X. Review of Market Failures

A. Significant increasing returns to scale, in the limit leads to monopolies.

  1. Natural monopoly – large capital costs and small operational costs (e.g. utilities)
    1. P > MC (inefficient)
    2. Output is below the competitive equilibrium output.
    3. Solutions:

                                                               i.      P = AC (profits are zero)

                                                             ii.      P = MC with a subsidy

    1. The first welfare theorem can be used to guide regulatory policy – regulations to mimic the competitive equilibrium solution
  1. Externalities – when an activity by some entity directly affects the welfare of another in a way that is not transmitted or reflected in market prices; market prices are wrong.
    1. Positive externality – external benefit; vaccinations, pre-school education, some types of research.

                                                               i.      Graph

                                                             ii.      One solution – subsidy = MEB at the efficient output; internalize the externality

    1. Negative externality – external cost; pollution (smoking a cigar at the Bellagio)

                                                               i.      Graph

                                                             ii.      Traditional solution- Pigouvian taxes: tax = MEC at the efficient output; internalize the externality

    1. Coase Theorem (non-traditional approach guided by the first welfare theorem) – In the absence of transactions costs, efficiency will be achieved regardless of the property rights structure as long as property rights are well-defined and can be enforced; efficiency will be attained independently of who is assigned the right.

                                                               i.      Transactions costs – costs of using the market: costs of arranging the contract ex ante, costs of monitoring the contract, costs of enforcing the contract ex post. These costs are different from the costs associated with the execution of the contract (production costs).

1.      search costs

2.      bargaining costs

3.      enforcement costs

                                                             ii.      When transactions costs are positive the law can have significant effects on efficiency. If transactions costs are “low enough” then Coase still applies.

    1. Illustration from Wisconsin environmental policy – transferable discharge permits (Wallace Oates “Environmental policy at the crossroads” American Domestic Priorities (1985) pp. 311-45.
    2. Illustration using game theory (review notes from ECON 301 and 303; Pindyck and Rubinfeld chapter 13)

                                                               i.      Review of game theory - Games of strategy are abstract rules that define the strategic situation, capture the salient features of situations where there exists an interdependence of payoffs

1.      Players

2.      Rules

3.      Strategies - complete plans of actions for playing the entire game

4.      Payoffs

5.      Solution concept - equilibrium concept used to predict the outcome(s); Nash equilibrium (most basic): an outcome such that no one player has any incentive to unilaterally deviate from his/her strategy given the strategies of the other players; each player does the best he/she can given the strategies of the other players (intersection of the best responses of all players). (Many other solution concepts [e.g. sub-game perfection] are derived from the Nash equilibrium concept.)

                                                             ii.      Coase game due to Roy Ruffin Economic Review 1996.

  1. Public goods
    1. Continuum of goods based on two properties:

                                                               i.      Rivalness (private good) allowing another to consume the good reduces the benefits of others who are already consuming it. Public goods are non-rival.

                                                             ii.      Excludability (private good) costless to exclude others from consuming the good once it is produced. Public goods are non-excludable.

                                                            iii.      The continuum

                                                           iv.      Problem with market provision of public goods – markets are expected to under produce public goods; “free rider” problem.

                                                             v.      Voluntary contributions experiment.