Transcript Market Failures

Economics Workshop
Better Regulation Executive
2006
Sandeep Kapur
WORKSHOP AIMS
To provide rigorous but non-mathematical training in
economics, enabling BRE staff to
• develop a simple but reliable toolkit for economic
analysis
• practise its application using concrete regulatory
problems
• explore the application of simple economic theory
to their own work
Objectives: Day 1
To understand
• how markets work, and their efficiency
• why markets sometimes fail to be efficient and how
various regulatory instruments can improve efficiency
• how regulation can improve on other aspects of market
outcomes, such as inequity
• how, in practice, regulatory interventions carry the risk
of government failure
Objectives: Day 2
To
• review the standard rationale for regulation
• the basics of regulatory impact assessment
• understand how good regulatory design can cope with
risk and uncertainty, informational imperfections, and
minimise distortion of incentives
• rationale for and implementation of RPI-X regulation
• the link between regulation and productivity growth
Introduction to Economics
Some Concepts and Tools
Markets vs. Command
The central questions: given existing resources
• what goods and service to produce?
• how to produce?
• for whom?
Alternative mechanisms
• COMMAND ECONOMY
direct control, as in Soviet economy, or firms’ internal
decisions
• FREE MARKET ECONOMY
outcome determined by private transactions in
markets, based on prices, incomes, wealth
Degree of government intervention differs..
Cuba - China - Denmark - UK - USA - Hong Kong
Most countries have mixed economies with both
• markets, which are regulated to different extent
• public production and provision
Scale of government
Spending as share of national income (%)
1880
1930
1960
2004
Japan
11
19
18
37
USA
8
10
28
36
UK
10
24
32
43
Germany
10
31
32
47
France
15
19
35
53
Sweden
6
8
31
57
The policy question
Markets are generally considered to be efficient
If so, why not leave things to the market?
Governments care about both equity and efficiency
• Free markets rarely deliver equitable outcomes, so
some redistributive intervention is unavoidable
• Free markets do not always lead to efficient
outcomes, so some interventions are motivated by
efficiency considerations
To understand this, we must look at how markets work
How Markets Work
Demand, Supply, and Price Adjustment
Market
• MARKET
any arrangement in which prices adjust to reconcile
buyers and sellers intentions
• DEMAND
quantity buyers wish to buy at each price
• SUPPLY
quantity producers wish to sell at each price
• EQUILIBRIUM PRICE
the price at which market clears
(i.e. quantity demanded = quantity supplied)
Price Adjustment
Supply curve
price
Equilibrium
Price
Demand curve
Equilibrium
Quantity
quantity
PRICE ADJUSTMENT
Equilibrium price clears market
Price Controls
Suppose government sets minimum price above market
clearing price
Price
Supply curve
Controlled price
Equilibrium price
Demand curve
Examples include
• Minimum wages
• Rent control
• Common Agricultural Policy
excess
supply
Quantity
What do price controls do?
Price controls interfere with the adjustment process
• minimum wages are good for equity: they boost the
income of some low-skill workers
• But such interventions may not be good for efficiency: if
employers are unwilling to hire as many at regulated
minimum wage, some potential workers are deprived of
the chance to work
Economic Efficiency
An intervention is said to improve efficiency if it makes
someone better off and nobody worse off
Economic efficiency: an outcome where no one can be
made better off without hurting someone else
The key question: do free, unregulated markets always
lead to efficient outcomes?
Markets and Choice
In markets
• consumers buy up to the point where the ‘marginal
benefit’ equals price
• competitive firms sell as long as price covers ‘marginal
cost’ of production (this is the opportunity cost of
producing another unit of the good)
The Efficiency of Markets
Thus, in competitive markets
• prices align marginal benefit with marginal cost
• all possible gainful exchanges are carried out
• PUNCH LINE: Free, unregulated markets lead to
efficient outcomes
This is the so-called Invisible Hand Theorem
But free markets are not always efficient..
Market failure: a circumstance in which free markets
fails to achieve an efficient outcome
Many interventions are designed to correct market
failures, and thus to increase efficiency
In sum: why intervene?
‘Economic regulation’
• Aims to correct market failures, and make the
market outcome more efficient
(when the ‘invisible hand’ does not work, the government
can provide a helping hand)
‘Social regulation’
• To prevent undesirable social outcomes inherent
in market outcomes
Group Work: Efficiency and Equity
Government intervention in the economy is pervasive. For
each intervention listed below identify the possible
rationale. Is it primarily
a. efficiency considerations?
b. equity consideration?
c. something else?
1. Income tax
2. Taxation of petrol
3. Regulating gas prices
…Group Work
4.
5.
6.
7.
8.
9.
10.
11.
12.
Regulating discharge of sewage in the Thames
Legislation against insider trading
Banning the use of cocaine
Making primary school compulsory
Regulating financial advisors
Regulating length of the working week
Compelling citizens to carry identity cards
Minimum wage legislation
Regulating taxi fares
Market Failures
Why intervene?
How to intervene?
Sources of Market Failure
• Externalities
• Public goods
• Imperfect competition
• Imperfect information
• Coordination problems
We will look at each of these in turn
MARKET FAILURE: Externalities
EXTERNALITY
• A circumstance in which an individual's choices
affects others' utility or productivity
• the effect is direct (not through market or prices)
Examples
• Adverse externalities: smoking, pollution
Since costs are partly borne by others, self-interested
decision-making might lead to excess
• Beneficial externalities: bees and orchards, personal
hygiene
Since benefits partly accrue to others, self-interested
choices lead to sub-optimal quantities
Why Externalities Matter
THE ESSENTIAL PROBLEM
• Social Cost = Private Cost + Externality
Social Benefit = Private benefit + Externality
• Market mechanism aligns private costs and benefits;
economic efficiency requires alignment of social costs
and benefits
• Externalities imply divergence between social and
private costs (or social and private benefit)
• If divergences exist, should not expect socially efficient
allocations
Adverse Production Externality
F
MSC
G
E
MPC
Demand
Q*
Q
Quantity
For social optimum, we want
marginal social cost = marginal social benefit
At free market equilibrium E, output Q is higher than social
optimum Q*
Correcting externalities
1.
2.
3.
Quantitative regulation or direct government action:
e.g. pollution quota
[Pigou] Taxes or subsidies to correct prices
e.g. pollution tax
[Coase] Create markets: assign property rights and
enable trade in pseudo-markets
e.g. carbon trading
Coasean Solution
MC (for you)
MB (to me)
Q*
Q
Quantity
Efficient quantity is
Q*
• Assign property rights and
let people trade these rights
in specially-created market
• Initial assignment of rights
affects distribution but get
an efficient outcome
regardless
• This solution does not work
if there are high transactions
costs
MARKET FAILURE: Public Goods
Examples: defence, broadcast TV signal
Characteristics
• Non-rival consumption: my consumption does not
diminish what is available for you
• Non-excludability: impossible or too costly to prevent
people from consuming it
Public goods: the problem and solutions
• If you cannot exclude, people will ‘free ride’. But if
no one pays, there is nothing to free-ride on (this is
the paradox of free riding)
• In fact, exclusion is not efficient either
In general, markets cannot provide public goods
SOLUTIONS
• public provision
• compulsion
Government needs to ensure right quantity, but need
not produce itself
MARKET FAILURE: Imperfect competition
The essential problem of monopoly
• Firms with ‘market power’ can charge prices that
exceed marginal cost
• which restrains consumption below efficient level
• other problems: resources wasted in securing monopoly
power (‘rent-seeking’), and in maintaining it
Solutions to monopoly problem
Solution 1. Nationalize and finance losses through taxes
politically not very feasible
Solution 2. Break monopoly
e.g. anti-trust legislation in US
However, no good for ‘natural monopolies’
Industries with severe economies of scale, so having
one producer avoids duplication of costs
And in some sectors monopoly is good for R&D, or for
internal coordination
More solutions to the monopoly problem
Solution 3. Regulate
Prevent abuse of monopoly power through price and nonprice controls
Practical issues: when is regulation necessary? What form?
How frequently?
Solution 4. Nurture competition
Encourage new entrants, (but will they enter and will it only
lead to cream skimming?)
Important to get the right mix of remedies
MARKET FAILURE: Imperfect information
Information in markets is imperfect. Often there is
asymmetry of information between buyer and seller
leading to problems of
• ‘adverse selection’: people who know themselves to be
risk-prone are more likely to buy insurance
• ‘moral hazard’: once you have insurance, incentive to be
careful is weakened
• these distortions may result in ‘incomplete markets’ or
even ‘missing markets’: e.g. low-risk people may not find
appropriate insurance
SOLUTIONS: Imperfect information
1.
mitigate informational problems
• mandating provision of information
(regulate financial advisors)
• providing information directly
(publish league tables)
2.
reduce the possibility of opportunistic behaviour
• consumer protection
3.
government provision of the good or service
Inefficiency due to strategic interaction
Individual choices do not always result in the best
collective outcomes
Country 2
Country 1
No nukes
Nukes
No nukes
8, 8
1, 12
Nukes
12, 1
2, 2
SOLUTION: coordinate individual choices through
agreements or regulation
Regulating technological standards
Problem: uncertainty about new technological standards
may slow down adoption
• VHS vs Betamax
• Blu-Ray vs HD-DVD
Should regulation aim to guide technological choices?
• GSM in mobile telephony
Lessons for Policy Makers
• Market failures makes a potential case for corrective
intervention
• However, we must beware of the possibility of
government failure. If so, the net effect may be to
replace market failure with government failure
Well-intentioned regulation may
• end up being ineffective
• have perverse, unintended consequences
• persist beyond its purpose
• be vulnerable to regulatory creep, with high cumulative
burden
The scope for successful regulatory intervention is limited by
• informational constraints
• agency problems
• lack of correction
Group Work: Pollution control
As the National Rivers Regulator, you must tackle the
problem of a chemical firm that is polluting the Thames
a. If everything could be quantified and valued, show in a
diagram how a pollution tax can induce the firm to
behave in a socially efficient manner.
Group Work: Pollution control
b. Instead of the tax you offer the firm a pollution quota
(specifying the maximum pollution it can discharge in
any year). Show the size of the quota in the diagram.
What difference does it make to the efficient quantity of
pollution?
Group Work: Pollution control
c. Now suppose information is harder to come by. As the
regulator, you are not entirely certain about the firm's
cost curve. Does this affect your choice between tax
and quotas?
Group Work: Pollution control
d. Lastly, suppose there are two chemical firms
discharging into the river, one cleaner than the other. Is
it better to
• set a pollution tax? (same rate per unit polluted for
both?)
• auction pollution quotas?
Regulatory Impact Assessment
COST-BENEFIT ANALYSIS
Analysis that quantifies costs and benefits, including items
that the market does not value properly
Used for
 capital projects and procurement decisions
 policy proposals, including regulatory proposals
environmental standards, health & safety, business
regulation
[Cost-effectiveness analysis when benefits are hard to
quantify, or externally specified]
THE PROCESS
1. Justify action and set objectives
Identify the market failure or the socially-undesirable
outcome that calls for regulatory intervention. For example
•
•
discharge of pollutants in atmosphere reduces air quality:
the objective is to reduce pollutant levels by amount x
congestion externality causes traffic jams in Central
London: the objective is to reduce peak-time traffic by 20%
THE PROCESS
2. Identify all options
•
•
•
•
•
prescriptive regulation (quotas, speed limits)
provide incentives to change behaviour (taxes and
subsidies)
create arrangements or institutions to change outcome
(tradable permits)
provide information/educate to alter behaviour
(public campaign on dangers of excessive salt)
no intervention
THE PROCESS
3. Identify costs and benefits of each option
• Evaluate direct policy costs & administrative costs
• Identify benefits and evaluate them as far as possible
Include externalities (esp environmental ones), consumers’
surplus, etc.
• Some benefits (e.g. prevented fatality) are hard to
evaluate. Can infer prices from revealed preferences. If
not, can use stated preference through contingent
valuation: Willingness to Pay (WTP) or Willingness to
Accept (WTA)
• Identify unintended consequences and cost them too
• Where relevant, identify distributional implications
What if benefits and costs are uncertain?
Risk evaluation and management is important.
• Identify sources of uncertainty. Not enough to look
at most likely outcome: evaluate costs & benefits
for entire range of scenarios. Recognise ‘optimism
bias’.
• Use pilot programmes to learn more about the true
costs and benefits of intended regulation.
• If possible at reasonable cost, transfer risk to party
best placed to control it: outsourcing of technologyrelated risk to private sector.
THE PROCESS
4. Develop and implement solutions
Good regulatory design must consider
•
regulator’s ability to monitor and verify choices
•
ease of ensuring compliance
•
setting robust targets: avoid setting targets whose
achievement may run counter to objectives
•
proportionality, accountability, consistency
THE PROCESS
5. Evaluation
•
•
•
Review costs and benefits of regulation periodically to
assess its usefulness
If necessary, use sunset clauses to force evaluation at
later date, in light of new information
Likewise, reassess the ‘no intervention’ decision in the
light of new information and developments
Green Accounting: A Case Study
Costs and Monetized Benefits of of reducing lead from gasoline, 1983 dollars
1985
1986
1987
1988
1989
1990
Children's health
Adult blood pressure
Other pollutants
Maintenance
Fuel economy
Total benefits
-Refining costs
Net Benefits
223
1724
0
102
35
2084
-96
1988
600
5897
222
914
187
7821
-608
7213
547
5675
222
859
170
7474
-558
6916
502
5447
224
818
113
7105
-532
6573
453
5187
226
788
134
6788
-504
6284
414
4966
230
767
139
6517
-471
6045
Children's health: lead in blood is related to IQ-impairment.
Lead causes hypertension and increased heart-attacks: a statistical life was valued at $1 mn
Low lead levels reduce other pollutants, economies in fuel & maintenance
Group Work: Impact Assessment
For each category of regulation below, identify the social
costs and benefits (including any unintended
consequences).
1. Compulsory identity cards
2. Legislation to keep pubs smoke free
3. Regulating price of calling mobile phones from
fixed line phones
4. Regulating the introduction of new drugs
5. Regulating the production of GM crops
Information and Incentives
An overview
Regulation amounts to state-imposed limitation on
individual discretion, usually supported by the threat of
sanctions (stick) or by the provision of appropriate
incentives (carrot or stick)
Information
Individual choices depend on information too
Two relevant aspects. Information tends to be
• imperfect (we do not know everything)
• de-centralised (we differ and know more about ourselves)
The questions
• how does information affect the case for regulation?
• how does information affect scope of regulation?
• how does regulation distort information and incentives?
Imperfect Information
For the class of decisions where
• individuals’ information is imperfect AND
• the state could better informed,
state regulation can correct for individuals’ ignorance and
protect their interests
Examples
• product safety regulation
• health and safety regulation
Why might the state be better informed?
•
Individuals cannot easily assess safety aspects of poor
product design
• Employees cannot always assess riskiness of work
environment, especially if damage comes with a lag
(asbestos exposure, coal dust)
Here the state can be better informed (commission scientific
studies) and regulate if necessary
Is statutory regulation necessary?
Regulation not necessary if markets create incentives for firms
to protect consumer / employee interests. For instance,
• Reputational concerns may persuade firms to maintain
product quality / work-place safety
• Risk of legal actions helps too
However, these mechanism are less effective when firms are
small or new
Sometimes self regulation works..
If reputational mechanism does not work, collective self
regulation may emerge
• ABTA for travel agents
• Kite marks
Voluntary codes work when insiders can monitor peers more
easily than outsiders
Even if it does not..
Strong regulation may not be necessary. It may be easier to
provide information
• require product labelling (‘smoking kills’)
• provide information directly (advertising)
Often markets are informationally efficient…
•
•
•
There are many contexts in which individuals or firms
know more about themselves than others: information is
de-centralised
Markets can work with de-centralised information:
individuals choices are based on private information but
prices convey the essential bits of information to
everyone.
Regulatory control, as in a command economy, requires
centralisation of information. This informational constraint
makes it harder to regulate
... and efficient regulation is hard to achieve
•
•
•
When firms / individuals have unequal compliance costs, it is
economically efficient to impose unequal standards (ask
‘dirty’ firms to do more)
but lack of information about compliance costs make it
harder to tailor-make regulation
so that the same regulation may pose too much burden on
some and not enough on others (identity cards, for instance)
and getting information is tricky
•
•
•
•
In principle, the government could try and gather more
information
but regulation distorts incentives for providing
information
for example, all regulated firms would like to argue that
their costs are high
Of course, some regulatory instruments are better able
to cope with informational constraints:
(carbon trading arrangements, for instance).
Regulation and Incentives
•
•
•
•
•
Individuals choice also depend on incentives
Markets provide sharp (‘high-powered’) incentives, both
carrot and stick
e.g., profits vs. risk of bankruptcy, promotion vs. being
sacked
It is not easy to fine-tune the regulatory stick: road safety is
only crudely regulated through speed limits
People invest a lot in avoiding detection: better monitoring
technology helps but cannot always solve the problem
If penalties are not proportional to violation, it may create
perverse incentives
Regulation changes behaviour
Regulation often has perverse effects
Examples
• Safety devices like seatbelts and airbags may have a
‘lulling effect’, lower effort in safety and even increase risk
levels
• Employment regulations that protect workers from being
fired reduce incentives to hire them
• Average-rate-of-return regulation distorts capital structure
Regulatory Targets
•
•
•
•
Regulation often sets targets (with carrot and sticks)
but it is not always easy to find robust targets (i.e., those
consistent with regulatory objectives)
Targets are often met in way that do not match regulatory
objectives
Train companies ‘slow down’ their schedules to reduce
the risk of delay-related penalties
Future of Regulation
There is good regulation..
Some regulation provides the framework of civil society
• regulations to protect private property: essential spur to
investment
• regulation to protect Intellectual Property Rights: provide
incentives for R&D and innovation
• regulations against insider-dealing: allow capital markets
to exist
..and bad regulation
Other regulation stifles growth
• price regulations inhibit investment
• labour-market regulations create inflexibilities: Eurosclerosis
• regulations that make it hard to set up / wind up business
make the economy less responsive to change
A broad correlation...
• High regulation, especially in developing countries, seems
to stifle growth
• But a cautionary note: growth is not an end in itself
• if the aim is greater welfare, some forms of regulation
increase welfare directly, even if they lower growth rates on
the margin
The broad trend
The last two decades have seen a trend towards regulatory
reform
• Economic regulation is down: state monopolies have
been replaced by privatised firms, with lighter regulation
overall; firms’ entry and exit has become easier
• Social regulation is up: not surprising as richer societies
invest more in health and safety, environmental
regulation
Some deregulation is unavoidable
• Globalisation limits the power of individual governments to
control behaviour
consider the Internet
• The greater role of technological innovation makes it
important to remove impediments to innovation
• In any case, regulation cannot always cope with fastchanging technologies
• Economic theory alerts us to dangers of regulation in the
presence of information asymmetries
Why does regulation persist?
• Some regulation corrects persistent market / information
failures, so needs to persist
• Political economy: those who would lose from deregulation
can lobby more effectively than those who gain from
deregulation (similarity with import restrictions)
• In many sectors deregulation has led to a reduction in
prices and profits (airlines, utilities, telecom): we should
hardly expect business to support such deregulation
Looking to the future
• If many of the economic inefficiencies associated with
monopoly power have already been eliminated in the UK,
scope for further gain may be lower
• However, anything that supports innovation or labourflexibility is still worth aiming for
• We should expect social regulation to rise, but aim to
minimise the cumulative cost of these
• We should be alert to regulatory spillovers: higher
standards in rich countries may only export dangerous
production and pollution to poorer
• international coordination may be necessary
Policy Conclusions
• Free markets are usually efficient: the invisible hand
works
• However, markets are not always efficient. Market
failures make a potential case for government
intervention to improve efficiency: when the invisible
hand does not work, the government can lend a helping
hand
• Beware the risk of government failure: the helping hand
may hurt rather than help (heavy-handed intervention)
• Informational problems affect both private decisionmaking and public interventions: regulation may have
perverse effects (fumbling hand)
• Further, the helping hand may become self-serving (the
grabbing hand of a predatory state)
Good regulation combines economic theory with practical
understanding