MANAGERIAL

ECONOMICS
 Unit 6
Market Efficiency and Role of Government
2

Unit Contents
 Market and efficiency: Effect of government policy (tax and price control

policy) in market equilibrium and market efficiency

 Market failure: Concept and sources of market failure: Market power and

deadweight loss, Incomplete information, Externalities, Public goods.

 Government response to market failure: Rationale for regulation,

Monopoly regulation, Antitrust policy, Patent system, Operating controls,

Subsidy policy, Tax policy, Regulation of environmental pollution.
 Regulation of international competition.

 Problems of regulation, effects of regulation on efficiency.

 Government failure: Theory of public choice.

 Market and Efficiency
3

 Market refers to interaction between buyers and sellers..

 Efficiency is defined as a situation in which resources are optimally allocated and utilized.

Economic efficiency is classified in two ways: productive efficiency (a situation in which price is
set equal to minimum average cost i.e. P = AC min.) and, allocative efficiency (a situation in which
price is set equal to marginal cost i.e. P = MC). Market is said to be efficient if marginal benefit of
consumption (MB) is equal to marginal cost of production (MC).
 Competitive market is said to be the most efficient market as compared to other market structures

because both productive and allocative efficiencies are achieved in competitive market.
 One of the most popular criteria of measuring efficiency is the total surplus (sum of consumer and

producer surpluses). Consumer surplus is defined as the willingness to pay (marginal benefit)
minus the actual price of a product. It is the benefit enjoyed by consumers from their own
perspective. On the other hand, producer surplus is defined as the actual price minus cost of
producing a product (MC).
 If the market is competitive or if there is no government intervention in the market, the

interaction of demand and supply curves provides maximum total surplus.

 Cont.
4

 The main factors causing market inefficiencies are underproduction and

overproduction. Due to under or overproduction, the total surplus is not at
maximum. The decline in total surplus due to market distortions leading to
under or overproduction can be termed as deadweight loss which is represented
in the following figures:
 Effect of Government Policies in Market
Equilibrium and Efficiency
5

1. Effect of Tax
If government interferes the free market system through
the imposition of tax on commodity, the total surplus
declines thereby creating deadweight loss in the economy.
P

Size of tax (t) S

Price that (P ) A DWL

buyers pay B
B C e
Pe
E
D
Price that (P )
sellers receive S F
D

O Q
QT Qe
 Cont.
6

From above figure,

Pre-tax Scenario
C.S. = A + B + C
P.S. =D+E+F
T.S. = C.S + P.S
=A+ B +C + D+ E+ F
Post-tax Scenario
C.S. = A
P.S. = F
Tax Revenue =B+D
Decline in C.S. = (A + B + C) – A = B + C
Decline in P.S. = (D + E + F) – F = D + E
DWL = Decline in C.S. + Decline in P.S. – Tax Revenue
= (B + C) + (D + E) – (B + D)
 DWL = (C + E)
Thus, the imposition of tax on product by the government creates deadweight loss in the economy.
7

2. Effect of Price Control Policies

Price control polices of the government in the form of price ceiling and price
floor have adverse effects in the market.
 Price Ceiling
P
Price ceiling is a legal maximum price
fixed by the government for a particular S

product produced by the firms. If the price e

Pe
ceiling is below the equilibrium price, demand PC

exceeds supply so that the market faces the D

situation of shortage. O Q
QS Qe QD

Shortage
 Profit
8

Price Floor
Price floor is a legal minimum price fixed by the government for a particular
product produced by the firms. Due to price floor, supply exceeds demand
thereby creating surplus and leading to market inefficiency.
P

Pf
e
Pe

O Q
QD Qe QS

Surplus
 Regulatory and Promotional Roles of Government
9

The role of government can be analyzed by dividing into

two broad parts: Regulatory role and Promotional role.
Regulatory Role of Government
The regulatory role of government is defined as the direct and indirect
measures employed by the government to control the private sector. The
regulatory roles of government can be listed below:
 To provide patent and subsidy, which provide direct benefit to the

business firms.
 To make operating control or levy specific tax.

 c. Direct regulation on monopoly to ensure enough output and restricts

monopoly profit.
 d. Make provision of antitrust act to maintain the level of workable

competition in the economy.

10

Rationale for Regulation

a. Economic Consideration
The economic reason for the regulatory role of government is to
prevent market failure. Market failure is a situation where an
economy fails to achieve maximum social welfare.
b. Political Consideration
 Preservation of Consumer Sovereignty

 Limit Concentration of Economic and Political Power

11

Promotional Role of Government: Role in

Promoting Private Business
The creation of economic overhead capitals includes the
following development of infrastructures:
 Development of transportation and communication facilities

 Development of irrigation

 Generation and distribution of electricity and exploration of

sources of energy
 Promotion and expansion of industries which have strategic

importance but are backward due to lack of private investment

 Development and adoption of new and efficient technology
12

The creation of social overhead capitals includes the promotion

of productivity and growth in the economy. It consists of the
following activities:
 Investment in education

 Investment in health

 Investment in housing

 Technical training

 Community development programmes

 Market Failure
13

Any distortion observed in the market mechanism is known as market failure. For
example, the presence of externalities leading to under or overproduction can be
termed as market failure.
Causes and Sources of Market Failure
There are four main causes and sources of market failure:
i. Market Power
ii. Presence of Externalities
iii. Existence of Public Goods
iv. Incomplete Information
14

Market Power
Market power is the ability of firms to influence price and output in the
market. In perfect competition, there is no market power enjoyed by the
firms and buyers as they are price takers. On the other hand, there is
highest degree of market power under the monopolistic market situation.
Monopoly enjoys the highest degree of market power.
C,R,P

MC
DWL

P1 e2
P2
e1 AR

MR
O Q
Q1 Q 2

Underproduction
15

Presence of Externalities
Externalities refer to the beneficial and detrimental (losses) effect of an
economic unit (firm/consumer) on others for which there are no provision
of compensation. There are two types of externalities discussed below:
a. Positive Externalities (External Economies)
Positive externalities are said to exist if an economic agent while
performing its economic activities impose beneficial effects in the
society for which it does not receive any payment.
Due to positive externalities, market fails because it faces
underproduction. In this situation, Social Marginal Cost (SMC) is
smaller than Private Marginal Cost (PMC) by the amount of positive
externalities created by the firm.
i.e. SMC = PMC – Positive externalities
16
17

b. Negative Externalities (External Diseconomies)

Negative externalities are said to exist if an economic agent while
performing its economic activities inflicts detrimental effects on others
for which it does not pay.
In this situation, the Social Marginal Cost (SMC) is greater than Private
Marginal Cost (PMC) by the amount of negative externalities so that
overproduction takes place.
i.e. SMC = PMC + Negative externalities
18
19

Existence of Public Goods

Public goods have the following two essential characteristics:
 Non-rivalry in consumption
 Non-excludability in consumption
Thus the characteristic of non-excludability in public goods creates
positive externalities thereby creating market failure through under
production.
 Incomplete Information
20

 Incomplete information or information failure is defined as a situation in

which economic agents like consumers and producers lack complete
knowledge regarding the goods and services in the market, Incomplete
information can occur in two basic situations.
 Firstly, it exists when some or all of the participants in an economic
exchange do not have perfect knowledge. Secondly, it occurs when one
participant in an economic exchange knows more than the other, a situation
referred to as the problem of asymmetric or unbalanced information.
 In both cases of incomplete information, there is likely to be a misallocation
of scarce resources, with consumers paying too much or too little, and firms
producing too much or too little.
21

Types of Market Failure

There are two types of market failure which are discussed below:
a. Structural Failure
Structural failure is the situation where perfectly competitive
environment is not present.
b. Incentive Failure
Incentive failure refers to the situation of the existence of
externalities positive or negative in the economy.
 Government Response to Market Failure
22

Regulatory Responses to Structural Failure

There are following three major instruments employed by the government in response to structural
failures:
a. Price Regulation under Monopoly
b. Public Utility Regulation
c. Anti-trust Law
23

a. Price Regulation under Monopoly

Government uses either of the following two methods:
i. Setting the price equal to marginal cost
ii. Setting the price equal to average cost
24

b. Public Utility Regulation

If a monopolist exploits consumers by charging abnormally high prices while producing
mass consumption goods, it is the responsibility of government to regulate it. Public
utilities are those goods which are enjoyed by high mass so that their price elasticity is
less than unity. (ep < 1). The government uses either of the following two tools in order
to regulate these firms:
i. Setting the price equal to marginal cost
ii. Setting the price equal to average cost
25

b. Anti-trust law
The law implemented by the government against trust is known as anti-trust law. Trust
is defined as an organized form of two or more firms intended to exploit consumers by
setting common and high price. In this context, anti-trust law restricts business practices
that are considered unfair or monopolistic. The objective of this law is to avoid
monopoly of single firm or an industry to protect customers against high price and low
supply. The economic case for anti-trust law is based on efficiency. Monopoly can lead
to an inefficient use of resources as compared to the competitive result.

The main philosophy of anti-trust policy is that by creating the environment of

competition, economic efficiency can be enhanced. USA is the first country to
implement anti-trust law in 1890. The popular acts used in USA are Sherman Act,
Clayton Act, Robinson-Patman Act and Federal Trade Commission Act.
26

Antitrust law has made following practices illegal:

 Monopolies or attempt of monopolies.
 Use of unfair methods of competition.
 Enter tying contracts. Tying contracts make buyers purchase other items to get the
product they want.
 Engage in the particular form of price discrimination.
 Degradation of quality of products.
There are two approaches to anti-trust law:
a. Market Performance Approach
This approach includes the industry's rate of technological change, efficiency and
profit, the conduct of individual firm and so on.
b. Market Structure Approach
According to this approach, government should look to the market structure in order
to find the undesirable monopolistic features and need of anti-trust policy to correct
the market structure.
 Regulatory Responses to Incentive Failure
27

The major instruments of regulatory response to incentive failure are:

a. Tax and Subsidies
b. Operating Control
c. Patent Right
d. Regulation of Environmental Pollution
a. Tax and Subsidies
Subsidies are provided to those firms who create positive externalities.
Market mechanism does not have the tool to encourage positive
externalities so that government should actively intervene the market in
order to promote positive externalities by providing compensation to the
firms in the form of subsidies.
 Cont.
28

P
SM

SS

e1
P1
e2
P2
Subsidy
a

DM

O Q
Q1 Q2

Taxes are opposite of subsidies. Taxation is used to control the negative externalities
created by the market. Market itself does not have any mechanism to prevent
negative externalities. In this situation, government role is inevitable to discourage
negative externalities so that overproduction can be minimized or avoided for this
government uses tax policy to limit the undesirable activities of firms. Pollution tax,
fines or penalties are the common examples of tax policies which are desired to
discourage negative externalities.
 Cont.
29

Taxes are opposite of subsidies. Taxation is used to control the negative externalities
created by the market. Market itself does not have any mechanism to prevent
negative externalities. In this situation, government role is inevitable to discourage
negative externalities so that overproduction can be minimized or avoided for this
government uses tax policy to limit the undesirable activities of firms. Pollution tax,
fines or penalties are the common examples of tax policies which are desired to
discourage negative externalities.
P

ST

SM
a
e2
P2 Tax
P1 e1

DM

O Q
Q2 Q1
 Cont.
30

b. Operating Control
Operating right grant is a legal permission granted by the government to the private
sectors in operating business firms.
Government controls media such as radio, television, broadcasting rights to provide
quality services to the public. The regulation of commercial banks and financial
institutions by central bank by providing operating grant is also an example of this
method.
Operating control is one of the most popular methods of correcting market failure
due to negative externalities. There are various forms of operating control which are
i. Control over Environmental Pollution
ii. Control on Food Products
iii. Industrial Work Conditions
iv. Wage and Price Control
v. Control in the Operation of Financial Institutions
vi. Control in Transportation
 Cont.
31

c. Patent Right
Patent Right is a special right granted by the government to an individual or firm in
order to promote a public objective instrument. A bulk amount of time, money and
effort are needed for research and invention. If there is duplication of the product,
idea, process or technology developed by one firm, there will be rarely new research
and invention. Patent rights are therefore granted to recognize research efforts of the
firms and to inspire for the investment of further research.
If social cost is less than social benefit, patent right can be provided. Patent system
is a regulatory effort to get the benefit of both right to research and development and
competition. The government by granting limited right to earn monopoly profit
through patent stimulates research and economic growth, but by limiting patent
monopoly, it encourages the competitors to make similar research and development.
 Cont.
32

d. Regulation of Environmental Pollution (Optimal Level of Pollution

Control)
The history of environmental pollution is as old as industries. Though many factors
are responsible for environmental pollution, the dominant factor has become
industries. Pollution created by industries give birth to the negative externalities
such that
PMC < SMC, hence market fails.
Since, pollution can't be made zero, there is a need of regulation by the government
so that optimal level of pollution can be determined.
Cost of Pollution Curve
As firms discharge pollution, the social cost of pollution increases. Cost of pollution
curve denotes the social cost of pollution imposed by the firms by discharging
pollution while performing their economic activities. It is an upward sloping curve
from left to right indicating that as more pollution is estimated by the private sectors,
the higher will be the social cost.
 Cont.
33

Cost of Pollution Control Curve

This curve represents the cost of firms when they are involved in controlling the
pollution they emit while performing economic activities. It is an upward sloping
curve from right to left indicating that less the quantity of pollution emitted by the
firms, higher will be the cost in order to control pollution.
 Cont.
34
 Cont.
35

The optimal level of pollution is determined when these two curves intersect each other
shown by the figure that follows:
 Government Policies Toward the Control of Pollution
36

When negative externality due to pollution causes a market to reach an inefficient

allocation of resources, the government can respond in one of two ways. Command–
and–control policies regulate behaviour directly. Market-based policies provide
incentives so that private decision makers will choose to solve the problem on their
own.
Command–and–Control Policies: Regulation
The government can remedy an externality by making certain behaviours either
required or forbidden.
Market–Based Policies: Corrective Taxes and Tradable Pollution Permits
i. Corrective Taxes
Taxes enacted to deal with the effects of negative externalities are called corrective
taxes. They are also called Pigovian taxes after economist Arthur Pigou. An ideal
corrective tax would equal the external cost from an activity with negative
externalities.
ii. Tradable Pollution Permits
 Problems of Regulation
37
 Government attempts to promote economic efficiency by preventing market failures
caused from various sources like monopoly, externalities, incomplete information and
public goods. However the regulation on these sources of market failure has adverse
effects on economic efficiency.
 Taxes are imposed to correct the negative externalities of economic agents. If tax rate is
not determined at optimal level, it can create excess burden to tax payers which finally
brings inefficiencies in the market.
 Similarly, subsidies are provided to those economic agents and sectors which provide
positive externalities. But subsidies may create inefficiencies in the allocation of resources
as they are provided to the specific sectors of the economy. The provision of subsidies can
lead to diversion of resources from productive to unproductive sectors of the economy.
 Government regulation of natural monopoly can create the problem on efficiency. It is
very difficult to control monopoly price as it distorts the incentives of the firms. Operating
controls can create adverse effects in the economy if they are not properly defined and
implemented.
 regulation in the form of patent right creates limited monopoly which prevents other
companies from entry in the market. Thus various studies have shown that government
regulation in the market create losses in efficiency. In other words, the economy has to
bear more cost than it is able to accrue benefits from regulations.
 Regulation of International Competition
38

 Governments of different countries have to intervene in the area of international trade

for both economic and non-economic reasons. Such intervention goes by the name
‘protec­tion’. Protection means government policy of according protection to the
domestic indus­tries against foreign competition.
 Most important methods of protection are tariff and quotas. A tariff is a tax on
imports. It is normally imposed by the government on the imports of a particular
commodity. On the other hand, quota is a quantity limit. It restricts imports of
commodities physically. It speci­fies the maximum amount that can be imported
during a given time period.P

SD

N
PT
Pt A' B'

Pw
}t R U L
DD

B Q
A E C
 Regulation of International Competition
39

i. Effects of Tariff
Now, if a country imposes a tariff = t per unit on its import, immediately the price of
the product will rise to Pt by the amount of tariff. There are four effects of tariff.
Since the tariff raises the price, con­sumers buy less. Now the consumption de­clines
from OB to OC. This is called consump­tion effect of tariff. The second effect is the
out­put effect or protective effect. Tariff raises domes­tic output from OA to OE, this is
because higher price induces producers to produce more. The third effect is the
import-reducing effect.
As tariff is imposed, import declines from AB to EC. The fourth effect is the revenue
effect earned by the government. The government revenue is the volume of import
multiplied by the tariff i.e., the area A’B’UR. It is a transfer from consum­ers to
government. However, if a tariff equal to T were imposed, price would have
increased to PT. Consequently, imports would drop to zero. Such a situation is called
prohibitive tariff.
 Regulation of International Competition
40

ii. Effects of Quota

Quotas are similar to tariff. In fact, they can be represented by the same diagram. The
main difference is that quotas restrict quantity while tariff works through prices. Thus,
quota is a quantitative limit through imports.
 If an import quota of EC amount is imposed then price would rise to P t because the
total supply (domestic output plus im­ports) equals total demand at that price. As a
result of this quota, domestic production, con­sumption, and imports would be the
same as those of the tariffs.
 The output effect, con­sumption effect and import restrictive effect of tariff and quotas
are exactly the same. The only difference is the area of revenue. We have al­ready
seen that tariff raises revenue for the government while quotas generate no govern­
ment revenue.
 Government Failure: Theory of Public Choice
41

 Public choice theory deals with the inefficiency of providing public goods and services by
the government. This theory is developed on the basis of the study of taxation and public
spending. This theory is considered to reduce the gap between economics and political
science. The main argument of public choice theory is that government fails to do right.
This theory states that politicians, bureaucrats, citizens, and states are guided by their self-
interest and use the power and authority of government for their own benefits.
 The first contributor to the theory of public choice was james m. Buchanan who wrote a
popular article, "social choice, democracy and free markets" which was published in the
journal of political economy in 1954. Later on buchanan and gordon tullock published a
book titled, "the calculus of consent: logical foundations of constitutional democracy" in
1962 which challenged the major belief that decisions of majority in democracy are
always fair. G.J. Stigler's work "the theory of regulatory capture" introduced a new
dimension in the public choice theory.
 Prior to public choice theory, economists used to accept government as "unquestionable
controller with perfect information and unlimited power." Similarly they used to advocate
government as a 'bureaucratic god'. However, bureaucrats and politicians are also human
beings who are guided by their self-interest so that inefficient outcomes are generated.
 Government Failure: Theory of Public Choice
42

The basic principle of public choice theory is that human beings are rational in the sense that
they always attempt to maximize their own benefits. Thus the supporters of public choice
theory strongly claim that self-interested and self-motivated activities and decisions of
government might create socially inefficient outcomes. Public decision making process may
lead to inefficient outcomes due to the following reasons:
 Citizens use political influence to get special benefits called "rents" from
government policies (e.G., Import licenses or rationed foreign exchange) that
limit right of entry to important resources.
 Politicians use government resources to strengthen and maintain positions of
power and authority.
 Bureaucrats and public officials use their position to obtain bribes from rent-
seeking citizens.
 States use their power to seize/capture private property from individuals.
 BASES OF PUBLIC CHOICE THEORY
43

i. Voters' ignorance
ii. Politicians
iii. Special interest groups
iv. Bureaucrats
 SUGGESTION OF CORRECTIONS
44

 Public choice theory points out the case of government failure-a term similar to the
market failure scenarios familiar from the traditional economic theory.
 The conclusion of the public choice theory is that self-interest guides all individual
behaviour and the behaviour of the government also; governments are inefficient
and corrupt because people use government to engage in (carry out) their own
agendas. So free market systems are supposed more efficient and more just.
 According to them, that government is the best which does the least. In order to
avoid government failure, perfectly competitive environment should be created
where market efficiency is at maximum.
 For perfectly competitive environment, privatization policy should be effective.
 End of Chapter 6
45

Thank You!!!

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