Market failure and the regulations of markets

1 What market failure means

The previous chapter showed how demand and supply are brought into equilibrium by prices moving until the quantity demanded equals the quantity supplied, and how that leads to an efficient allocation of resources.

But that argument requires the market to WORK. Prices and output have to be free to move; there has to be a price at all; buyers and sellers have to know what they are buying; and the price has to reflect all of the costs and all of the benefits of the transaction. When one of those conditions fails, the market produces the wrong quantity of something — too much, too little, or none at all — and consumers are worse off than they need to be. That is MARKET FAILURE, and it is why governments intervene.

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2 Imperfect competition and restrictive practices

2.1 Monopoly

A MONOPOLY exists where there is only one supplier of a good or service.

Take a pharmaceutical company holding a patent on a uniquely effective drug. No other supplier can start production, because no other supplier has the patent. That allows the company to charge a very high price, because demand for a highly desirable product is strong, and to make what economists call SUPER PROFITS. Because the price is high and output is restricted, there is permanent excess demand.

In a properly functioning market other producers would have entered, supply would have increased and the price would have fallen. More patients would benefit from the drug at a lower price, and that is a better allocation of resources.

Monopolies arise in three broad ways: naturally, through the acquisition of rivals until only one supplier remains, or by grant — a patent, a licence or a statutory exclusive right.

2.2 Natural monopoly

A NATURAL MONOPOLY is a true monopoly that arises because a single supplier serving the whole market is genuinely cheaper than two suppliers serving half each. It is the extreme case of the economies of scale taught in chapter 4 section 5: where the fixed cost of the network is enormous and the cost of carrying one more unit across it is small, average cost keeps falling however large the output gets.

Electricity distribution is the standard example. It is very unlikely that rival networks of cables to the same houses would ever be worth building, and if they were built, each would be running at half the volume over the same fixed cost. Water pipes and rail track are the same. The market therefore delivers a monopoly by itself, and no amount of competition policy will change that — which is why these industries are REGULATED rather than broken up.

2.3 Restrictive trade practices

Firms that are not monopolists can behave as though they were. The practices to know are:

• CARTELS, where several suppliers collude to keep prices artificially high instead of competing. The customer sees several suppliers and no real choice.

• PREDATORY PRICING, where a financially strong supplier cuts its selling price — sometimes below cost — until weaker rivals are driven out of the market, and then raises it again. The consumer gains briefly and loses permanently.

• TIED SELLING, where a buyer who wants one product is required to take another from the same supplier, or a retailer is contracted to stock only one supplier’s goods. The rival never gets in front of the customer.

• MARKET ALLOCATION, where competitors agree not to compete: you take the United Kingdom and France, we will take Germany and Switzerland. Each is a monopolist at home by agreement.

2.4 Regulating markets: the CMA and the sector regulators

Governments seek to regulate these kinds of behaviour. In the UK the COMPETITION AND MARKETS AUTHORITY (CMA) is responsible for:

• investigating mergers that could restrict competition;

• conducting market studies and market investigations where there may be competition or consumer problems;

• investigating suspected breaches of the prohibitions on anti-competitive agreements and on abuse of a dominant position;

• bringing criminal proceedings against individuals who commit the cartel offence; and

• enforcing consumer protection legislation, to tackle practices and market conditions that make it difficult for consumers to exercise choice.

Separately, industries that are natural monopolies — telecoms, electricity, gas, water — are regulated by sector agencies. Ofgem, the Office of Gas and Electricity Markets, has as its principal objective the protection of the interests of existing and future electricity and gas consumers. Where competition cannot do the work, a regulator does it instead: it caps prices, sets service standards and controls access to the network.

3 Public goods

Examples include public roads, street lighting, national defence and law enforcement.

Public goods have two defining characteristics and one that usually follows:

• NON-RIVAL: one person’s consumption does not affect anyone else’s. Consumers are not rivals — my use of the street light does not diminish yours.

• NON-EXCLUDABLE: no consumer can be prevented from consuming it, even if they have not contributed to its supply.

• NON-REJECTABLE: you generally cannot opt out either. You may not want a nuclear deterrent, but if your country has one, you have one.

The market does not supply public goods, and the reason is the second characteristic. If nobody can be excluded, nobody has to pay — and some people will enjoy the benefit WITHOUT contributing to the cost. That is the FREE-RIDER PROBLEM. A private supplier of street lighting would have no way of charging the people who walk under the lights, so no private supplier appears, and the good that everybody wants is supplied by nobody.

Public goods are therefore provided by the state and financed out of tax revenue, which is a way of making the contribution compulsory. Government then has to decide how much of the good to supply and how much tax to raise for it, without a market price to guide either decision.

4 Externalities and government responses

For example:

• people living near an airport bear the cost of noise and air pollution;

• airlines do not bear the full consequences of the air pollution they cause;

• car manufacturers bear no part of the cost of the road infrastructure their products require; and

• society at large benefits from university education, because a more skilled workforce improves the economy.

4.1 Negative externalities

Externalities interfere with the ability of market forces to allocate resources properly, and the mechanism is worth following through carefully.

Suppose there is a strong relationship between the level of car ownership in a country and the incidence of lung disease. That extra disease is a cost: a personal cost through ill health, and a public cost through the medical care needed to treat it.

If the cost of that healthcare is not reflected in the cost of manufacturing and running cars, then cars are CHEAPER than they should be — and because they are cheaper, MORE of them are demanded than should be. The manufacturers have shifted what ought to be their costs onto the health sector, where the cost of supplying services is now higher than it should be, so government may decide it can afford to supply less of it.

That is the general shape of every negative externality: the price is too low, so the quantity is too high, and somebody outside the transaction pays the difference.

4.2 Positive externalities and merit goods

Where there are POSITIVE externalities, the same logic runs the other way. Producers are not rewarded for the side-benefits they create, and consumers do not properly value them, so the price is too low to be worth supplying and too little is produced.

Take a bee-keeper. The price of honey determines the supply of and demand for honey. But the bees also pollinate the crops of nearby farmers, which is a positive externality: more bees would mean more pollination and higher yields. The bee-keeper receives nothing for it and so has no reason to keep more bees. Government can correct this by subsidising honey, by paying bee-keepers a grant to increase their stocks, or by levying a charge on the farmers who benefit — based, say, on crop weight — and paying it into a fund for bee-keepers. That last version is the neatest, because it moves the money from the people receiving the benefit to the people creating it.

A MERIT GOOD is a commodity or service — education is the classic case — that society or government regards as deserving public finance, because otherwise it would be UNDER-CONSUMED. Flu vaccination is a good illustration. If people had to pay for a vaccination, many would decide not to bother. If it is free, uptake is far higher, and at some point a large enough proportion of the population is vaccinated to achieve herd immunity, which stops an epidemic. That last effect is a very large positive externality that no individual buying a vaccination is taking into account.

4.3 The government responses

Pricing an externality is difficult, but the difficulty is not a reason to make no attempt. The syllabus names five responses, and you should be able to give an example of each.

Negotiation between the affected parties is a sixth possibility and it is sometimes enough on its own: where few people are involved and the rights are clear, the airport and the residents may simply settle on compensation and soundproofing without any government action at all.

5 Minimum and maximum prices

From time to time governments set minimum or maximum prices. A minimum price helps suppliers; a maximum price helps consumers. Both switch off the mechanism chapter 5 relies on, so in both cases the market stops clearing and something else has to do the rationing.

5.1 Minimum prices, including the minimum wage

Suppose a government is concerned about the future of the dairy industry, because many farmers are giving up milk production. One way to keep them in business is to set a minimum price per litre, so that farmers are more or less guaranteed a profit.

But a minimum price for producers is also a minimum price for buyers. It has to be set ABOVE the equilibrium price, or it would have no effect, and above the equilibrium price the quantity supplied exceeds the quantity demanded.

The consequences follow directly from that gap:

• OVER-PRODUCTION. Lots of farmers produce at the artificially high price, but many consumers will not buy at it.

• PRODUCERS ARE ATTRACTED INTO A BUSINESS THAT ALREADY HAS SURPLUS SUPPLY, because the guaranteed price makes it look profitable.

• WASTE OF RESOURCES. The land, the labour and the capital could have been employed making something consumers actually wanted.

• INEFFICIENCY IN PRODUCTION. Why work at being efficient when the selling price is guaranteed and there is no price competition?

The government is then left holding the surplus, and normally has to buy it, store it, destroy it or export it — all of which cost money on top of the misallocation.

5.2 Maximum prices

Now suppose a government is concerned about the high price of petrol — opinion polls have shown it is a major concern to voters — or wants to hold down inflation. It sets a maximum price per litre. To have any effect it must be set BELOW the equilibrium price.

The low price increases the quantity demanded and suppresses production, because producers’ profits are held down. Development of new sources of energy for cars is inhibited too, because any new technology has to compete against an artificially suppressed price.

Demand and supply still have to be balanced — it is simply a matter of physical quantities having to match — but the price can no longer do it. Something else must, and the candidates are:

• RATIONING, by allocating a fixed entitlement to each buyer;

• QUEUING, which allocates the good to whoever is willing to spend the most time rather than the most money; and

• VOUCHERS or quotas that limit how much any one person may buy.

These approaches then usually give rise to BLACK MARKETS, where some buyers are willing to pay very high prices to get hold of scarce goods. Ticket touting outside a sold-out concert or sporting event is the same phenomenon: the official price is below the market-clearing price, so the queue and the resale market do the rationing that the price was not allowed to do.

6 Transaction costs and the decision to outsource

The last source of market failure in this chapter is the least obvious, because it is about the cost of USING a market at all.

6.1 What a transaction cost is

Every organisation faces a make-or-buy question about each of its activities. Should it do this itself, or buy it from somebody who specialises in it? A specialist supplier will usually have lower PRODUCTION costs, because it has the economies of scale that chapter 4 section 5 describes. Against that, buying from an outside supplier carries transaction costs that doing the job in-house does not.

The failure, when it happens, is that a transaction which would have made both parties better off does not take place at all, because the cost of arranging and policing it is greater than the gain.

6.2 Why transaction costs have fallen

Over the last few decades transaction costs have fallen sharply, and for identifiable reasons:

• COMMUNICATIONS AND INFORMATION TECHNOLOGY. Finding a supplier on the other side of the world, sending them a specification and receiving progress reports costs almost nothing now, where once it needed an office and a visit.

• STANDARD CONTRACTS AND STANDARD SPECIFICATIONS. Where the terms are conventional and the product is defined by a standard, negotiation is short and monitoring is a test rather than an argument.

• COMPARABLE SUPPLIERS AND PUBLISHED PRICES. Search costs collapse when there are many suppliers offering a comparable service at a price you can look up.

• PLATFORMS AND MARKETPLACES that do the searching, the contracting and part of the enforcement for both sides.

• BETTER MEASUREMENT. Service-level agreements, tracking and automated reporting make it cheap to check that what was promised has arrived — which is exactly the monitoring cost.

The consequence is the one the syllabus asks about: as transaction costs fall, MORE ACTIVITIES ARE OUTSOURCED, and the organisation gets smaller and more focused. Firms that once owned their own transport fleet, printing works, canteen, IT department and payroll function now buy all of them in.

6.3 Network organisations, shared service centres and flexible staffing

Three organisational forms are the direct result, and the syllabus names all three.

Notice what all three have in common. Each one substitutes a MARKET relationship for a MANAGED one, and each becomes viable at the point where the cost of using the market falls below the cost of managing the activity in-house. That is the whole of this section in one sentence, and it is what the outcome is asking you to be able to explain.

The direction is not one-way. Where transaction costs RISE — because quality becomes hard to monitor, because a supplier becomes the only one available, or because a supply chain proves fragile — organisations bring activities back in-house. That is the same rule running backwards.

7 Tests

The chapter’s own five questions follow. Work each one before you open the answer.

8 Test your knowledge

Two quick checks before you move on: work through the flashcards to fix this chapter’s key terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.