Market Failure and Market power

1. Market Failure

2. Types of Market Failure
• Market power
• Externalities in Production and Consumption:
• Positive
• Negative
• Public goods
• Merit goods & Demerit goods
• Common Property resources
• Inequalities in:
• Wealth distribution
• Income distribution

3. Efficiency and Equity (c) Andrew Tibbitt
2008
Slide 3
Market failure
Markets sometimes fail to produce efficient results
because the necessary conditions do not exist.
They fail, for example when :
1. Producers have scarcity or monopoly power (and
they dominate the market, raise prices and earn
excessive profits
2. Externalities are not taken into account (and
bystanders suffer collateral damage)
3. Key information is not known or shared evenly
4. Income distribution is unfair.

4. 4
Market Power-general characteristics
• Four types of markets (generalised competitive
forms)
Perfect
competition
Monopolistic
competition
Oligopoly Monopoly
less competitive
more competitive
What criteria determine competitiveness?

5. 5
To understand competitiveness ..
• numbers of buyers and sellers
• degree of product differentiation
• barriers to entry
• degree of control over price
• competitive methods
Economists describe, measure and analyse:

6. 6
Perfect competition
A market structure which features
1 a large number of small firms
2 Very little product differentiation
3 very easy entry into or exit from the market.
4 Perfectly mobile resources
5 Perfect knowledge

7. 7
Some ‘close tos’

8. Oligopoly
• Competition between the few
• May be a large number of firms in the industry but the industry is dominated
by a small number of very large producers
• Concentration Ratio – the proportion of total market sales (share)
held by the top 3,4,5, etc firms:
• A 4 firm concentration ratio of 75% means the top 4 firms account for 75% of
all
the sales in the industry

9. Oligopoly
• Example:
• Music sales –
The music industry has
a 5-firm concentration
ratio of 75%.
Independents make up
25% of the market but
there could be many
thousands of firms that
make up this
‘independents’ group.
An oligopolistic market
structure therefore may
have many firms in the
industry but it is
dominated by a few
large sellers.
Market Share of the Music Industry 2002. Source IFPI: http://www.ifpi.org/site-content/press/20030909.html

10. Oligopoly
• Features of an oligopolistic market structure:
• A few firms selling similar product
• Each firm produces branded products
• High barriers to entry
• Price may be relatively stable across the industry –
possible kinked demand curve?
• Potential for collusion (Game theory)
• Behaviour of firms affected by what they believe
their rivals might do – interdependence of firms
• Branding and brand loyalty may be a potent source
of competitive advantage
• Non-price competition may be prevalent

11. Oligopoly
The kinked demand curve - an explanation for price stability?
Price
Quantity
D = elastic
D = Inelastic
$5
100
Kinked D Curve
The principle of the kinked demand
curve rests on the principle
that:
a. If a firm raises its price, its
rivals will not follow suit
b. If a firm lowers its price, its
rivals will all do the same
Assume the firm is charging a price of
$5 and producing an output of 100.
If it chose to raise price above $5, its
rivals would not follow suit and the firm
effectively faces an elastic demand
curve for its product (consumers would
buy from the cheaper rivals). The %
change in demand would be greater
than the % change in price and TR
would fall.
Total Revenue A
Total
Revenue B
If the firm seeks to lower its price to
gain a competitive advantage, its rivals
will follow suit. Any gains it makes will
quickly be lost and the % change in
demand will be smaller than the %
reduction in price – total revenue
would again fall as the firm now faces
a relatively inelastic demand curve.
Total Revenue B
Total Revenue A
The firm therefore, effectively faces
a ‘kinked demand curve’ forcing it to
maintain a stable or rigid pricing
structure. Oligopolistic firms may
overcome this by engaging in non-
price competition.

13. THEORIES ABOUT OLIGOPOLY PRICING
Efficiency and Equity (c) Andrew Tibbitt
2008
Slide 13
There are four major theories about oligopoly pricing:
(1) Oligopoly firms collaborate to charge the monopoly price and get
monopoly profits
(2) Oligopoly firms compete on price so that price and profits will be
the same as a competitive industry
(3) Oligopoly price and profits will be between the monopoly and
competitive ends of the scale
(4) Oligopoly prices and profits are "indeterminate" because of the
difficulties in modelling interdependent price and output decisions

14. Oligopoly - Game Theory
Efficiency and Equity (c) Andrew Tibbitt
2008
Slide 14
Prisoner’s dilemma
Scenario
- Two suspects
- Insufficient evidence to charge them
- Cops need one criminal to rat out the other to
charge them
- Offer a deal

15. The Deal
Slide 15
If no one confesses (stays silent) that is if they
cooperate with each.
∴ Lack of evidence
• 1 year in jail each
If one confesses (defects) and betrays the other
• 0 years for the rat
• 10 years for the quiet one
If both confess- testimony isn’t as valuable
• 5 years each

16. Assumptions
Slide 16
 Each cares about minimising own jail time
 Each wants to maximise their pay-off – no concern for the
other. – (zero-sum games: pure competition -- one party
better off only if other is worse off).
 Rational choice leads to both defecting (betraying)
 Even though individual reward greater if both co-operated
with each other.

17. Let the Games begin
Slide 17
Prisoner B
Stays silent
Prisoner B
Confesses
Prisoner A
Stays Silent
PA – 1 year
PB – 1 year
PA – 10 years
PB – 0 Years
Prisoner A
Confesses
PA – 0 years
PB - 10 years
PA – 1 year
PB - 1 year
If prisoner A believes PB is going to stay silent his best
option is to betray no matter what.
If PA stays silent he will get 1 year in jail, if PA betrays he
gets to walk free.

18. The payoff
Efficiency and Equity (c) Andrew Tibbitt
2008
Slide 18
Higher payoff for betraying
 No Matter what PB does I am personally better off ∴ I should betray
However if Prisoner B acts in the same way and betrays PA the outcome
is the same for both.
∴ both get a lower pay off than staying silent (co-operating)
Game theory
Rational self-interest decisions result in each being worse off than if
each had chosen to cooperate.

19. 19
The monopoly
market structure
• Monopoly is characterised by
• a single seller
• a unique product
• high barriers which make it difficult or impossible for other firms to enter the
market.

20. 20
Comparing monopoly and perfect
competition
• Compared to perfect competition, the monopolist
• allocates resources inefficiently
• produces less output.

21. 21
Resource misallocation
in monopoly
• Perfectly competitive firms produce more output (in total) than the
monopolistic firm.
• The monopolistic firm charges higher prices – in monopoly, price
exceeds marginal cost (this is known as an economic profit).

22. Efficiency and Equity (c) Andrew Tibbitt
2008
Slide 22
Scarcity or monopoly power
If one of the players in a market has power over the
other then the market outcome becomes distorted and
the result can be inefficient. If a producer has monopoly
power in a sense they have scarcity power.
Monopoly power comes from a lack of competition.
Producers can deliberately minimise competition (e.g.
by branding, innovation, take overs). Producers with
monopoly power can restrict supply or push up prices.
The price no longer reflects the costs of production.

23. Efficiency and Equity (c) Andrew Tibbitt
2008
Slide 23
Monopolists restrict supply and push up prices.
Monopolists have the
power to control supply
in the market. This can
lead to prices that are
higher than those set in
competitive markets.
The result is inefficiency.
Price
Quantity
Supply
(competitive)
Demand
New Supply
(monopoly)
Deadweight
loss
Consumer
surplus
Producer
surplus

24. Efficiency and Equity (c) Andrew Tibbitt
2008
Slide 24
Information gaps
Competitive free markets only produce efficient
outcomes if
 Demand curves reflect the true level of consumer value or
marginal benefit
 Supply curves reflect true costs of production (the
opportunity of using the resource inputs)
If producers don’t know the cost of production (like
insurance companies) and consumers don’t know the
value of the product they are buying (like health care
and second hand cars) then the market can’t operate
efficiently.

25. Efficiency and Equity (c) Andrew Tibbitt
2008
Slide 25
When there are externalities
Bystanders (third parties) can be affected by economic
decisions made by others. These spin-off or side effects
of an economic decision are called externalities.
Bystanders can be affected in a good or positive way
(e.g. your neighbour has nice garden). These positive
externalities create social benefits.
Bystanders can be harmed or affected in a negative way
(e.g. people become sick from factory pollution). These
negative externalities create social costs.

26. Efficiency and Equity (c) Andrew Tibbitt
2008
Slide 26
Ignoring externalities leads to inefficiency
If market players do not
take these negative
externalities or social
costs into account (do not
include them in their
demand and supply
decisions) the market will
not work efficiently.
Too much will be
produced and consumers
will pay too low a price.
D
S
airlines
Air travel
Price
Quantity
S total
Greenhouse Gases are emitted by planes.
So do free markets create too many flights
at too low a price?

27. Efficiency and Equity (c) Andrew Tibbitt
2008
Slide 27
In a similar way, if market
players do not take positive
externalities or social
benefits into account (do not
include them in their
demand and supply
decisions) the market will
not work efficiently.
Too little will be supplied and
consumers will pay too high
a price.
D
S total
Public transport
Price
Quantity
S private
Free market public transport could be
too expensive if it forces people to
use their cars and cause congestion
Ignoring externalities leads to inefficiency

28. Efficiency and Equity (c) Andrew Tibbitt
2008
Slide 28
Other problems for the market economy
Income distribution
Demand curves reflect effective demand.
Effective demand exists if a need or want can be backed up by the
ability to pay for it.
If income distribution is unfair (lacks equity) the pattern of effective
demand will be unfair.

29. Efficiency and Equity (c) Andrew Tibbitt
2008
Slide 29
Other problems for the market economy
Public and collective goods
Products
• that are non-rival products (one person using the good doesn’t prevent another
for using it as well)
• where the exclusion principle does not operate (the supplier or owner can’t
prevent non-payers or free-riders from using the product)
• where individual demand is unrealistic (such as national defence)
will not be efficiently produced in a free market economy.

30. Efficiency and Equity (c) Andrew Tibbitt
2008
Slide 30
Modified market economies
As a result of market failure, nearly all economies are not
pure free market economies but mixed economies.
Government’s modify markets or override the market
altogether by influencing:
 the allocation of resources (e.g. through taxes, subsidies,
or directives) – allocative role
 business behaviour (e.g. through regulations and
legislation) – regulatory role
 the distribution of household incomes (e.g. through
taxation and welfare) – redistribution role
 the overall level of aggregate demand (e.g. through fiscal
and monetary policy) – demand management role

31. Efficiency and Equity (c) Andrew Tibbitt
2008
Slide 31
Government modifications
Policy measures to fix up or prevent market failure
include:
1. Taxing bad behaviour, taxing high income earners
2. Subsidising good behaviour, paying welfare to low income
earners.
3. Regulating or legislating against bad behaviour
4. Regulating or legislating good behaviour
5. Establishing markets to trade ‘permits to behave badly’

32. Efficiency and Equity (c) Andrew Tibbitt
2008
Slide 32
Government failure
In some situations government intervention does prevent or fix up
market failure. But overall central planning does not provide a more
efficient and fairer rationing system. Government run economies suffer
from:
1. Bureaucratic and cumbersome allocation processes
2. Moral hazard
3. Rent seeking behaviour (corruption)
4. Lack of incentive – bottomless pots, feather bedding, no
competition
5. Lack of consumer freedom or sovereignty
The trick is to intervene only when necessary.

33. Efficiency and Equity (c) Andrew Tibbitt
2008
Slide 33
Taxing a competitive market reduces net economic welfare.
Taxing a
competitive market
reduces welfare.
Price
Quantity
Supply with
tax
Supply
without tax
Demand
REDUCTION IN NET
WELFARE = DEADWEIGHT
LOSS

34. Efficiency and Equity (c) Andrew Tibbitt
2008
Slide 34
A difference of emphasis
LEFT
Responsibilities
Entitlements
Equity
Market failure
Government intervention
RIGHT
Rights
Choice
Efficiency
Incentives
Government failure
When to intervene and modify a market is a matter of judgement
for governments. Economists can use the concepts of consumer
surplus, producer surplus and net economic welfare to inform the
policy debate.