DPM 2100

Lecture 4
The role of government and the need for
public finance
-Market Failure
-The economic rationale for government
and its response to market failure
 What is Market Failure?
When the key conditions for market efficiency
are not met, a “market failure” is said to occur.

The first fundamental theorem of welfare

economics asserts that the economy is Pareto
efficient only under certain circumstances or
conditions.

Markets are not Pareto efficient under six

important conditions, referred to as market
failures, which provide a rationale for
government activity.
 What causes Market Failure?
1. Failure of Competition
2. Public Goods
3. Externalities
4. Incomplete Markets
5. Information Failures
6. Unemployment, Inflation & Disequilibrium
 Failure of Competition
For markets to result in Pareto efficiency, there must be perfect
competition; that is, there must be a sufficiently large number of firms that
each believes it has no effect on prices.

In reality, there may be relatively few firms, or one or two firms who have a
large share of the market.
 Failure of Competition
There are a variety of reasons why competition may be limited. When
average costs of production decline as a firm produces more, a larger firm,
will have a competitive advantage over a smaller firm. There may even be a
natural monopoly, a situation in which it is cheaper for a single firm to
produce the entire output than for each of several firms to produce part of
it.
 Market Imperfection
Three sources of market imperfection are cost,
size and barriers to entry.

● Large firms enjoy economies of scale where

average cost tends to decline as output
expands. The range over which the decline
in average cost occurs is much wider than in
a situation of perfect competition. The
ability to cause the cost curve to keep falling
enables the firm to bring the price down to
the point where it becomes uneconomical to
enter the industry.
 Market Imperfection
Barriers to entry could arise from several factors.
One is product differentiation. Another is patents
which restrict production.

● Product differentiation can also cause imperfect

competition. What the monopolist does most
of all is to stop production where MR=MC and
then set a price above the MR=MC point.
Consumer surplus decreases significantly. The
monopolist takes away benefits from the
consumer. In that way, the monopolist
maximizes profits without having to maximize
the benefits to society.
 Public Goods
Some goods either will not be supplied by the market or, if supplied, will be
supplied in insufficient quantity. An example on a large scale is national
defense; on a small scale, navigational aids (such as buoys). These are
called pure public goods.
 Characteristics of Public Goods
1. They are non-rival. That means the consumption of a public good by
one person does not interfere with the consumption of that good by
another person.

2. They are non-excludable. It is, in general, difficult or impossible to

exclude individuals from the enjoyment of a pure public good.
Examples of pure public goods, pure
private goods, and mixtures.
 Why Do Markets Fail to Provide Public
Goods?
Private individuals and firms, left to their own devices, will undersupply
public goods as it reaps no benefit to them financially in the long run. The
market outcome will fail to be efficient.
 Externalities
It refers to the direct, unintentional and uncompensated effects of the
unwanted by-products of an economic activity that impose on others costs
that are not captured by the market (Keohane & Olmstead).

The reason it is referred to as an externality is because the cost that is

imposed on others is not included in the decision to take the action.
 Externalities
Examples of unwanted by-products are air pollution, water pollution,
second-hand cigarette smoke and over-utilization of common resources.
These are regarded as negative externalities.
 Incomplete Markets
Whenever private markets fail to provide a good or service even though the
cost of providing it is less than what individuals are willing to pay, there is a
market failure that we refer to as incomplete markets (because a complete
market would provide all goods and services for which the cost of provision
is less than what individuals are willing to pay).
 
 Examples of Incomplete Markets
● Insurance and Capital Markets-The private market does not provide
insurance for many important risks that individuals face. Imperfect
capital markets made it difficult for students acquire loans.

● Absence of Complementary Markets- one market cannot function

without the existence of another.
 Information Failures
Information is in many respects, a public good. Giving information to one
more individual does not reduce the amount others have. Efficiency
requires that information be freely disseminated or, more accurately, that
the only charge be for the actual cost of transmitting the information.
 Information Failures
However, a number of government activities are motivated by imperfect
information on the part of consumers, and by the belief that the market, by
itself, will supply too little information.
Unemployment, Inflation & Disequilibrium
High unemployment is the most dramatic and most convincing evidence of
market failure.

With Guyana’s youth employment rate at 22.9%, do you thing this is a case
of market failure or is it that the economy is not growing?
 Interrelationships of Market Failures
● Externalities are often thought to arise from missing markets.

●   Public goods are sometimes viewed as an extreme case of

externalities, where others benefit from my production of the good.
 Government intervention in the market
There are four actions that governments take.

1. Price controls.
2. Nationalization.
3. Taxes.
4. Regulation.
 The tragedy of the Commons
This refers to a situation where each person makes a decision based only
on his or her own costs and benefits and end up making matters worse for
everyone. The net benefits end up being zero.
 The tragedy of the Commons
Open access resources are goods that are non-excludable but rival.
Diminishing marginal returns occur as the number of users of the resource
grows. In other words, the benefit increases at a decreasing rate. Each
user also imposes a negative externality on the other. This implies that
unrestricted use of a resource would lead to overexploitation of the
resource since users will ignore the negative externality their efforts
impose on others.
 Functions of Government
In light of the foregoing, governments step in to bring rationality to social
and economic interactions. They perform three functions.
These are:
● The allocation function;
● The distribution function; and
● The stabilization function.
 Functions of Government
● The allocation function is considered useful
under imperfect market conditions or where
markets have failed entirely. Consumers will
not voluntarily offer payment where access
to benefits could be achieved without paying.
In democratic societies, the authority for
allocating resources comes from voting and
the budget process. Candidates offer
proposals which voters accept or reject.
Pareto efficiency is used as the standard for
evaluating the desirability of allocating
resources.
 Functions of Government
● The distribution function is considered
useful under conditions of unequal income.
Income depends on the returns to factor
income or income from work and from
capital ownership or unearned income
(investment or inheritance). Income from
work varies according to rates of pay,
training, skill level and educational
achievement. It is generally concerned with
equality and adequacy of income or
poverty reduction. One question that
arises is what is the optimal distribution?
 Functions of Government
● The stabilization function seeks to achieve high employment, price
level stability, acceptable levels of international reserves and economic
growth. Full employment and price stability are not automatic
outcomes in a market economy. These two factors depend on the level
of aggregate demand. The level of demand depends on spending by
consumers, investors, companies, corporations and small businesses.
End of Lecture