Economics Demystified: Market Failure - Equity or Opportunity?


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Shane Vallance, South West RDA / Economy Module, delivers a presentation on the economics of intervening as a result of market failure.

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  • We look at the different viewpoints about why and how the public sector should intervene in the economy.
  • Profit is the oil that drives the engine. Does optimisation of utility drive your behaviour? Non powerful – no single actor (consumer or producer) can influence the market. Perfect entry & exit – firms can switch resources from one product to another. Externalities – will return to that later but costs equals individual and society benefits.
  • In essence – supply and demand.
  • 1 & 2 signify the arguments for no public sector intervention. 3, 4 & 5 present arguments for intervention.
  • Government has attempted to ‘internalise the market’ in parts of the public sector such as health and parts of education. The long term implications are obviously what’s been focused upon by the Government – not just an ideological argument but also elements of the productivity argument – by cutting less productive elements of the economy then they hope to drive growth.
  • Public sector variability connected to difficulties of measurement. However, consistent theme is that it has lagged the rest of the economy (remembering that the whole economy already includes the public sector measurement – meaning that the private sector element will tend to be higher than the red line. It will be interesting to see what happens to public sector productivity during the job losses (normally productivity measurements improve when inputs (people) are cut).
  • Rise in inputs over the last 10 years (particularly early part of the decade) represents the expansion in public sector employment – as well as financial inputs.
  • ‘Crowding out’ also refers to use of resources (reference Philip Green Review?). Review of construction contracts show that public sector tends to pay more for contracts than private sector clients. Why is that – less pressure on margins and a lack of ‘profit as the incentive’.
  • What we’re presenting here is our view of what BIS and HM Treasury will look for when public sector projects are being asked for approval. It is their view of the world and that is only being reinforced from the Coalition Government’s point of view – “private sector growth” – important for your potential role in putting forward projects for LEPs/regional growth fund etc.
  • This could also encapsulate the high costs of information – effectively acting as a barrier to entry
  • Interesting debate about air travel – whether the taxation should go on the producer (the air company) or the consumer (the air traveller)
  • Market failure 4 & 5 have the similar outcome – one is production focused and the other is consumption focused, both result in over use of resources which causes a negative externality to wider society and therefore Government needs to intervene, effectively distorting the market price to reflect this externality.
  • Do non-perfectly performing markets operate more effectively than public sector – depends on your view of externalities
  • Economics Demystified: Market Failure - Equity or Opportunity?

    1. 1. Rationale for intervening in the economy Market failure, equity or opportunity? Shane Vallance - SWRDA
    2. 2. Reminder - how to increase economic output Simple production function: Y = f(T, K, L) Therefore, you can increase economic output by: Improving stock of technology Increase the level/quality of capital Increase the supply/quality of labour Essentially the areas where public/private intervention (should) take place
    3. 3. If markets function properly (‘perfect competition’) Firms – maximisation of profit acts as ‘perfect’ incentive Consumers - optimisation of utility drives behaviour Multiple, all knowing, non powerful actors Perfect information – consumers and producers (eBay?) Perfect entry & exit (no barriers to entry) No market rigidities – markets quickly adjust Unrestricted flow of factors of production Market costs reflect total cost to society – no externalities No Government intervention (it distorts the market) – Adam Smith’s ‘invisible hand’
    4. 4. ‘The invisible hand’ Markets are (normally) the most effective mechanism to allocate resources Producers have an incentive to produce for consumers through their willingness to pay (price) for a scarce resource Consumers willingness to pay (price) will match the benefit that they will derive from that product Producers will earn a profit that will act as an incentive to produce more If they produce too much, the price will reduce because the resource has got less scarce This will reduce profits, meaning less will be produced – making the resource less scarce, raising the price and so on, and so on……
    5. 5. ‘Just let the market get on with it’ 1. Productivity/efficiency argument – the importance of price signal 2. Ideological argument – ‘crowding out’ Or, 3. Market failure (a tale of farmers and lumberjacks) 4. Equity argument 5. Opportunity?
    6. 6. The Productivity argument Lack of price signal means the public sector is not as effective as the market in the allocation of resources (despite Government attempt in some services) Lack of profit means there is an ‘incentive gap’ As a result, public sector productivity performance lags rest of economy (caveat – difficult to measure public sector productivity because often lack of output to be measured) Recent history is tale of falling output and rising inputs Implications for long-term resource efficiency – public sector too big, performance of economy suffers
    7. 7. The productivity argument – declining public sector productivity Comparison of public sector productivity (% annual change) -2 -1.5 -1 -0.5 0 0.5 1 1.5 2 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Public sector productivity Whole economy productivity
    8. 8. The productivity argument – declining public sector productivity Falling public sector productivity (% annual change) 0 1 2 3 4 5 6 7 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Public sector output Public sector input
    9. 9. The ideological argument Based on same premise – that non-market actors are less efficient at allocating resources than market actors You will use £1 of earnings more efficiently (maximising your utility) than if £1 were taxed and spent by Govt on your behalf Leads to concept of ‘crowding out’ – usually refers to Govt spending using financial & other resources that would otherwise be used by private sector (firms & individuals) Case 1 – Govt spend, Tax, Private consumption Case 2 - Govt spend, Borrowing, Private investment Case 3 - Govt spend, Wages, Private investment (a Keynesian would argue this would also Private consumption)
    10. 10. However, markets are not perfect A tale of farmers and lumberjacks….
    11. 11. and that is economics… it’s the allocation of resources to meet society’s (unlimited) needs as effectively as possible
    12. 12. Market Failure #1: Lack of property rights Intervention Type: Fish Quotas, Public Realm
    13. 13. Market Failure #2: Lack of (or imperfect) information Intervention Type: Overseas offices, Tourism Marketing
    14. 14. Market Failure #3: Lack of price signal Intervention Type: Direct development (up to a point until price signal established) Govt as the buyer?
    15. 15. Market Failure #4: (Negative) Externalities – price of production does not reflect true value to society A < B (over production) Intervention Type: Taxation on airlines A B
    16. 16. Market Failure #5: (Negative) Externalities – cost of consumption does not reflect true value to society C < B (over consumption) Intervention Type: Congestion charging, tax on petrol, cigarettes, air travel; etc. A B C
    17. 17. Market Failure #6: (Positive) Externalities – private benefits of production do not reflect true value to society D < B (under production) Intervention Type: Renewable Energy A B CD
    18. 18. So there are benefits to intervening to address market failures However, should there be a role on the grounds of equity? Depends on your (macro or micro) viewpoint
    19. 19. The Equity argument – the macro view Remembering that in perfect (and non-perfect) markets firms will seek to maximise profit – therefore will seek to reduce costs & increase benefits Costs - therefore move to lower cost bases (i.e. offshoring) Benefits – close to greatest demand (i.e. commercial property) This is just the market allocating resources efficiently In the long-term those areas ‘left behind’ will adjust (land & labour costs will ) and economic activity will be attracted back Therefore there is no role for public sector – questions (competitive) economic development approach
    20. 20. The Equity argument – the micro view This is not a perfect market and the ‘structural adjustment’ takes a long time During this time the social costs are such that there is an argument for justification of public sector support Unlikely any role in  costs (unless we consider subsidies i.e. GBI or indirect costs such as transport infrastructure) However, role in benefits (improving skills, quality of R&D, quality of environment etc.) Therefore there is a role for public sector
    21. 21. The (lost) opportunity argument Often held up as the argument for public sector intervention Should there be a role for the public sector? Linked to equity macro versus micro argument Macro view is that if the opportunity was strong enough then profit potential should act as incentive enough for market provision Micro view is that we would like that opportunity to be exploited in a specific area – meeting equity and competitive advantage needs How to deal with opportunity cost (in a world of increasingly scarce ‘public’ resources)?
    22. 22. Conclusion Economics is allocation of scarce resources Markets are the most effective way of allocating resources, price signal is the oil in the engine Even non-perfectly performing markets operate more efficiently than public sector (or do they?) Market failure justifies intervention to address imperfections Are there grounds for intervention for equity purposes – depends on viewpoint (short term versus long term argument) Always will be an ideological argument about role of Government