UNIT SIX

MARKET EFFICIENCY
AND
ROLE OF THE
GOVERNMENT

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Historical Background:
• Classical and Neo-classical Economic Thought
• Laissez Faire Economy
• Period of Great Depression
• Stagflation
• Modern Economic Thought
• Strong Role of the Govt. (Command Economy)
• Post Modern Economic Thought
• Capitalism – Market Economy
• Current Economic Thought
• Mixed Economy
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• WDR 1988, “State-dominated development has failed, but so
will stateless development, Development without an effective
state is impossible.”
• Musgrave and Musgrave, “In this market economy, market
is un-doubtfully a powerful instrument to determine
economic activities but the market alone cannot undertake
entire economic functions. So, public sector has an important
and constructive role to perform rather than being.”
• WDR 1988 explained the government involvement is
inevitable to two areas:
1. In the production and distribution of public goods like defense,
Justice, Legal and institutional arrangement etc.
2. Provide social, physical and other infrastructures like health,
transport, environmental protection, energy, minerals etc. 3
Meaning of Market
• Market is a mechanism by which buyers and sellers interact to
each other to fix price of a good and its quantity.
• Market equilibrium – equality between demand(marginal
Benefit) and supply (marginal cost).
Meaning of Efficiency
• Economic efficiency is the situation in which every resource is
optimally allocated by minimizing waste.
• Or Economic surplus=(Producer surplus + consumer surplus) is
maximum.

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Consumer surplus is the
difference between the
maximum price a consumer
is willing to pay and the
actual price they do pay.
Producer surplus is the
difference between actual
price and seller’s reservation
price. Consumer surplus plus
producer surplus equals the
total economic surplus in the
market.

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Productive efficiency
Productive efficiency refers to the situation where output is
produced at minimum cost. It is also called cost efficiency.
In order to achieve productive efficiency, a firm should
allocate its factors of production in such a way to produce at
lowest possible cost i.e. at minimum point of AC curve.
Output is produced at minimum cost as technically.
Allocative Efficiency (price is equal to marginal cost
(P=MC)
Allocative efficiency refers to the situation where price is
equal to marginal cost i.e. P=MC. In other words,
consumers should pay a price for the last unit of output
which covers only extra cost of producing that output.
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 Competitive market is considered as
efficient market because it has the
characteristics of both productive
efficiency and allocative efficiency.
Conditions of Economic
Efficiency
Marginal benefit (MB) must equal
to marginal cost (MC)
The marginal benefit of consuming
the good should be equal for all
consumers
The marginal cost of producing the
good should be equal for every
producer

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 Two conditions of Production Inefficiency:
a) Underproduction than market equilibrium quantity,

Underproduction and deadweight loss

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 Two conditions of Production Inefficiency:
b) Overproduction than market equilibrium quantity.

Overproduction and deadweight loss 9

Effect of Tax and Subsidy In Market Equilibrium And Efficiency

Tax on goods and deadweight loss

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Effect of Price Control Policies

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 Main Roles of the Government
1.Production and distribution of public goods.
2.Correct market failures.
3.Increase efficiency of Private and public enterprises.
4.Limit exploitation, remove poverty and proper distribution of
income and wealth within the nation.
5.Stabilize the economy by using appropriate monetary and fiscal
policy.
6.Achieve high economic growth
7.Give protection to the government acts and laws (maintain law
and order)
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 Types of Role of the Government
Promotional role
1. Economic Growth achievement.
2. External Economies of scale.
Regulatory Role
1. Direct regulation on monopoly to ensure enough
output and restrict monopoly profit.
2. To provide patent and subsidy to provide benefit to
the business firms.
3. To make operating control over goods and services
production and their process.
4. To ensure competitive environment in the economy.
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 Market Failure

According to Pappaz and Hirschey, “Market failure can be

described as the failure of a system of market institutions to
sustain desirable activities or to eliminate undesirable ones.”
WB (WDR 1988), “Market failure refers to the set of conditions
under which a market economy fails to allocate resources
efficiently.”

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 Market Failure

We know that the competition ensures the output of the product

according to the demand of the consumers but due to various
reasons market mechanism fails to create optimal result. If the
market is not regulated, the market activity itself creates
inefficiency or market failure.
In conclusion, if market mechanism is not being able to make
the equality between demand and supply in the market (either
demand exceed supply or supply exceed demand) it exploits one
side giving advantage to another side. It is called market failure.

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 Types of Market Failure
1.Market Failure due to market structure
- Monopoly or near to monopoly market structure
- High Price less quantity
2. Market failure due to market incentives
- Externalities

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 Sources/Causes of Market failure
1. Market Power
2. Public Goods (Free rider problem)
3. Incomplete Information
4. Externalities (MSC not equal to MSB)

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 INCOMPLETE INFORMATION
Incomplete information refers to lack of complete information
to the consumer or producer about the goods and services in
the market regarding technology, demand, supply, price,
quality, reliability or safety. This incomplete information
makes difficult to distinguish trustworthy from untrustworthy
buyers and sellers. Analyzing the effects of incomplete
information is similar to analyzing externalities with one
important difference. Externality involves third party while
this discussion considers only buyers and sellers. So it is also
called information externality. The result of incomplete
information leads to adverse selection and moral hazard which
are undesirable.
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 Government’s Response to Market Failure
1. Control of monopoly and provide competitive environment

2. Operating Controls (regulation on production process and

product)

3. Imposition of Tax and provide subsidy

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 Rationale for Government Regulation

• Economic Considerations
• Related to cost and efficiency
• Price, Output, allocation etc.
• Social/Political Considerations
• Related to equity and fairness
• Social justice
• Equal distribution of income and wealth

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Direct Regulation of Government

• Monopoly regulation

• Price Regulation

• Profit Regulation

• Incentive Regulation

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 Antitrust Policy
• Competition is desirable because it reduces price as well
as increases output and efficiency in the allocation of
resources, but the economy can’t achieve the situation of
perfect competition due to political decision making and
complexity of market.
• workable competition is the realistic goal for the policy
makers, or the goal of antitrust policy is to achieve the
workable competition. Generally, antitrust policy is
related to the structure and conduct of the industry.

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 Antitrust Policy

• Antitrust law restricts business practices that are considered unfair

or monopolistic.
• the laws brought with the objective of controlling monopoly and
maintain workable competition among the producers is known as
antitrust policy.
• It is the primary device used to encourage competition. Imposition
of fines or fixing prices in unison is the examples of antitrust
policy.
• Edwin Mansfield, “The antitrust laws are aimed at promoting
competition and limiting monopoly.”
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• The First antitrust law was “Sherman Act” – USA 1890 – used to
discourage monopoly and to preserve and encourage competition.
Clayton act (1914) and Federal trade commission Act (1914) are
other examples of antitrust laws practiced by USA.
• Competition Promotion and market Protection Act (2007) is
antitrust policy practiced in Nepal.
• Antitrust law makes the following practices illegal.
1. Monopolies and attempt to monopolies
2. Use of unfair methods of competition
3. Engage in particular form of price discrimination
4. Enter a contract (combination) in restraint of trade
5. Enter exclusive and tying contracts (tying contracts make buyers to
purchase other items to get the product they want.)
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 Approaches of Antitrust Policy
• Market Performance Approach:
• relies on “technological progressiveness and dynamism”
• Economists believed that to judge antitrust laws, the market
performance of firms should be reviewed in detail.
• The problem associated with this approach is to tell “good” or
“bad” performance of the firms.

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 Approaches of Antitrust Policy
• Market Structure Approach:
• Market structure means the number and size distribution of the
buyers and the sellers in the market, ease of the entry of new
firms, product differentiation etc.
• Economists believed that the above stated facts should be
reviewed to study monopolistic situation of the economy.
• It has been suggested that such ‘market Power’ should be
declared illegal.
• The problem associated with this approach is the weak
relationship between market structure and market performance.

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• The antitrust policy adopted in Nepal is , “Competition Promotion and
Market Protection Act, 2063 (2007)”.
• Aims to make national economy more open, liberal, market-oriented and
competitive by maintaining fair competition among the firms.
• Also aims to protect markets against undesirable interference and to
control monopoly and restrictive trade practices.
• The act defines following activities as anticompetitive practices and
prohibits conducting such practices:
1. Prohibition on Anti-competitive Agreements
2. Prohibition on Abuse of Dominant Position
3. Prohibition on Merger with Intent to Control Competition
4. Prohibition on Bid Rigging(Collude competing parties)
5. Prohibition on Exclusive Dealing(tied to buy from supplier on the understanding)
6. Prohibition on Market Restriction
7. Prohibition on Tied Selling
8. Prohibition on Misleading Advertisement 31
 Patent System
• The granting of special right to produce, use or sale any invention to any
firm for the specified period by the government.
• It is used to promote and prevent inventions.
• Pappaz and Brigham, “Patents are the government grant of exclusive right
to produce, use or sell an invention or idea for a specified period of time.”
• Milton H. Spencer, “A Patent is an exclusive right conferred by a
government on an inventor for a limited time period.”
• In conclusion, patent is a method to promote invention by providing
temporary but legal monopoly power to the inventors. So that, the inventors
firm will be able to take advantage of its inventions.
• USA practiced Patent Right for 20 years.
• In Nepal, According to Patent, Design and Trade Mark Act (1965)- patent
can be provided for 7 years and can be renewed not more than twice.
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 Arguments in favor of Patent

• It is an important incentive to induce the inventor to make

inventions.
• It is a necessary incentive to induce the firms to work more and
invest in new machine.
• The inventions are disclosed soon due to patent act but if there
was no such act it will not be disclosed for long time. So, in long-
run newly invented commodities or services are easily available
for the consumers.

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 Arguments against Patent
• New knowledge will not be much used. So, there is no possibility
of decrease in MC.
• Patent right system in general increases the imitation cost. This
discourages the new entrants. So, it is ineffective.
• If it is misused, it creates further market inefficiency.
• It increases monopoly thinking of individuals and firms.

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 Operating Controls
• The government also tries to control market failure associated with external
diseconomies.
• For this, government uses operating controls. Operating control refers to the
control imposed by the government to limit the activities of the business
firm.
• The main Controls of Govt. are:
1. Control on Environment Pollution and Degradation
2. Control on food products and drugs
3. Control on industrial work conditions
4. Control on price
5. Control on wage rate
6. Control on services of financial institutions
7. Control on public services like transportation etc.
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• Subsidy policy and tax policy are used to make correction on market
failure. Government withdraws resources as tax from the firms' producing
goods and services with negative externalities whereas provides resources
as subsidy to the firms producing goods and services with positive
externalities.
• Type of subsidy : a) Direct Subsidy b) Indirect Subsidy
• It can also be categorized as Production subsidy and Consumption
Subsidy.

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Production Subsidy Consumption Subsidy
• Tax is the most practiced economic instrument to address negative externality and regulate
market failure.

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 Regulation of Environmental Pollution
• Environment Pollution is the best example of external diseconomies of
scale.
• Since environment pollution is also causing market failure because it
increases social cost and decreases social benefit. For which the
government should implement the appropriate measures to control it.
• The optimum level of pollution control can be explained with the help of
pollution cost curve and pollution control cost curve.
• Pollution Cost: It is the social cost realized by the society due to the
pollution emitted by the industries. Pollution cost increases with increase in
quantity of pollution emitted. It means pollution cost curve is positively
sloped.
• Pollution Control Cost: It is the cost required to control pollution. It
decreases with the increase in quantity of pollution emitted due to which
pollution control cost curve is negatively sloped. 38
 Optimum level of Pollution Control
Optimum level of
pollution is determined
by the interaction
between positively
sloped pollution cost
curve and negatively
sloped pollution
control cost curve as in
figure.

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 GOVERNMENT REGULATIONS OF
ENVIRONMENTAL POLLUTION
• Command and Control (CAC)
• In CAC regulation method, government sets specific limits for pollution
emissions or compels that specific pollution-control technology that
must be used.
• Government imposes penalties if pollution limits exceeds.
• Market Based Incentive (MBI)
• Market based incentive approach works toward preventing
environmental problems by providing inducements to encourage
polluting entities to reduce pollution.
• Through this approach, companies are rewarded for incorporating
pollution reduction into their business decisions.
• The rewards are typically some type of financial gain.
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 Regulation of International Competition

• In this age of globalization, free trade is regarded as

economically efficient.
• In some cases, global market doesn’t automatically lead to
efficiency due to market distortions.
• Govt. regulates the international trade by the means of tariff and
non-tariff measures like Import/export tax, Quota system,
Protectionism policy etc.

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 Problems of Regulation
• Cost of regulation
• Poor Information
• Shifts in Government policy
• Regulatory lag
• Behavior of Regulating Agencies
• Lobbying and influencing cost
• Unintended effect etc.

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 GOVERNMENT FAILURE
• Government failure is the situation where government intervention in the
economy causes an inefficient allocation of scarce resources and a decline in
economic welfare.
• Often government failure arises from an attempt to solve market failure but
creates a different set of problems.
• Government intervention to resolve market failures fails to achieve a socially
efficient allocation of resources and creates further inefficiencies in the market.
• As for example, taxes on incomes can create a disincentive effect and
discourage individuals from working hard.
• tax on goods and services can raise prices artificially and distort the efficient
operation of the market.
• Government failure can arise because government is made up of politician and
bureaucrats, each with their own objectives and self interests.
• Public Choice theory can be used to explain the cause of government failure.
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 THEORY OF PUBLIC CHOICE

• James Buchanan (noble prize winner in economics,1986) and

Gordon Tullock developed the concept of public choice theory in
their most famous work, The Calculus of Consent (1962).
• They argued that unless constitutional rules are structured in a
manner that will bring the self-interests of the political players into
harmony with the wise use of resources, government action will
often be counterproductive (having opposite effect than desired)
• Public choices (political actions) are affected by self interest and
incentives of mainly three players i.e. voters, politicians and
bureaucrats.
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 THEORY OF PUBLIC CHOICE
• All these want to maximize their self interest due to which
public policies fail.
• There are four major reasons why the political allocation of
resources will often result in inefficiency.
1.Special interest effect
2.Short sightedness effect
3.Rent seeking (manipulating public policy to enhance profit)
4.Inefficiency of government operation

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Cracking The case
• Read the case carefully at least twice
• Crack the case
• Focus on key issues in each case (point out in written form if
needed)
• Use all the facts of case but not outside of them
• Backup the facts by theory
• Give analytical answer to different questions separately
• Do not restate the sentences of the case but analyze it

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Thank You !

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