Role of Government in Market

ROLE OF GOVERNMENT IN MARKET
BY: KHEMRAJ SUBEDI
ASSOCIATE PROFESSOR
For Managerial Economics
Far Western University Nepal
MBS

 6.1 Concept and sources of market failure,
 6.2 Government response to market failure; natural monopoly
regulation, antitrust policy, patent system, operating control,
subsidy and tax policy regulation, regulation of environmental
pollution.

INTRODUCTION
In the past, the role of the government was thought to be limited in
maintaining law and order, and providing national defence. But in
the modern age, the role of government is increasing and the
government's rules, regulation and policies have influences on
industries, firms and consumers. Therefore, it is important for
managers to be sufficiently familiar with the business laws and
regulations to know when to seek legal help in the conduct of their
business and to be able to recognize when competitors are harming
the firm through illegal business practices.

ROLE OF GOVERNMENT IN THE ECONOMY
The government is playing important role in all types of economic
systems. The government has been providing the facilities like
education, health, peace and security, water and electricity supply,
transport and communication, and so on. The roles of government
are explained briefly below:
1. Role of government in the market economy
2. Role of government in the socialist economy
3. Role of government in the mixed economy

TYPES OF GOVERNMENT ROLE
1. Regulatory role: Regulatory role of the government includes
all direct and indirect policy measures which the government
employs from time to time to control and regulate the private
sector's economic activities.
2. Promotional role: Promotional role of the government
includes all the activities that are undertaken and all the
policies that are adopted to build up the infrastructure (i.e.
economic and social overhead capital) necessary for overall
development of the country.

MARKET AND EFFICIENCY
Efficient markets ensure optimal resources utilization by allowing
for prices to motivate independent actors in the economy. The
market efficiency can be achieved only in the competitive markets.
The concept of economic efficiency includes the three main measures
of efficiency, which are as follows:
1. Productive efficiency
2. X-efficiency
3. Allocative efficiency

CONT.
1. Productive efficiency
This occurs when output is
produced at the lowest possible
cost and occurs where marginal
cost (MC) equals to average cost
(AC). This is achieved only in the
perfect competition in the long
run. In the imperfect
competition, it is impossible to
achieve productive efficiency
because the firms do not produce
at the bottom of the average cost
curve. This is show in the
Figure 6-1:
Figure 6-1: Productive Efficiency
O
Y
Quantity of Output
Price,
Cost
and
Revenue
X
P
Q
LMC
LAC
E
MR = AR
Productive
Efficiency (MC = AC)

CONT.
2. X-efficiency
This is achieved when average
cost and marginal cost are as low
as possible. This is usually
occurs under the condition of
perfect competition, where the
forces of competition will drive
down costs. This concept is show
in the Figure 6-2.
Figure 6-2: X- Efficiency
O
Y
Quantity of Output
Price,
Cost
and
Revenue
X
AC3
AC2
AC1

CONT.
3. Allocative efficiency
Allocative efficiency is concerned
with the how much quantity is
produced. Allocative efficiency is
achieved when marginal utility of
the good equals to the marginal
cost, i.e. MU = MC. The firms
operating under imperfect
competition do not achieve
allocative efficiency because they
produce output level where price
is higher than marginal cost, i.e.
P > MC. This concept can be
explained by the help of Figure
Figure 6-3: Allocative Efficiency
O
Y
Quantity of Output
Price,
Cost
and
Revenue
X
Q1
P
Q Q2
D
D (MU)
S (MC)
S
E
Loss of Welfare
(Deadweight loss)

EFFECTS OF GOVERNMENT POLICY IN
MARKET EQUILIBRIUM AND MARKET EFFICIENCY
The effect of government policies in market equilibrium and market
efficiencies can be explained as follows:
1. Effect of Tax Policy in Market Equilibrium and Efficiency
Basically, there are two types of taxes: direct taxes and indirect
taxes. Direct taxes are imposed on the income and wealth where
as indirect taxes are imposed on goods and services. Here, we will
study the effect of indirect taxes (e.g. value added tax, excise
duty, sales tax, etc.) on market equilibrium and efficiency. When
taxes are levied on goods and services, it has the same economic
effects as increase in cost of production. The indirect tax will
cause fall in supply.

EFFECT OF TAX POLICY IN MARKET EQUILIBRIUM AND
EFFICIENCY CONT.
Consequently, there will be change
in market equilibrium and
efficiency. This concept can be
clearly explained by the help of
Figure 6-4.
Figure 6-4: Effect of Tax Policy
P
O
Y
Quantity of Output
Price
X
Q
P1
Q1
D
D
S1
S1
S
S
E1
E
a
b
A
B
Tax
DWL

MARKET EQUILIBRIUM AND MARKET
EFFICIENCY CONT.
2. Effect of Subsidy Policy in Market Equilibrium and
Efficiency
Subsides may be regarded as the negative taxes. Subsidies are
provided by the government to the producers and consumers in order
to encourage production and consumption of the goods and services
which have positive externalities or which are under produced by the
market.
Products, such as health care and education are under-produced by
the free market. Subsidies reduce market price and help to correct
market inefficiency created by positive externalities. In other words,
subsidies help to enhance market efficiency.

EFFICIENCY CONT.
The effect of subsidies can be shown
the help of Figure 6-5.
Figure 6-5: Effects of Subsidies
P1
O
Y
Quantity of Output
Price
X
Q1
P
Q
D
D
S
S
S1
S1
E
E1
a
b
Subsidies

MARKET EQUILIBRIUM AND MARKET
EFFICIENCY CONT.
3. Effect of Price Control Policy in Market
Equilibrium and Efficiency
Price control policy is the government restriction on prices
of goods and services in the market. The price control
policies have adverse effects in the market. The different
types of price control policies and their effects are discuss
below:

EFFICIENCY CONT.
i. Price ceiling (Maximum
price): Price ceiling is the
maximum price fixed by the
government for a particular
product produced by the firms.
The Figure 6-6 shows the
effect of introducing ceiling
price.
Figure 6-6: Effect of Price Ceiling
O
Y
Quantity of Output
Price,
Cost
and
Revenue
X
Q1
P
Q Q2
D
D
S
S
E
Price
Ceiling
Shortage
A B
P1

EFFICIENCY CONT.
ii. Price floor (Minimum price):
If the price is set above the
equilibrium price, it is known
as the price floor. It is also
known as the minimum price.
The main objective of setting
price floor is to protect small
producers, raise wages, and
reduces the consumption of
harmful goods. The Figure 6-7
shows the effect of setting floor
price.
Figure 6-7: Effect of Price Floor
O
Y
Quantity of Output
Price,
Cost
and
Revenue
X
Q1
P
Q Q2
D
D
S
S
E
Price
Floor
Surplus
A B
P1

EFFICIENCY CONT.
iii. Buffer stock: If price is set
between the upper and lower
boundaries, it is known as the
buffer stock. It makes use of both
minimum and maximum prices.
If the market price starts to move
outside the upper and lower
boundaries, the government will
intervene. Such kind of
government interference creates
market inefficiency. The concept
of buffer stock can be explained
by the help of Figure 6-8.
Figure 6-8: Effect of Buffer Stock
O
Y
Quantity of Output
Price,
Cost
and
Revenue
X
P
Q
D
D
S
S
E
Upper
Boundary
P2
Lower
Boundary
P1

MARKET FAILURE
Market failure is defined as the situation of allocative inefficiency. It
arises when the free market forces of demand and supply fail to
produce the quantities of goods and services people want at prices
which reflect their marginal cost and benefits. The major causes of
market failure are existence of market power, public goods,
incomplete information and externalities.

SOURCES OF MARKET FAILURE
There are various sources or causes of market failure. Among them,
the most common sources of market failure are as follows:
1. Market Power
2. Incomplete Information
3. Externalities
4. Public Goods

SOURCES OF MARKET FAILURE CONT.
1. Market Power
Market power is defined as the degree of control that a firm or a group of firms
has over the price and production decision in an industry. In the perfectly
competitive market, there is no market power but in the monopoly, there is
high degree of market power. The firms under oligopoly and monopolistic
competition also enjoy market power but in the small extent. It means the
monopoly has power to set the price in the market whereas firm under perfect
competition does not have power to set price of their product.
Market Power and Deadweight Loss
The market failure arising due to market power can be understood through an
economic concept known as deadweight loss. Deadweight loss refers to the loss
of economic welfare due to the fact that potentially desirable production and
consumption do not take place. Economic welfare is the sum of producer surplus
and consumer surplus.

SOURCES OF MARKET FAILURE
CONT.
The concept of deadweight loss can
be clearly understood by the help of
Figure 6-9.
Figure 6-9: Deadweight Loss
P1
O
Y
Quantity of Output
Price,
Cost
and
Revenue
X
Q1
AR (D)
P2
S = MC
B
E2
E1
Q2
C
MR
Deadweight loss
A

2. Incomplete Information
Incomplete information is a source or cause of market failure which
occurs when people can not maximize their satisfaction due poor or
lack of complete information about the things they are buying or
selling. Market works best when everyone is well informed or has
complete information. The situation of incomplete information is
also known as the information asymmetry or information failure.

Basically, there are two situations which cause incomplete information:
 Firstly, incomplete information exists when some or all of the
participants in an economic exchange do not have perfect knowledge.
 Secondly, incomplete information exists when one participant in an
economic has better information than other. This situation is also
known as the asymmetric or unbalanced information.
In these both situation, there is inefficient allocation of resources, which
causes market failure. Complete information is impossible in the
imperfect markets. It is possible only in the perfectly competitive market
because it is based on the assumption of perfect market information to
both buyers and sellers.

How does incomplete information cause market failure?
Incomplete information causes market failure because of inefficient allocation
of scarce resources, with consumers paying too much or two little, and firms
producing too much or two little. The major causes of information failure or
incomplete information are as follows:
 Misunderstanding of true cost or benefits of a product,
 Uncertainty about cost and benefits,
 Complex information when buying special product,
 Inaccurate or misleading information such as presuasitive advertising which
leads to more consumption than optimal,
 Addiction and lack of awareness, such as drug addicts may not stop
consumption of harmful materials.

3. Externalities
An externality is defined as a cost or benefit to third
parties, i.e. to those not directly involved in the production
or consumption of the goods and services.
They are also known as the third party effects and
sometimes neighbourhood effects, because parties other
than primary participants in the transaction (the
consumers and producers) are affected. Externalities are
the important sources or causes of market failure.

Types of Externalities
There are two types of externalities, which are as follows:
i. Positive externalities: Positive externalities are the benefits to the third
party from the consumption and production activities of others. Positive
externalities are also known as the external benefits. Positive externalities
are possible only when social benefits exceed private benefit.
ii. Negative externalities: Negative externalities are the cost imposed on
third parties from the consumption and production of the others. In other
words, negative externalities are the cost borne by third parties who are not
involved in economic activities of others. Negative externalities are also
known as the external costs.

Concept of Cost and Benefits
There are two types of costs and benefits which are as follows:
i. Private costs and private benefits: Private costs are the cost incurred
by those who buy and produce products.
ii. Social costs and social benefits: Social cost is the total cost of an
economic activity, i.e. production or consumption activity. It is the sum of
private costs and negative externalities.
Social Cost = Private Costs + Negative Externalities
Social benefit is the total benefit to the society from an economic activity,
i.e. production or consumption activity. It is the sum of private benefit and
positive externalities.
Social Benefit = Private Benefits + Positive Externalities

How externalities cause market failure?
Externalities cause market failure or inefficient use of resources. It
means that there will be either overproduction or under production
of goods and services due to existence of externalities.
The significant cause of market failure is the existence of
externalities in the production and consumption; and the output is
based on private cost and benefit. The socially optimum output is
achieved where marginal social cost (MSC) equal to the marginal
social benefits (MSB).
1. Overproduction caused by Negative Externalities
2. Underproduction caused by Positive Externalities

1. Overproduction caused by
Negative Externalities:
The existence of negative
externalities causes
overproduction of goods and
services. This concept can be
explained by the help of Figure
6-10.
Figure 6-10: Overproduction caused by Negative
Externalities
P1
O
Y
Quantity of Output
Price
X
Q1
P2
Q2
D
D
S1
S1
S
S
E2
E1

2. Underproduction caused by
Positive Externalities:
The existence of positive
externalities also causes market
failure. Due to existence of
positive externalities, there will
be underproduction of goods
and services. This concept can
be explained by the help of
Figure 6-11.
Figure 6-11: Underproduction caused by Positive
Externalities
P2
O
Y
Quantity of Output
Price
X
Q2
P1
Q1
D
D
S
S
S1
S1
E1
E2

4. Public Goods
Public goods are those goods which are non-rival in consumption
and their benefits are non-excludable. In other words, public goods
have characteristics of non-excludability and non-rivalry. Non-
excludability means the consumption of a public good cannot be
confined to those who have paid for it so there can be free riders.
People can enjoy the good by one person does not reduce the
consumption of any other individual. Public goods are also known
as the social or collective goods because these goods common to all
and are owned by society collectively.

Characteristics of Public Goods
The major characteristics of public goods are as follows:
i. Non-rival in consumption
ii. Non-excludable
iii. Free rider problem
iv. Drop in the bucket problem

How public goods cause market failure? (Public Goods and
Market Failure)
Public goods are the sources or causes of market failure. In other
words, public goods cause inefficient allocation of resources. Since,
these goods can not be prevented to the non-payers, market
mechanism can not guarantee their production according to the
market demand. It means that a profit maximising firm will either
not produce a public good or produce to little of it because of its free
rider problem or inability to prevent to those who do not pay for it.
Let us take an example of street light. Street light is a public good.
Its consumption can not be prevented to those who do not pay for it.
So street light is not provided by the market mechanism.

TYPES OF MARKET FAILURE
There are two types of market failure which are as follows:
1. Market Failure by Market Structure/ Structural Failure: If
market failure occurs due to market structure, it is known as the
market failure by market structure. In case of imperfect competition,
specially monopoly and oligopoly markets, where there are no enough
sellers and buyers and there is no entry of new firms, market failure
occurs.
2. Market Failure by Incentive/ Incentive Failure: If market
failure occurs due to the existence of externalities, it is called market
failure by incentive. There are two types of externalities: positive
externalities and negative externalities. Because of such externalities,
social cost and social benefits of consumption and production are
different. These benefits and costs are also not reflected in price.

GOVERNMENT RESPONSE TO MARKET FAILURE
Market failure reduces social welfare due to inefficiency in allocation of
resources. It will lead to either over production or underproduction of goods
and services. Therefore, society's resources should be efficiently allocated to
the production of those goods and services which people must highly desire.
The government can play very important role in the correction of market
failure.
Rational for Regulation (Why Regulation is Necessary?)
Regulation means use of legal intervention by the government to force
consumers and produces to behaviour in certain ways. It is a broad term
used to define various ways in which the government may intervene in the
working of the market in order to influence the allocation of resources. It
includes direct and indirect measures such as changes in ownership regime
of enterprises, administration of prices or price regulation, nationalisation
and privatisation of particular sectors of the economy, creating legal barriers
to entry into the market, setting quality standards, and so on.

GOVERNMENT RESPONSE TO MARKET FAILURE CONT.
The rational for regulation is affected by economic, social and political
considerations which are explained as follows:
1. Economic considerations of regulation: The economic
consideration of regulation is concerned with market failure due to
market imperfections. It is sometimes believed that unregulated
market activity can lead to inefficiency and waste or to market
failure.
2. Social considerations of regulation: Competition promotes
efficiency by giving firms incentives to produce those goods which
consumers want.
3. Political consideration of regulation: The political consideration
of regulation in concerned with creating equity and fairness.

TYPES OF GOVERNMENT RESPONSE TO MARKET
FAILURE
There are two types of government response to market failure, which are as
follows:
A. Regulatory Response to Structural Failure
1. Monopoly Regulation
2. Antitrust Policy
B. Regulatory Response to Incentive Failure
1. Patent System
2. Operating Controls
3. Subsidy Policy
4. Tax Policy
5. Regulation of Environmental Pollution

FAILURE CONT.
A. Regulatory Response to Structural Failure
Structural failure is the situation of market where perfectly competitive
environment is not present. In other words, structural failure occurs due to the
existence of monopoly or oligopoly in the market. The major instruments used
by government in response to structural failure are as follows:
1. Monopoly Regulation
Customers are much affected by monopoly because of excess prices and low
quality products. Therefore, government regulates monopolies to prevent excess
prices, provide good quality products, promote competition, and so on. Some
industries are natural monopolies due to high economies of scale. Natural
monopoly means the case of declining long-run average costs over a sufficiently
large range of outputs so that single firm will supply in the entire market.

FAILURE CONT.
Under the perfect competition, a firm sets price of its product equal to marginal
cost (MC). At this situation, there will be economic efficiency. But under the
monopoly, there is underproduction or the monopoly firm produces less than
socially desirable output and sets price higher than marginal cost of production
(P > MC).
Government uses either of the following two methods in order to correct market
failure caused by monopoly power:
 Setting price equal to marginal cost.
 Setting the price equal to average cost

TYPES OF GOVERNMENT RESPONSE TO
MARKET FAILURE CONT.
The method of monopoly regulation
can be explained by the help of
Figure 6-12.
Figure 6-12: Monopoly Regulation
P1
O
Y
Quantity of Output
Price,
Cost
and
Revenue
X
Q1
P2
Q2
MC
AC
E1
E AR (D)
MR

FAILURE CONT.
2. Antitrust Policy
Antitrust policy is defined as the government policy formulated to
regulate or prevent monopolies and encourage fair and free trade.
In other words, antitrust policy is the government policy designed
to protect competition and break-up or regulate the monopolises.
The main objective of antitrust policy is to create the environment
of competition and enhance economic efficiency to provide benefit to
the economy and society as a whole. USA is the first country to
formulate and implement antitrust policy in 1890.

FAILURE CONT.
Antitrust Law
Antitrust laws are designed to promote competition and prevent
unjustified monopoly. This law restricts all the business practices
that are considered unfair, reduce competitive environment and
maintain monopoly power. The main objective of antitrust law is to
promote efficiency or eliminate inefficient use of resources.

FAILURE CONT.
According to antitrust law, following practices are illegal:
Monopolies or attempt to monopolise
Use of unfair method of competition
Engage in particular form of price discrimination
Degradation of quality of products
Enter a contract to restraint a trade
Enter exclusive and tying contracts, i.e. making buyers
purchasing other item to get the product they want.

FAILURE CONT.
Approaches of Antitrust Policy/ Law
i. Market performance approach: In judging antitrust cases,
some lawyers and economists look directly and primarily market
performance- the industry's rate of technological change,
efficiency and profits, the conduct of individual firms, and so on.
ii. Market structure approach: This approach in antitrust policy
emphasises the importance of an industry's market structure-
the number and size of distribution of buyers and sellers in the
market, the ease with which new firms can enter, and extent of
product differentiation.

FAILURE CONT.
History of Antitrust Law
United States of America is the first country to implement antitrust law in 1980.
i. Sherman Act (1890): The Sherman Act of 1980 was first antitrust
legislation in the USA.
ii. Clayton Act (1914): This act as passed in 1914 by US congress to overcome
weakness in the Sherman Act. It addresses the problems of mergers, price
discrimination and tying contracts.
iii.Federal Trade Commission Act (1914): This act challenges unfair
competition which can be applied to consumer protection as well as mergers.
This regards unfair competition in commerce unlawful.
iv. Robinson-Patman Act (1936): This is Unites States Federal Law passed in
1936 to outlaw price discrimination which prohibits anticompetitive practices
by producers, especially price discrimination.

FAILURE CONT.
B. Regulatory Response to Incentive Failure
Incentive failure is the situation of market where is existence of positive and
negative externalities in the economy. In this situation, there will be either
over production or under production of goods and services due to existence of
externalities. In other words, due to existence of externalities, market will fail
to produce amount of goods and services that are socially optimal and price of
the product reflects marginal utility.
1. Patent System
2. Operating Control
3. Subsidy Policy
4. Tax Policy

FAILURE CONT.
1. Patent System
Patent right is defined as an exclusive right to produce, use or sell
an invention or innovation for a limited period of time.
Nepal's law has also granted protection of patent for it's exclusive
rights for a period of 7 years.
Hence, patent is the right to the inventor to build, use and transfer
or keep his/her invention with himself/herself. Patent system
promotes invention providing temporary but legal monopoly to the
inventors.

FAILURE CONT.
The major advantages of patent
right are as follows:
i. Important incentive
ii. Inventions disclosed
iii. Necessary incentive
There are some disadvantages of
patent right, which are as follows:
i. Discourage competition
ii. Less use
iii. Ineffective
Advantages/ Importance/
Argument in Favour of Patent
Right
Disadvantages/ Arguments against
Patent Right

FAILURE CONT.
2. Operating Control
Operating control is defined as the government regulation designed to control
socially undesirable activities of the firm. It is a common method to provide firm
with an incentive to promote services in the public interest. It prohibits certain
actions while compelling other. For example, the central bank controls the
banks and financial institutions. The effectiveness of operating control
regulation can be limited by vague legal standards.
The aim of both operating controls and taxes are similar. Both of them aim to
correct market failure created by negative externalities. The operating controls
discourage or prohibit negative externalities through non-monetary compliances
where as tax and subsidy policy charges monetary compliances to discourage or
prohibit negative externalities.

FAILURE CONT.
Forms of Operating Controls
There are many forms of operating controls. Among
them, the main operating controls are as follows:
i. Control of environment pollution and degradation
ii. Control in the operation of financial institutions
iii. Control on food products
iv. Control on price and wages
v. Control in transportation

FAILURE CONT.
3. Subsidy Policy
Subsidy is defined as the amount of money granted to firms by
government in order to encourage production and consumption. Subsidies
are given to assist the poor, to help producers and/ or to encourage the
consumption and production of goods which have positive externalities.
Subsidies are given to consumers as well as the producers.
In the free market economic system, merit goods like education, public
health, etc. and under-produced. In other words, these goods are produced
less than the socially desirable quantity. This is the market failure caused
by existence of positive externalities. Subsidy policy is an important tool
to correct such type of market failure. The government grants subsidy in
order to increase the production of such goods and services.

FAILURE CONT.
Subsides are implemented through a variety of financial
techniques, such as, direct payment in cash or kind,
government provision of goods and services at prices below
the normal market price, government purchase of goods
and services in excess to the market price, tax concession
and similar inducements.

FAILURE CONT.
Direct and Indirect Subsides
Subsidies can be classified into direct subsidies and indirect
subsidy. These are explain as follows:
i. Direct subsidy: Direct subsidy is defined as the financial
incentive directly provided to the firms. For example, discount on
raw materials, special provision on customer, etc. are direct
subsides.
ii. Indirect subsidy: Indirect subsidy is defined as the financial
incentive which has indirect benefit to the producer. For
example, construction of highways and their maintenance
benefit to the transportation industry, etc. are indirect subsidies.

FAILURE CONT.
Production and Consumption Subsidies
Production subsidy is the financial grant of the government to the firm in order
to encourage the production of particular commodity. It includes subsides on
agricultural loan, subsidies on fertilizer, electricity, etc. On the other hand,
consumption subsidy is the financial grant of the government to the consumer
in order to encourage the consumption of a particular commodity. It includes
subsides on food, water, education, health care, etc.

PRODUCTION SUBSIDIES
If subsidy on production is given,
production will increase and
equilibrium price will decrease. This
can be shown by the help of Figure
6-13.
Figure 6-13: Production Subsidy
P1
O
Y
Quantity of Output
Price
X
Q1
P
Q
D
D
S
S
S1
S1
E
E1

CONSUMPTION SUBSIDY
On the other hand, subsidies on
consumption like education, health
care, etc. will increase the demand.
This concept can be shown by the
help of Figure 6-14.
Figure 6-14: Consumption Subsidy
P1
O
Y
Quantity of Output
Price
X
Q1
P
Q
D
D
S
S
E
E1
D1
D1

FAILURE CONT.
4. Tax Policy
Tax is defined as the compulsory payment made by people to the
government. It is the major sources of government revenue.
Subsidy policy gives firms positive incentive for desirable
performance where as tax policy is like penalty and it is designed
to limit undesirable performance. Government uses tax policy in
order to discourage over production of undesirable goods and
services. Tax policy can also be used to control over consumption of
harmful goods and services.

TAX POLICY
The indirect taxes like VAT, sales
tax, customs, etc. reduce production
and consumption of goods and
services. This is shown in Figure 6-
15.
Figure 6-15: Effect of Tax Policy
P
O
Y
Quantity of Output
Price
X
Q
P1
Q1
D
D
S1
S1
S
S
E1
E

FAILURE CONT.
Apart from industries, growing population and commercial exploitations are
also responsible for creating this problem. The major pollutions we are facing
these days are the pollution of the air, water and land.
To solve the problem of environment pollution following points are useful. These
are basically known as regulations for environment pollution.
 A detailed report should be prepared identifying the sources of pollution.
 A similar report should be prepared for domestic and agricultural pollution.
 Functioning of the central and state population control broads should be
strengthened and be made more open.
 Comprehensive and realistic standard should be formulated for
environmental pollution. Proper procedures and standard for assessing
environmental damage should be formed.

FAILURE CONT.
 Industries should be made to recognize, if necessary by a dialogue with the
government the cost on economy for managing environmental effect and be
persuaded to show greater leadership and responsibility for controlling
pollution through built in measures.
 Public participation in prevention and control of pollution and environmental
degradation should be facilitated by providing necessary technical help by the
governments. There should be setting of appropriate machinery for speedy
response to investigation and disposal of public complaints.
 For encouraging public vigilance, incentives should be offered for reporting
instances of violation of laws related to pollution, forest, wildlife and other
environmental issues, and
 The regulatory functions of the government should be decentralized.
Especially, in relation to pollution with essential training and equipment
should be provided to the representatives of communities.

FAILURE CONT.
Optimal Level of Pollution Control
Manager, like other members of society, should be able to look at
matters from social, as well as private view point. They should be
sensitive to the effects of their actions on society as a whole, and on
their firm’s interest. Industries generally vary, at each level of
output on the amount of pollution it generates. For instance, it may
install pollution control devices like scrubbers to lower the amount
of pollution it generates at each level of output. In this section, it
deals on socially optimal level of pollution control. The socially
optimum level of pollution control can be explained by the help of
Figure 6-16, Figure 6-17 and Figure 6-18.

Quantity of Pollution Emitted
Cost
of
Pollution
Control
O
X
Y
Figure 6-17: Private Marginal Cost of
Pollution
Figure 6-16: Social Marginal Cost of
Pollution
Quantity of Pollution Emitted
Cost
of
Pollution
Control
O
X
Y
SMC
(Cost of
Pollution from
social point of
view/ Social
Marginal Cost)
PMC
(Cost of pollution
control from firm's
point of view/
Private marginal
cost)

OPTIMUM LEVEL OF POLLUTION CONTROL
The Figure 6-18 shows the
optimum level of pollution control.
It shows that optimum level of
pollution control is determined from
the interaction between SMC and
PMC.
Figure 6-18: Optimum Level of Pollution Control
QE
C
Quantity of Pollutions
Emitted
Cost
of
Pollution
Control
O
X
Y
E
PMC (Private
marginal cost)
SMC (Social
Marginal Cost)

FAILURE CONT.
Methods of Regulating Environmental Pollution
Government uses various methods to control environmental
pollution, which are as follows:
1. Direct regulation
2. Pollution tax
3. Issue of transferable emissions permits
4. Public awareness
5. Regulations through subsidies

REGULATION OF INTERNATIONAL COMPETITION
International competition refers to competition between the producers of two or
more countries. The regulation of international competition means protecting
domestic firms or producers or industries from foreign competition. The main
aim of regulation of international competition is to raise export and reduce
import. There are many ways of regulating international competition or trade.
The important ways or instruments of regulating international competition or
trade are tariffs, quotas, voluntary restraints, antidumping duties, as well as
technical and administrative regulations. An import tariff is simply a tax on
imports.
As such, it increases the prices to domestic consumers, reduces the quantity
demanded of the commodity at home and imports from abroad and encourages
the domestic production of import substitutes.

REGULATION OF INTERNATIONAL COMPETITION CONT.
The nation also collects tariff
revenues. This concept can be
explained by the help of Figure 6-
19.
Figure 6-19: The Effect of Import Tariff
Q1
E
Q2 Q3 Q4
Quantity of Output
Price
O
X
Y
P1
P2
DS (Domestic
Supply)
WS'
DD (Domestic
Demand)
WS
A
B C
D
t

CONT.
Objectives of Regulation of International Competition
The major objectives regulating international competition or trade
are as follows:
 To increase domestic output.
 To increase employment opportunities within the country.
 To increase revenue of the government.
 To discourage import and encourage export.
 To promote well-being of people in the country.

CONT.
Various Method of Regulation of International Competition/ Trade
The major methods of instruments of regulation of international competition or
trade are as follows:
1. Tariffs
2. Quotas
3. Embargoes
4. Voluntary export restraint
5. Subsidies
6. Antidumping duties

PROBLEMS AND EFFECTS OF REGULATION ON
EFFICIENCY
Problem of Regulation
The need of regulation stems from economic and social factors which stimulate
market failures due to incentives or structural problems.
While regulating the economy, various problems arise which are as follows:
1. Cost of regulation
2. Effects on efficiency
3. Poor information
4. Uncertainty
5. Regulatory lag
6. Lobbying cost

PROBLEMS AND EFFECTS OF REGULATION ON
EFFICIENCY
Effects of Regulation on Efficiency
The main objective of government regulation is to overcome the problem of
market failure and to promote economic efficiency.
The regulatory body of the government makes efforts to control market power
such as monopoly by creating competitive environment through anti-trust
policy. If this policy is not implemented efficiently and in the justified manner,
it may create cartel in the market which charges higher price and restrict
competition.
Taxes and subsidies are the instruments of government regulation. Taxes are
imposed to correct negative externalities.
The regulations in the form of patent rights and operating controls also cause
economic inefficiency. Operating control may lead to economic inefficiency due
to poorly defined regulations and patent right may also lead to economic
inefficiency due to creation of monopoly and barriers to entry new firms.

GOVERNMENT FAILURE
Government failure is the situation where government intervention
in the economy to correct market failure creates inefficiency and
leads to a misallocation of scarce resources.
If government fixes maximum or ceiling price, there will be
situation of shortage, i.e. demand will exceed supply and if
government fixes minimum price or floor price, i.e. price above the
natural market rate, there will be surplus, i.e. supply will exceed
demand. In this situation, there will be over production of goods and
services, which will cause wastage of resources.

GOVERNMENT FAILURE CONT.
There are various causes of government
failure, which are as follows:
1. Rigidities
2. Decision markers' objective
3. Inefficient public choices
The major effects of government
failure, which are as follows:
1. Social loss
2. Market failure
3. Inability to address complex
issues
Causes of Government
Failure
Effects of Government
Failure

THEORY OF PUBLIC CHOICE
The theory is the philosophy of how government decisions are made and
implemented. It considers how government and the political process
actually work, rather than how they should work. It clearly recognizes
the possibility of government failure, or situations where public policies
reflect narrow private interests, rather than the public interest.
This theory of public choice is based on the ground that individuals
attempt to promote personal interests in the political field just as they
seek to promote private economic interests in the marketplace.
Economists have long recognized that when an individual pursues
private economic interests in the marketplace, that person is moved by
an “invisible hand” to also promote the welfare of society as whole.

THEORY OF PUBLIC CHOICE CONT.
Participants in the Political System
Public choice theory examines how government decisions are
made and implemented by analyzing the behaviour of four
broad groups of participants in the political system, which are
as follows:
1. Voters
2. Politicians
3. Special interest group
4. Bureaucrats

Policy Implications of Public Choice Theory
 The characterization of the political process by public choice
theorists is sometimes viewed as suspicious. Many voters are well
informed and unselfish in their political beliefs. Politicians also
sometimes refuse to compromise basic principles simply to
maximize chances for confirmation. Collectively important public
interests prevail more often than one might expect; powerful
special-interest groups are sometimes defeated. Government
bureaucracies are often supervised by well-intentioned and
committed public servants.

 Nevertheless, these contradictions do not undermine the theory of
public choice. Although public policy can improve the economic
system in the presence of market failures, the public policy
process itself is subject to systematic influences that can lead to
government failure. The theory of public choice can be used to
suggest institutional changes that can lead to improvements in
public-sector performance. One method that public choice theory
suggests for improving public-sector performance is to subject
government departments and organizations to private-market
competition whenever possible.

EXERCISE 1
Let us suppose, marginal external cost of producing a commodity 4Q and private
marginal cost (PMC) is 14Q. The demand function for the commodity is P = 200 – Q.
Then answer the following questions:
a. Compute the socially efficient output (optimum output).
b. How much output would be produced by a competitive firm?
SOLUTION
a. Given,
Demand function, P = 200 – Q
Private marginal cost (PMC) = 14Q
External cost (MEC) = 4Q
We know that,
Social marginal cost (SMC) = PMC + MEC
= 14Q + 4Q
= 18Q

For socially efficient output,
SMC = P
or, 18Q = 200 – Q
or, 19Q = 200
 Q = 10.53
Hence, the socially efficient output is 10.53 units.
b. The competitive firm would produce output price (P) equals to private marginal
cost( PMC)
P = PMC
or, 200 – Q = 14Q
or, –Q – 14Q = –200
or, –15Q = – 200
 Q = 13.33 units
Hence, the competitive firm would produce 13.33 units of output. The socially
efficient output is les than output of competitive firm.

EXERCISE 3
Suppose, the supply of a commodity by domestic firms is QSD = 10 + 2P and supply
by foreign firms is QSF = 10 + P. The domestic demand for the product is given by Qd
= 30 – P.
a. What is the total supply of the good in the absence of quota?
b. What are the equilibrium price and quantity of the good?
c. Suppose the quota of 10 units is imposed, what is the total supply of the
product.
d. Determine equilibrium price in the domestic market under the quota of 10
units.
SOLUTION
a. In absence of quota, the total supply of the good will be equal to the sum of
foreign and domestic supply, i.e.
QT = QSD + QSF
= 10 + 2P + 10 + P
= 20 + 3P

b. The equilibrium price and quantity are determined by equating demand and
supply functions.
QT = Qd
or, 20 + 3P = 30 – P
or, 3P + P = 30 – 20
or, 4P = 10
 P = = Rs. 2.5
Hence, the equilibrium price is Rs. 2.5 per unit.
For equilibrium quantity,
Qd = 30 – P
= 30 – 2.5
= 27.5 units
c. When quota of 10 units is imposed, total supply will be
QT = QSD + 10
= (10 + 2P) + 10
= 20 + 2P

d. Equilibrium price and quantity after imposing quota of 10 units,
QT = QD
or, 20 + 2P = 30 – P
or, 2P + P = 30 – 20
or, 3P = 10
 P = Rs. 3.33
After imposing quota of 10 units, the equilibrium is Rs. 3.33.
Equilibrium quantity (Qd) = 30 – 3.33
= 26.67 units

EXERCISE 4
Let us suppose marginal cost of producing fertilizer is: MPC = 4Q. The market
demand for fertilizer is Q = 50 – 0.25P and marginal externality cost is: MEC = 2Q
a. At the socially desirable output level, what is product price?
b. What per unit tax an output should be levied by the government to achieve a
socially desirable output level?
c. What are the government revenues at the socially optimal output level?
SOLUTION
Given,
Marginal private cost: MPC = 4Q
Marginal externality cost: MEC = 2Q
Market demand for fertilizer: Q = 50 – 0.25P

a. We know that the socially optimum level of output occurs at an output level
where marginal social cost (MSC) equals to price of the product (P), i.e.,
MSC = MPC + MEC
or, P = 4Q + 2Q
or, P = 6Q
or, P = 6(50 – 0.25P)
or, P = 300 – 1.5P
or, P + 1.5 P = 300
or, 2.5P = 300
 P = Rs. 120
The socially desirable output is
Q = 50 – 0.25P
= 50 – 0.25 × 120
= 50 – 30
= 20 units
Hence, socially desirable output level is 20 units and product price is Rs. 120.

b. In order to achieve socially desirable or optimal output, market price should be
equal to so marginal social cost (MSC). Marginal private cost (MPC) and
marginal external cost (MEC). The government should impose per unit tax (t)
equal marginal external cost (MEC). Therefore,
MSC = MPC + t
or, MPC + MEC = MPC + t
or, MEC = t
or, 2Q = t
 t = 2 × 20 = 40
Thus, government should impose per unit the tax equal to Rs. 40 in or to
achieve socially optimal output.
c. At the socially optimum output government revenue (T) = t × Q
= 40 × 20
= Rs. 800
Thus, the government revenue at the socially desirable output is Rs. 800.

Role of Government in Market

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