Sunday, November 3, 2013

Market failures


Economic theory has shown that a perfectly competitive economy, guided by
Adam Smith’s ‘invisible hand’, attains a Pareto-efficient allocation of resources.
But most real-world markets violate at least some of the assumptions which
underlie the economists’ idealised free-market model. Such deviations of real
markets from the efficient model economy are called ‘market failures’. Market
failure can arise for four main reasons: 1. monopoly power, 2. externalities,
3. public goods, and 4. information asymmetries.


Monopoly power

    The distortionary effects of monopoly have already been analysed.
Monopoly involves a breach of the rule that marginal cost # price by introducing
a wedge between marginal cost of production of a good and the utility it provides
the marginal consumer as measured by prices. Monopoly pricing also creates an
income distribution effect. Monopoly profits are earned at the expense of the
consumers, who pay a higher price relative to what they would pay in a competitive
market. This is the reason why consumer organisations oppose monopolies
and cartels, and lobby their governments for stricter competition legislation.

    However, the gain of monopoly producers at the expense of consumers can
involve serious losses at both domestic and international level. The World Bank
has estimated that cumulative overcharges to developing countries over the life
of the cartels in vitamins, citric acid, lysine ,steel tubes and graphic electrodes ranged from $3bn to $7bn._8 Uncompetitive behaviour also reduces economic efficiency. As we move from a competitive situation, with a large quantity supplied at a low price, to a monopoly, where a smaller quantity is supplied at a higher price, what occurs is not a zero-sum redistribution of income from consumers to producers, but a net loss of utility to society at large. This is the ‘deadweight loss’ of monopoly.

    The deadweight loss, as described above, is a static phenomenon relating to the
market situation at one point in time. Empirical estimates of the deadweight
losses caused by existing monopolies or oligopolies typically amount to only
a few percentage points of the values of total sales in the particular industry.
A forerunner in trying to measure the deadweight loss, Arnold Harberger was surprised to find that such welfare losses amounted to a mere 0.1 per cent of US
national income in the 1920s._9 Later, detailed studies have come up with much
higher estimates, though these have been subject to a wide range of variation.

    As readers will recall from Chapter 7, the efficiency losses from monopoly
occur over time. Monopolists or oligopolists have less of an incentive than competitive firms to maintain efficiency, to innovate and to improve their services.
Indeed, as Hicks once noted in a famous dictum, ‘the greatest of monopoly profits
is a quiet life’._10 This is a central theme of the Austrian School. The pressure of
competition forces firms to aim at lowering their costs continuously,
while sheltered firms do not have to be so concerned about their costs and the
improvement of output quality. The losses due to such so-called X-inefficiencies
are even more difficult to estimate empirically than deadweight losses.
Nevertheless, in many circumstances they outweigh the deadweight losses
stressed by economic theory. The Cecchini Report, for example, estimated that
the X-efficiency losses of nontariff barriers on intra-European trade amounted to

2 per cent of GNP in the late 1980s.

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