considered, i.e., How is Public Choice made to mitigate pernicious effects of Market Failure?


1. Market Power

Unlike Perfect Competition under all forms of Imperfect Competition producers supply a smaller quantity at a higher price, generate a deadweight loss of consumer & producer surplus while some consumer surplus is appropriated as excess, economic or monopoly profit.   Furthermore, in the long run Imperfect Competition fails to attain the lowest average cost per unit output. 

Under Imperfect Competition firms are thus price makers rather than price takers as under Perfect Competition.  They exercise Market Power defined as the ability to determine the price/quantity outcome in the market.  The Public Choice is whether Equity requires intervention to protect consumers?  Whether or not Equity or any other moral principle justifies public intervention in the marketplace is considered in 4. Public Choice.

i -Monopoly (MKM C15/331-4)

In the case of Monopoly the sources of Market Power may be: (a) economies of scale/network economies resulting in a Natural Monopoly; (b) exclusive possession of a critical input to the production process; (c) State grant of intellectual property rights (IPRs) such as copyrights, patents, registered industrial designs or trademarks; and/or, (d) State grant of a public francise over a natural monopoly or grant of self-regulating authority, e.g., to accountants, architects, dentists, engineers, lawyers and medical doctors, a.k.a., the self-regulating professions or the Practices: 

a) in the case of a Natural Monopoly rooted in economies of scale, one firm can satisfy all market demand at the lowest possible average cost (MKM Fig. 15.1).  In response to any entrant the monopolist can drop price below the break-even point of any aspiring rival.  There are at least two policy solutions.  The first is to place the Monopoly under public ownership.  This a generally done only when output is considered critical to public welfare, e.g., municipal water and sewage systems.  The technical term is a 'franchise'.  The second alternative is to regulate the Monopoly in an attempt to reduce price and increase quantity approximating the outcome of Perfect Competition.   Problems associated with regulation are discussed below under 4. Public Choice;

b) in the case of a Monopoly based on exclusive possession of a physical input there are also at least two policy solutions - break up the monopoly into a number of smaller, competing firms or regulate it.  The classic case is Standard Oil of New Jersey founded by John D. Rockefeller Sr.   The firm controlled virtually all oil and oil refining in the U.S.A.   In 1911 the Supreme Court of the United States broke up the firm into 34 separate companies;

c) in the case of a Monopoly based on IPRs, there are three alternative policy solutions - break up the monopoly, regulate it or amend its IPRs.  Thus Microsoft was, like Standard Oil, threatened with break up during the Clinton administration in the 1990s.  It was proposed to break up the firm into three distinct companies - one each for Windows operating system, Office applications and Server software.  The subsequent George W. Bush Administration choose to regulate.  In the European Union, however, Microsoft was required to open up its 'interface’ code to competitors to allow their products to work smoothly with Windows and thereby compete in the marketplace. This 'interface’ was unpublished and treated as a trade secret by Microsoft as remains the case with the ‘kernel’ of its operating system.  Alternatively IPRs can be legally amended, e.g., requiring compulsory licensing, shortening duration or abrogating some or all rights; and,

d) in the case of a Monopoly based on a State grant of self-regulating authority, a.k.a., the Practices, there are a number of policy solutions: (i) change their charters; (ii) regulate their procedures and rates, e.g., under Medicare; (iii) pass profession-specific legislation, e.g., the U.S. Sarbanes–Oxley Act of 2002, also known as the "Public Company Accounting Reform and Investor Protection Act"; or, (iv) as in Germany and Austria, make the Practices constitutionally recognized and accountable for their actions and their standards.

ii - Monopolistic Competition (MKM C16/356-9)

In the case of Monopolistic Competition, with many small firms, the source of Market Power is product differentiation.  However, while in the short run excess, economic or monopoly profits are earned, in the long run excess profit is eliminated by free entry into the marketplace (MKM Fig's 16.2 a & 16.3).  The Public Choice is whether product differentiation is worth the added cost to consumers?  Generally the answer is yes and the State does not intervene other than for health and safety reasons.  

iii - Oligopoly (MKM C17/383-7)

In the case of Oligopoly a few large firms dominate the industry accompanied by a competitive fringe of smaller firms.  Market Power under Oligopoly generally results from some combination of: (a) economies of scale/network economies; (b) process/product differentiation; (c) process/product innovation; and/or, (d) collusion.  In the case of economies of scale, if there are several competing firms break up is not usually a policy option.  With respect to product differentiation and innovation Public Choice involves determining whether such benefits out weight the added cost to consumers.  In this regard it is important to note that under Perfect Competition firms are lean, mean fighting machines with no excess profit to finance long term research and development leading to innovation or to launch major advertising campaigns.  It is, however, with respect to collusion that regulation, e.g., of the Canadian cell phone industry, is not an option but rather a necessity involving competition policies that, among other things, prohibit price fixing which is common in oligopolistic industries.


2. Externalities (MKM C10/211-37)

Until now we have assumed that the market price for a good or service includes or internalizes all relevant costs and benefits.  This means the consumer captures all the benefits and the producer pays all the costs.  Such goods & services are called perfectly private goods.  An externality refers to costs or benefits not captured by market price, i.e., they are external to market price.  In effect, the market demand curve reflects only the marginal private benefit (MPB) curve of consumers but not external benefits to society as a whole.  When external benefits are added, vertically, to the market demand curve we derive the marginal social benefit (MSB) curve inclusive of both private and public marginal benefits. 

Similarly, if there are external costs to production, i.e., not explicit costs to the producer, the market supply curve reflects only the marginal private costs (MPC) not costs external to the firm’s bottom line, e.g., pollution costs that society must pay.  When social costs are added, vertically, to the market supply curve we derive the marginal social cost (MSC) curve inclusive of both private and public costs.

The Standard Model is based on the assumption that all relevant costs and benefits are internalized in market price, i.e., there are no externalities.  If this is true then ‘X’ marks the spot.  If, however, there are externalities then market equilibrium is not allocatively efficient nor is the greatest good for the greatest number achieved.  If a social optimum equilibrium is to be achieved then a Public Choice must be made as to the costs and benefits of intervention in the marketplace and alternative public policy solutions to mitigate negative externality-generating goods (demerit goods) and foster positive externality-generating ones (merit goods).  The appropriateness of public intervention in general including Market Failure due to Externalities is discussed under 4. Public Choice.

Ideally, external or social costs and benefits should be added to private costs and benefits reflected not by market supply and demand curves but rather by the MSB & MSC curves.  The point is that external costs must be paid and external benefits must be accounted for if the socially optimal price/quantity equilibrium is to be established.  The agency to do so is not the market but rather the State.  Put another way, the market 'X' solution is superseded by a social ‘X” marking the spot where allocative efficiency exists and achieves the greatest good for the greatest number.  It is thus up to the State to correct the miscalculation of private agents to achieve a socially optimal equilibrium We will now examine examples of negative and positive externalities and alternative public policy solutions

i - Negative Externalities (MKM C10/214-17)

There are many forms of negative externalities but the most widely recognized is environmental pollution.  Recognition of such negative externalities tends to be the result of increasing income, education and especially new scientific knowledge revealing the unintended social costs of production.  Thus the modern environmental movement was born with publication of Silent Spring by Rachel Carson in 1962.   DDT had been a boon to both military and civilian operations during WWII.  Malaria, yellow fever and other mosquito-borne disease was dramatically reduced.  No one knew it built up in the food chain leading to thinning birds' eggs and hence to the Silent Spring There are five major types of environmental pollution:

a) air pollution mainly caused by road transportation and industrial processes;

b) biological pollution mainly caused by: ocean-going vessels dumping bilge water, e.g., lampreys, zebra mussels, fishhook water fleas, etc.; agricultural import of foreign organisms to counter infestations, e.g., the sugar cane frog in Australia;and, by consumers dumping exotic pets, e.g., pythons in the Florida Everglades

c) land pollution mainly caused by industrial waste and by consumers;

d) sound and light pollution mainly caused by urbanization; and,

e) water pollution mainly caused by industrial waste (land and sea) and farm run off.  

With respect to production, firms do not internalize external costs because they are not out-of-pocket expenses and therefore are not reported in the firm's bottom line (MKM C10/Fig. 10.2).    This leads to a lower price and higher output relative to the social optimum.  It also means that society as a whole must pay these external costs, e.g., increased health and/or purification costs and suffer a deadweight loss of producer and consumer surplus (MKM C10/Fig. 10.3). 

Negative externalities in consumption of, for example, demerit goods such as drugs, gambling, smoking, pornography, etc., are similarly not included in a firm's accounting. As with negative externalities in production this leads to a lower price and higher output relative to the social optimum.  It also means that society as a whole must pay such costs, e.g., increased health and/or social costs and suffer a deadweight loss of producer and consumer surplus. 

The Public Choice is if and how to make firms internalize such costs and achieve a socially optimum price/quantity equilibrium.  There are five basic policy tools: prosecution, property rights (including quotas), regulation, subsidies and taxation.

a) Prosecution

To the degree a firm's negative externalities result in damage to individuals or communities they are subject to civil action as a tort, i.e., a civil wrong unfairly causing loss or harm to someone else and creating legal liability for the individual or firm committing the act.  To the degree harm results in loss of life or limb or threatens national security, criminal proceedings by the State are also possible.  In both cases legal costs as well as any damage settlement increases cost to the firm shifting the supply curve up to the left, ideally merging with the MSC curve and achieving a socially optimal price-quantity equilibrium;

b) Property Rights (MKM C10/228-30)

Arguably externalities arise due to a lack of property rights, i.e., arrangements governing ownership of factors of production as well as consumer goods and services.  Property rights establish legal title enforceable by the courts.  Externalities, however, generally arise as unintended consequences initially not recognized or owned by anyone.  Once recognized, however, the State may establish property rights and assign ownership.  It is important to note that Economics does not operate in a vacuum.  It is the Law that ultimately defines what is property, i.e., what can be bought and sold and therefore what legitimate markets may exist.

If property rights exists and transaction costs are low then private transactions can resolve an negative externality, e.g., water pollution from a plant, (P&B 4th Ed. Fig. 20.3; P&B 7th Ed Fig. 16.3).  At first glance it would seem that to whom a property right is assigned is significant but assuming transaction costs are low then the outcome will be the same.  Thus if the polluter owns the river then victims must pay to abate it; if victims own the river then the polluter must pay.  In either case MSB should eventually equal MSC.  This is known as the Coase Theorem (MKM C10/229-30). 

If transaction costs are high, however, then private transaction are inadequate to resolve the problem.  Thus if there are dozens of polluters and/or many victims, e.g., many different municipalities along the river, then transaction costs may be high (sometimes higher than the cost of the negative externality) and the State may choose to intervene.  Usually a scientific assessment is made of the sustainable level of pollution and a quantity (quota) becomes available to be divided among polluters as marketable permits (MKM C10/224-6)  In effect, the State creates a property right and market in pollution.  Competition among polluters should raise the price discouraging more pollution and encouraging the search for non-polluting technologies (MKM C10/Fig. 10.5b).  Exceeding the permitted level leads to increased competition for permits or punitive penalties enforced through the courts. 

c) Regulation

In a sense all State intervention in the economy involves regulation.  Legislation sets out the strategy and tactical means for politically justified intervention but the logistics, where the rubber hits the road, takes the form of rules & regulations often developed and always enforced by the bureaucracy.

In the case of State intervention justified by Externalities the first cost is detection, i.e., determining there is an externality and, in the case of a negative externality like pollution, what is its sustainable economic level?  This is usual accomplished through scientific or policy research.  Then follows Legislation and then Rules & Regulations.  In directing the industry towards a socially optimum outcome.  Ideally the associated cost of State enforcement should appear in the analytic geometry of the extended Standard Model.  Compliance costs (filling out forms and answering questions) paid by either the producer or consumer should be included as a part of the social cost curve in the case of a negative externality or as part of the subsidy shifting the private marginal cost curve in the case of a positive externality.

d) Taxation & Subsidies (MKM C10/220-1)

Alternatively, the State may tax polluters rather than establish a market permit system.  Ideally using a scientific assessment the State can set a price per unit of pollution or emission charges based on marginal social cost/benefit analysis (P&B 7th Ed Fig. 16.4).  To the degree firms treat taxes as a cost of doing business the tax is added to their production function causing a shift of the industry supply curve up to the left raising costs to polluters until it ideally merges with the MSC cost curve.

By contrast, subsidies can be used to reduce the cost of substitutes (cross elasticity).  Thus subsidies to nuclear, solar and wind power should reduce demand for coal, gas and oil in turn reducing pollution and its external costs.

ii - Positive Externalities (MKM C10/217-19)

There are many forms of positive externalities but the most widely recognized is higher education. A rational student will calculate the increase in life long earnings from an additional year of higher education and compare it to the cost of that extra year.  Such a student, however, does not include in the calculation external benefits to society as a whole.  Accordingly a socially optimal level of education does not occur.  Such benefits include reduced youth-related crime or, as an old professor of mine noted: "Universities and colleges are concentration camps for youth.  If they are in a classroom they are not on the street doing rude and naughty things".   Furthermore, society benefits from more educated people who can better communicate and innovate.  

There are two principle ways to achieve the socially optimal level of education.  The first is to subsidize the supplier, e.g., State grants per student to universities and colleges, shifting the supply curve to the right, lowering the price of tuition and encouraging more students to stay in school, ideally at the optimum level.  The second is to subsidize students, e.g., bursaries, grants, loans, scholarships, etc.,  effective lowering the cost of education and shifting the demand curve to the rights until, ideally, it merges with the MSB curve leading to a socially optimal outcome (P&B 7th Ed Fig. 16.5 & 16.6 & Fig. 16.7; MKM C10/Fig. 10.4). 

There are also private positive externalities such as good neighbourhood effects including well kept lawns, flower beds, etc., that cost the pssing visitor nothing but pleasure.   There are in fact a range of merit goods that the State chooses to support because of their positive externalities.  Examples include the Arts, scientific and industrial research & development and many other non-profit or Third Sector activities.  Subsidies are provided by the State in the form of grants and tax exemption.


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