OUTLINE

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Government Intervention and the Market System
Session 4 (chs 8, 6, 7, 9) Professor Dermot
McAleese
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OUTLINE

• ?Government spending in the economy
• ?Case for government intervention
• ? Types of government intervention
• ? Problem of government failure

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Government spending ( GDP)
Sources European Economy, OECD pre-Second World
War figures taken from Vito Tanzi and Ludger
Schuknecht, The Growth of Government and the
Reform of the State in Industrial Countries, IMF
Working Paper, December 1995
4
General government net debt ( GDP)
Source European Monetary Institute, First Annual
Report, April 1995 OECD Economic Outlook,,
various issues.
5
Elderly dependency ratios
Source Eurostat 65 as total population
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Table. 6 Public sector debt and net public
pensions liabilities, 1990 ( GDP)
Source Van Noord and Herd (1994)
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ADAM SMITH THE REASONS FOR GOVERNMENT
INTERVENTION

• ? Monopoly
• ? Defence/national security
• ? Police and justice system
• ? Public health

8
Modern Case for Government Intervention

• Income Distribution
• Market Failure

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INCOME DISTRIBUTION

• ? Income equalisation
• ? utility maximised by distributing from rich
  to poor
• ?adverse effect on incentive to work and
  enterprise
• ? Efficiency
• ?efficiency less ambiguous objective than
  equality
• ?Pareto efficiency
• (an outcome where nobody can be made better off
  without making at least one other individual
  less well off)
• ? Equality/efficiency trade-off

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EMPIRICAL EVIDENCE ON INCOME DISTRIBUTION

• ?Governments are concerned about inequality
• ? Market forces can produce highly unequal income
  distribution
• ?Government redistribution reduces inequality
• ?Declining emphasis on redistribution through
  taxation
• ? More emphasis on targeting expenditure to the
  poor

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GINI INDICES FOR SELECTION OF HIGH-INCOME
COUNTRIES
Soruces Gini coefficients A. Atkinson, Income
Inequality in OECD countries evidence from CIS
data, paris OECD, 1995.
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MARKET FAILURES
? Monopoly power (dead-weight loss,
X-efficiency loss, etc.) ? Externalities
(congestions, pollution, ) ? Public goods
(free rider problem) ? Information
asymmetries (insurance, banking, taxis, health)
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Begin with monopoly one seller only -- the
extreme case of absence of competition
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THE THEORY OF MONOPOLY
? Static Efficiency effect ? Income distribution
effect ? Dynamic effects
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THE SINGLE MONOPOLIST
Price
MC
R
Pm
AC
S
F
T
D
MR
Qm
0
Quantity
16
Profit maximisation dictates that firms in the
market system are motivated to discover, exploit
and ruthlessly protect a monopoly niche.
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MONOPOLY vs. COMPETITION
Price
Same costs
D
R
Pm
S
Pc
T
D
Qc
Qm
0
Quantity
Deadweight loss RST
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MONOPOLY vs. COMPETITION
Higher costs under monopoly
Price
R
Costs under monopoly MC AC
S
A
Cost under competition MC AC
B
V
D
Quantity
Qc
Qx
Qm
0
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MONOPOLY PRICE DISCRIMINATION
Price
Price
Price
P2
P1
E
MC
C
C
C
MR1
MR2
CMR
Q1
Q(12)
Q2
Quantity
Quantity
Quantity
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FOUR REASONS FOR A MONOPOLY
? Economies of scale ? Government policies ?
Ownership know-how ? Ownership of natural
resources
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SUSTAINING MARKET POWER

• Distinctive capability
• ? Architecture
• ? Reputation
• ? Innovation
• Strategic entry-deterrent measures
• Setting price deliberately below
  profit-maximising level in order to reduce
  attractiveness of the industry to the outsiders
• Conceasing profit figures for monopolised parts
  of business
• Below cost selling, predatory pricing and dumping
• Deliberate over-investment in capacity and
  extension of product range

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MARKET POWER WITH A FEW FIRMS
? The case of cartel ? Price leadership ?
Kinked oligopoly model ? Non-price competition
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CONCLUSIONS
? Large section of modern industrial economies
can be described as effectively competitive ?
Yet monopolies influence and market power are
important realities in the business world ?
Hence need for competition policy
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MARKET STRUCTURE IS DETERMINED BY

• ?Numbers and size-distribution of sellers and
  buyers
• ?Characteristics of the product and degree of
  market segmentation
• ?Barriers to entry into the industry
• ?Barriers to exit from the industry

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MARKET STRUCTURE AND FIRMS PERFORMANCE

• ?Contestability firms may be few in number and
  yet competition can be intense
• ?Innovation thrives more in competitive
  conditions than under monopoly

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COMPETITION ADVANTAGES OVER MONOPOLY
? It makes organisations internally more
efficient ? It allows the more efficient
organisations to prosper at the expense of
the inefficient (selection process) ? It
improves dynamic efficiency by stimulating
innovation
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EXTERNALITIES

ORIGIN
Production
Consumption
Primary education Training employees in general
skills Aesthetic company headquarter buildings
Vaccine against contagious disease Neighbours
well-kept garden
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EFFECT
Congestion Radio noise
Air, water and noise pollution Ugly factory
buildings
6
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NEGATIVE PRODUCTION EXTERNALITY
Chemical Plant Polluting River
SMC

PMC
P
Demand
Œ
E
Output of chemical plant
Q1
Q2
Q 1- private profit maximum output level Q2 -
social optimum level
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DEFINITION OF A PUBLIC GOOD

• ? Non-Rivalrous
• the marginal cost of an additional individual
  consuming the good is zero, at least up to a
  certain level
• ? Non-Excludable
• the cost of excluding an individual from
  consuming it is prohibitively high
• Note Public goods are not the same as merit
  goods

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PUBLIC GOODS
Apples Cars
Marginal cost of consumption (rivalry)
Fire service
Cinemas
City Parks
Art Galleries
Motorways
Bridges
Clean Air Innovation basic research National
Defence Monetary stability
National Parks
TV Programme
Ease of excludability
Private Goods and Public Goods
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Examples of Information Asymmetries

• Medical bills inflated demand
• Fake antiques
• Gasoline
• Bank deposits

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Government Action is needed to Prevent or Correct
Market Failure
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COMPETITION POLICY IN ACTION THE EXAMPLE OF EU

• ? Prohibited agreements
• ? Abuse of dominant position
• ? Control of mergers
• ? State aids

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COMPETITION POLICY IN ACTION

• Horizontal restraints
• ?restraints in markets for close substitutes
• (e.g. price fixing, market sharing)
• ?presumption of illegality
• Vertical restraints
• ? restraints between producers of complementary
  goods and services
• ? presumption of legality unless interest of
  consumers, existing competitors, potential
  entrants are shown to be damaged

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COMPETITION LAW WITH TEETH   Breaches of
competition law can carry severe penalties. In
1999, two top European companies were fined a
record 725 million in the US for their part in
a worldwide conspiracy to control the market in
vitamins. According to US investigators, the
executives met once a year to fix the annual
budget of a fictitious company Vitamins Inc.
In practice this involved setting prices, sharing
geographic markets and setting sales volume. The
annual summit was followed by meetings, quarterly
reviews and frequent correspondence. The cartel
controlled the most popular vitamins including
vitamins A, C and vitamin premixes. A former
executive of Roche agreed to serve a four-month
prison sentence he was the first European
national to submit to such a sentence for
anti-trust offences. The European Commission
said it was investigating the same matter.
Practices that once would have been tolerated if
not condoned in the past are now being subjected
to the full rigour of the law.   Source
Financial Times 24 May 1999  
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COMPETITION AND GLOBALISATION
? A more open market is more competitive ? A
need for level playing field ? Monopoly power
by giant multinationals
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COMPETITION POLICY DOES NOT SOLVE ALL PROBLEMS

• ?Natural monopolies the core activities where
  economies of scale dominate
• ?Can be controlled by
• Regulation
• Outcontracting and franchising
• Privatisation

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REASONS FOR PRIVATISATION

• ?new managerial culture
• ?source of funds for government
• ?disposes of loss making
• ?weaken trade unions
• ?encourage efficiency
• (access to capital, avoid policy confusion)
• ?develop and expand domestic capital market
• ?engender competition

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METHODS OF PRIVATISATION

• ?Share flotation
• (British Telecom 1984)
• ?Direct sale to existing private sector business
  or institutional buyers
• (Rover cars to British Aerospace)
• ?Management buy-outs
• (National Freight corporation 1982)
• ?Contracting out
• (competitive tender)

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EFFECTS OF PRIVATISATION

• ?Efficiency
• ?Government revenue
• ?Income distribution
• ?Privatsation not necessarily superior to state
  ownership
• (Railways, London underground)

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DEREGULATION THE CASE OF NATURAL MONOPOLY

• ?Isolate the core natural monopoly element in the
  industry
• ?Deal with the natural monopoly element
• ? Pricing ? P MC
• ? break-even or average return on K
  
• ? RPI minus X
• ? Access
• ? Quality

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REGULATION
?Costs of direct regulation can be
high ?Incentive regulation can also be
problematic - RPI minus X (UK) - Fair return
on capital (US) ? Competition the best
solution - Break up into separate competing
firms - Competitive tendering for provision of
services - Encourage new entrants (including
foreign) - Separate natural monopoly (network)
and regulate that only
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Solutions to Market Failure -- Externalities

• ? Taxes and subsidies
• ? Regulation
• ? State provision

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COASE THEOREM

• Externalities do not necessarily require
  government intervention.
• Market system can correct externalities, provided
  property rights are defined and transactions
  costs are low.

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REGULATION

• Regulation is costly
• ? High administrative costs
• ? Insufficient flexibility in implementation
• ? Stultifying effects of standardisation on
  industrial innovation
• but necessary
• ? Natural monopolies
• ? Asymmetric information
• ? When risks of catastrophic failure exists
• ? When the pollution generated by the polluter
  cannot be measured
• ?When major health risks are involved

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Solutions to Market Failure Public
GoodsAsymmetric Information

• YOUR SOLUTIONS!

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GOVERNMENT FAILURE
Government failure arises when the cost of
attempting to correct free market distortions
turn out to be greater than the cost of the
original distortion itself.
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CAUSES OF GOVERNMENT FAILURE

• ? Absence of invisible hand
• ? Absence of full information
• ? Theory of public choice
• political parties formulate policies in order
  to win elections, rather than win elections in
  order to formulate policies Prof. Anthony Down
• ? Distortions created by taxes and subsidies
• (rent-seeking society and the grantepreneurs)

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RESPONSE TO GOVERNMENT FAILURE

• Reduce direct public provision (1)
• privatisation
• out-contracting
• Standards
• regulation

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Response (2)

• Use market incentives instead of regulation where
  possible
• Reform public sector learning from the private
  sector
• ? Management by objectives
• ? Incentives

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Example The Polluter Pays Principle

• Tax the polluter, get as near to the source of
  the problem as possible, use market incentive
  instead of regulation

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The Polluter Pays Principle

• Gives firm incentive to reduce pollution
• Cuts down on compliance and monitoring costs
• Incentive to innovation with pollution costs
  integrated into market signals

• Pollution may not be costly or impossible to
  measure accurately
• Lessens government control over amount of
  pollution created

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FUNCTIONS OF THE STATE
Source The State in a Changing World, World
Development Report 1977, Jun, p. 27.