Market Failure

Market failure has become an increasingly important topic for students.There is a clear economic case for government intervention in markets where some form of market failure is taking place. Government can justify this by saying that intervention is in the public interest. Basically market failure occurs when markets do not bring about economic efficiency. When a market fails to allocate resources efficiently, there is said to be market failure.
Government intervention occurs when markets are not working optimally i.e. there is a Pareto sub-optimal allocation of resources in a market/industry. In simple terms, the market may not always allocate scarce resources efficiently in a way that achieves the highest total social welfare.

There are plenty of reasons why the normal operation of market forces may not lead to economic efficiency.

Public Goods
Public Goods not provided by the free market because of their two main characteristics

  • Non-excludability where it is not possible to provide a good or service to one person without it thereby being available for others to enjoy
  • Non-rivalry where the consumption of a good or service by one person will not prevent others from enjoying it

Examples: Street lighting / Lighthouse Protection, Police services, Air defence systems, Roads / motorways, Terrestrial television, Flood defence systems, Public parks & beaches
Because of their nature the private sector is unlikely to be willing and able to provide public goods. The government therefore provides them for collective consumption and finances them through general taxation.

Merit Goods
Merit Goods are those goods and services that the government feels that people left to themselves will under-consume and which therefore ought to be subsidised or provided free at the point of use.
Both the public and private sector of the economy can provide merit goods & services. Consumption of merit goods is thought to generate positive externality effects where the social benefit from consumption exceeds the private benefit.
Examples: Health services, Education, Work Training, Public Libraries, Citizen's Advice, Inoculations

Few modern markets meet the stringent conditions required for a perfectly competitive market. The existence of monopoly power is often thought to create the potential for market failure and a need for intervention to correct for some of the welfare consequences of monopoly power.
The classical economic case against monopoly is that

  • Price is higher and output is lower under monopoly than in a competitive market
  • This causes a net economic welfare loss of both consumer and producer surplus
  • Price > marginal cost - leading to allocative inefficiency and a pareto sub-optimal equilibrium.
  • Rent seeking behaviour by the monopolist might add to the standard costs of monopoly. This includes high (possibly excessive) amounts of spending on persuasive advertising and marketing.
  • Libenstein's X-inefficiency may also result if the monopolist allows cost efficiency to drop. An upward drift in costs because of a lack of effective competition in the market-place can lead to consumers facing higher prices and a reduction in their real standard of living

Any exam question on market failure must make some reference to externalities. What are the potential market failures arising from externalities?
The social optimum output or level of consumption diverges from the private optimum.
Main problem is the absence of clearly defined property rights for those agents operating in the market. When property rights are not clearly defined, market failure is likely because producers & consumers may not be held to account
Don't forget that positive externalities can also justify intervention if goods are under-consumed (social benefit > private benefit)

Market failure can also be caused by the existence of inequality throughout the economy. Wide differences in income and wealth between different groups within our economy leads to a wide gap in living standards between affluent households and those experiencing poverty. Society may come to the view that too much inequality is unacceptable or undesirable.
Note here that value judgements come into play whenever we discuss the distribution of income and wealth in society. The government may decide to intervene to reduce inequality through changes to the tax and benefits system and also specific policies such as the national minimum wage


Government intervention may seek to correct for the distortions created by market failure and to improve the efficiency in the way that markets operate

main roles of govt include:
Regulatory -laws and rules
allocative -providing collective and public goods
distributive -redistributing income and wealth more fairly through taxation
stabilisation- fiscal and monetary policy

ways this is done:
  • Pollution taxes to correct for externalities
  • Taxation of monopoly profits (the Windfall Tax)
  • Regulation of oligopolies/cartel behaviour
  • Direct provision of public goods (defence)
  • Policies to introduce competition into markets (de-regulation)
  • Price controls for the recently privatised utilities

Economists of different political philosophies argue about the extent to which governments need to intervene in the workings of the free market. Free market economists argue that government intervention should be kept to a minimum whilst socialist economists, in favour of more state ownership and control, argue that there is greater need for intervention. One argument where there is considerable debate is concerned with the environment and its sustainability. It is when the protection of the environment is considered that the free market appears to fail on several counts.
Market failure occur due to several reasons

1. Environment as a public good
Certain parts of the environment such as communal land in Zambia could be considered a public good and as such have a characteristic of non excludability. Commonly owned land where there are no established property rights produces little incentive to care for the environment. Slash and burn agriculture or chitemene can lead to deforestation, as cutting down trees incurs no cost given that the farmers are shifting to new areas. However the environment does not conform to the other characteristic of public goods that of being non-rivalrous. Using the land for farming means that the land can not be used for conserving wildlife. The environment is scarce and if the use of environment is free then it will invariable be over-used.

2. The existence of externalities
The production of agricultural goods, horn, ivory, electricity and tourism all involve incurring private costs and yield private benefits. Typically the market price of a good or service reflects these private costs and benefits. The production and consumption of goods and services can involve additional external costs or negative externalities experienced by people other than those who are directly producing or consuming the good. For instance the relocation of people when the Kariba Dam was built or the diversion of water supplies for the benefit of the tourist industry. These spillover effects can also impact on the natural history such as the extinction of species of wildlife. The socially efficient level of output and price would be at a level where these external costs were taken into account. This would result in a higher price and a lower output.

3. Ignorance
Given the limited access to education there is considerable lack of knowledge about the impact of poaching and hunting on the population of many species of animals. Markets fail where the lack of information means that rational decisions are not made. If the communities were educated about the impact of their actions on the level of sustainability then different decisions might be taken.

4. Short term benefit versus long term benefits
Killing a rhino and selling its horn will generate considerable income and give significant benefit to the family of the hunter. However the impact of killing the rhino on future generations is not considered. Self-interest, one of the guiding principles of the free market fails to take into account of the future interests of others. Little if any consideration is given to the future.

Conditions to achieve allocative efficiency

Allocative efficiency is a theoretical measure of the benefit or utility derived from a proposed or actual choice in the distribution or apportionment of resources
Market failure may occur because of
  • imperfect knowledge,
  • differentiated goods,
  • resource immobility,
  • concentrated market power (i.e, monopoly, oligopoly, or imperfect competition, instead of perfect competition),
  • insufficient production,
  • externalities, or
  • inequality of consumers' and producers' bargaining power
  • no perfect competition
  • no consumer sovereignty

characteristics of market failure:

eco website:

Government Intervention to Correct Market Failure
  • The economic rationale for Government intervention
    • (i) Correction for market failure/loss of economic efficiency
    • (ii) Desire for greater degree of equity in the distribution of income and wealth

Private Goods

Characteristics of Private Goods
  • Private good; a good or service that is individually consumed and that can be profitably provided by owned firms (i.e. automobiles, clothing, personal computers, etc)
  • Rivalry(in consumption):
    • When one person buys and consumes a product, it is not available for another person to buy and/or consume.
      • Ex. When Adam purchases and drinks a bottle of water, the same bottle of water Adam has is not available for Benson to purchase and consume.
      • Ex. If Linda buys and uses a Wii, it is not there for Jason to buy and use.
      • Ex. If I buy a BMW car, you cannot buy the same car I bought.
  • Excludability(by a seller):
    • Only those who can afford a product may obtain its benefits.
      • Ex. Person A may have the means and will to pay for a t-shirt for $20. Person B may not wish to pay $20 or may not be able to; person B would not be able to purchase the good.
      • Ex. Only people who are willing and able to pay the market price for bottles of water can obtain these drinks and the benefits they confer.
    * These characteristics ensure that firms in a free market may find it profitable to produce and sell such private goods and if they are profit-seekers, suppliers enter the market and produce the desired goods.

  • A competitive market also allocates society's resources efficiently to the particular product (no under/over production or under/overallocation). It produces at the point where P=MC.
  • Firms can profitably "tap market demand" for private goods, and will produce and offer them for sale.
  • Market demand for a private good is the horizontal summationof individual demand schedules (Collective demand), where as an individual demand is just the inverse relationship between the quantity demanded by a consumer and the price.
  • Consumers fully express their personal demands for private goods in the market.

Characteristics of Public Goods
  • Non-rivalry(in consumption):
    • One person's consumption of a good does not prevent the others from consuming it.
      • Ex. Everyone can simultaneously obtain the benefit from a public good such as national defense, street lighting, public toilets, a global positioning system, or environmental protection without exerting any extra effort than the effort that is being put forth in a normal day without taking the benefit's costs into account.
  • Non-excludability(by a seller):
    • There is no effective way of excluding individuals from the benefit of the good once it comes into existence.
      • Ex. Once in place, one cannot exclude another from benefiting from national defense, street lighting, a global positioning system or environmental protection.
      • Ex. There is no way to exclude people from looking at a public statue in the park. Say that Ana paid her taxes (that paid for the statue) and Alan didn't. They are both allowed to view the statue. Alan doesn't have to wear blindfolds every time he walks by.
  • Note:Public goods are a market failure because resources are under allocated towards producing them. The market fails to provide these goods.
  • Examples:
  • Street lighting / Lighthouse Protection, Police services, Air defence systems, Roads / motorways, Terrestrial television, Flood defence systems, Public parks & beaches Because of their nature the private sector is unlikely to be willing and able to provide public goods. The government therefore provides them for collective consumption and finances them through general taxation.

Consumption of public goods creates the free rider problem:
  • Everyone can benefit from the good; therefore, people have no incentive to pay for something free – "free riders".
  • If demand is not fully expressed in market, it is impossible for firms to gather together resources and profitably provide the good.
  • Solution: government provision of public goods through taxation. However, the free rider problem may still exist if illegal immigrants do not pay taxes and still enjoy the benefits of the goods in question.

Note: Controversy often arises over how mixed goods (ie excludable/nonrivalrous or nonexcludable/rivalrous) should be categorized.

  • Example: Highways with tollbooths: these roads are charged but one person driving on a highway does not usually reduce the usefulness of the highway to others.
  • Example: You cannot exclude someone from fishing in a public lake, but once a fish is caught it cannot be caught by any other fishermen.

User pay means the user has to pay for a good or service, e.g. bridge toll, this is considered inefficient because it leads to a loss of welfare

Optimal quantity of a public good

  • MB (society's marginal benefit) = MC (government's marginal cost).
  • Marginal benefit is defined as the collective willingness of costumers to pay for a public good, as best as it can be determined.
  • Demand is expressed by survey or public votes → compare it with the MC-MB-Analysis → Gov considers the extent to which the project will be constructed.
  • Adhering to the MB=MC rule, government can provide the right/ efficient amount of public good.
Demand for a public good

  • Demand for Public Goods (i.e. Collective Demand) is represented through price-quantity schedules, showing the price someone is willing to pay for the extra unit of each possible quantity.
  • This is much different than the market demand schedule we previously learned; before it was how many goods for said price, but now the consumer can state what they want the price to be
  • Downward slope: decreases due to the law of diminishing marginal utility.
  • Demand curve = MB curve
  • Person A's willingness to pay + Person B's willingness to pay = collective willingness to pay = Demand C
  • Market demand for a public good is the vertical summation of individual demand schedules

Supply for a public good

  • Supply curve for private or public good = its MC curve
  • MC rises as Q of good produced increases due to the law of diminishing returns.
  • Upward slope : law of diminishing returns + fixed plant + fixed resources + variable resource = diniminshing total product.

Marginal benefit and marginal cost

  • Remember,Demand curve= MB curve, Supply curve= MC curve
  • Optimal quantity of good occurs where MB = MC or where the two curves intersect.
  • When MB = MC, the firm has achieved allocative efficiency.
  • If MC cannot equal MB, then you could take the closest quantity and price where MB>MC.

Cost-benefit analysis

  • Used to decide whether to provide a particular public good and how much of it to provide by comparing the marginal costs and marginal benefits.
  • Can also help the government decide on the extent to which a project should be pursued.
  • An activity/project/output should be increased as long as MB > MC since marginal benefit exceeds marginal cost.
  • The activity should be stopped at the point where MB = MC, and do not pursue a project where MB < MC.

  • This is the marginal-cost-marginal-benefit rule, which tells us which plan gives society the maximum net benefit.
  • Economy in government does not mean minimization of public spending.

  • Governments use cost-benefit analysis on a large scale when determining the amount of resources to allocate to public goods vs. the amount of resources to allocate to private goods. They must compromise because there is always a trade-off.

Collective good

Collective goods (or social goods) are defined public goods that could be delivered as private goods, but are usually delivered by the government for various reasons, including social policy, and finances from public funds like taxes.
A mixed good has unclear price signals because of externalities of consumption/production.

This is a featured page
This is a featured page

Externalities - Welker'sWikinomics Page
Externalities - Welker'sWikinomics Page
Externalities (spillover)- costs or benefits inflicted upon a third party outside of a market transaction, caused by either under- or over-allocation of resources to a particular product.

Market failure must make some reference to externalities. What are the potential market failures arising from externalities? The social optimum output or level of consumption diverges from the private optimum. Main problem is the absence of clearly defined property rights for those agents operating in the market. When property rights are not clearly defined, market failure is likely because producers & consumers may not be held to account. Don't forget that positive externalities can also justify intervention if goods are under-consumed (social benefit > private benefit).

Negative Externalities

  • When production or consumption of a product places external costs on society (overproduction/over allocation) the society is receiving more of this spillover effect than is optimal.
    • The producer's supply curve is S= MPC or to the right of (below) the fullcost curve (S= MSC).
    • Polluting producer's supply curve understates the total cost of production (S=MSC) .
    • Because the total cost of production is lower (absorbed by society), producers will produce more at a lower cost.
    • Therefore, the supply curve of society (S=MSC) lies to the left of the firm's supply curve (S=MPC) since the cost is greater to the society, due to the spillover costs.
  • e.g. Cigarettes create secondhand smoke (negative externalities) for people around the smoker
  • e.g. Pollution in the world around us the biggest negative externality today.
    • Causing the biggest market failure: global warming
Externalities - Welker's Wikinomics Page
Externalities - Welker's Wikinomics Page

Positive Externalities

  • When production or consumption of a product creates external benefits for society (underproduction), resources are underallocated.(Positive externality is a market failure becuase the resources are underallocated.)

  • The market demand curve D (D= MPB) is to the left of (below) the full-benefit demand curve (D= MSB) due to the spillover benefits that all of society receives.

  • e.g. If one person gets vaccinated, it prevents others from contracting the disease from that person, thus benefiting a third party that is not involved in the transaction.
  • e.g. If one person gets educated, it benefits the entire society. The person can work as a trained worker, or he/she can be a trained professional worker at any job.
  • e.g. Environment-friendly coffins deteriorate purchased by an individual cause less damage to the soil, as it doesn't contain deadly toxins and chemicals. The third party, everyone else, benefits as the environment is less contaminated.
  • Welker's Wikinomics is a positive externality for us all. because we contribute to it, and all benefit from it.

Individual Bargaining: "Coase Theorem"

  • Government is not needed to remedy external costs or benefits under these conditions:
    1. Property ownership clearly defined, which provides incentive for negotiation.
    2. A small number of people involved.
    3. Negligible bargaining costs.
  • Confined role of government - encourage bargaining between affected individuals/groups
  • Property rights→ externality creates opportunity costs for all parties
  • Bargaining results in mutually acceptable solution to externality problem. Compromise!
  • Limitations – when dealing with large number of affected parties, high bargaining costs, and community property (ex. air and water) people must rely on the government to find a solution.
    • e.g. global-warming problem, with regard to international issue of carbon-dioxide emission.
CLICK HERE for Mr. Welker's explanation of the "COASE THEOREM"

Liability Rules and Lawsuits

  • Government erected a framework of laws that define private property and protect it from damage. Damage recovery system permit parties suffering negative externalities to sue for compensation.
  • Clearly defined property rights and government liability laws help remedy some externality problems. They do so directly by forcing the perpetrator of the harmful externality to pay damages to those injured. They do so indirectly by discouraging firms and individuals from generating negative externalities for fear of being used.
  • Limitations – many externalities do not involve private property but rather property held in common by society ("public")
  • Also lawsuits are time consuming and have uncertainty associated with court outcome.

Government Intervention
Externalities - Welker's WikinomicsPage
Externalities - Welker's WikinomicsPage

Government can intervene to correct the under/overallocation using taxes, subsidies, or other means:

  • Direct controls and taxes to counter NEGATIVE externalities
    • Direct controls - (i.e. passing of legislation) force offending firms to incur actual costs of offending activity
      • Raises the MC of production because the business must either pay their fines or adopt new production lines to fix their negative spillover effects on society
    • Taxation: taxes violators to share a portion of the marginal social cost
    • These correct the overallocation. Notice that when an industry produce at S= MPC, the equilibrium amount is Qe, but after regulation, supply will shift to S=MSC, in which total quantity supplied decreased by x amount to Qso.
    • C + P = total tax revenue
    • Shifts the production from point Qe to Qso (socially optimal).
    • Quantity decreases and price increases.
  • Subsidies and Government Provision counter POSITIVE externalities
    • Subsidies to buyers (e.g. discount coupons for a series of inoculations).
    • Subsidies to producers (e.g. subsidy for inoculation to physicians and medical clinics); also known as an inverse tax.
    • Government Provision (occurs when extremely large externalities lead the government to produce the product as a public good).
    • Shift the production to a socially optimal point, and this will increase quantity and price.

A Market-Based Approach to Negative Externalities
The Tragedy of the Commons

  • Public lands (i.e. parks, streets, rivers, lakes, etc.) are all subject to pollution as the rights to use these resources are held "in common" by society.
    Externalities - Welker's Wikinomics Page
    Externalities - Welker's Wikinomics Page
  • Commonly owned land/resources are not maintained or used as carefully as privately owned goods because no one is responsible for them.
  • As rational thinkers, each human seeks to maximize his gain. The positive utility of doing something accrues only to that person, but the negative utility is shared by society, so marginal utility always outweights marginal cost. As rational humans, then, people continue to perform deeds harmful to society as a whole.
  • There is a lack of incentive to incur internal costs linked to getting rid of pollution when these costs can be transferred externally to society.
  • Each person believes his/her own contribution to pollution is negligible, but together, the collective contribution brings an overwelming effect upon society.
  • Ex. A common pasture in which anyone can graze cattle will quickly be overgrazed beause each rancher has an incentive to graze as many cattle as possible.

Solution: Privatization of the "Commons"

  • If public goods or lands are privatized, then those individuals or firms who own them will take the responsibility upon themselves to take care of and regulate the commons
  • This solution is not always viable, e.g. the air we breathe in cannot be privatized; nor the oceans.

A Market for Externality Rights

  • An appropriate pollution-control agency determines the amount of pollutants that firms can discharge into the water or air of a specific region annually while maintaining the water or air quality at some acceptable level.
  • Essentially, a market is created for the "commons". A price tag is put on pollution.
  • Advantages: reduces society's costs by allowing pollution rights to be bought and sold; provides monetary incentive for potential polluters not to pollute; growing revenue from the sale of a fixed quantity of pollution rights can be used for environmental improvement; rising price of pollution rights should stimulate the search for improved pollution-control techniques. Also can be held by conservatist groups to increase the scarcity of the permits, further encouraging less pollution-based methods.
  • The price will rise because more and more people will try to obtain the pollution right as the time passes.
  • There are two ways of exchanging pollution rights which are exchanging internally and externally. Internally, the polluters might transfer pollution by changing sources within their plants, and externally, they might change regions where the minimum standards are not being met to meet their pollution rights.

Global Warming

  • Global warming policies aiming to reduce greenhouse-gas emissions in order to slow or get rid of global warming creates costs and benefits. (Important to look at the MC and MB when deciding on policies)
  • Greenhouse gas limits shouldn't be so strict that the costs for the society would outweigh the benefits, but at the same time, limits shouldn't be too relaxed so that society does not receive potential benefits that it would have attained otherwise.
  • Market mechanism with its system of prices and profits/losses will adjust appropriately based on the new climates.
    • e.g. air-con sales may rise, while snow shovel sales may decrease
  • If no actions are taken to reduce the greenhouse gases, it is certain that the transition costs, which are costs associated with making economic adjustments, will be extremely high.
    • Reducing or eliminating these transition costs is a part of the benefit of slowing or getting rid of the greenhouse problem.

Fixing Failures

Should markets fail for one or more of these reasons, governments are often called into action. The very existence of governments is largely attributable to the market failure of public goods. The scope of modern governments has expanded over the years to address other market failures.
Governments have three key tools for addressing the market failures of public goods, market control, externalities, and imperfect information.

  • Direct Provision: A common method used by governments to address the market failure of public goods is direct provision. That is, governments oversee the production of public goods and/or their distribution to the public. This alternative is most obvious with national defense. The national government hires military personnel, purchases armaments and equipment, maintains military bases, and generally oversees the operations of military actions. Governments are also inclined to directly provide goods failing from market control, so called public utilities that include water distribution, electricity generation, and trash collection.

  • Regulation: A second noted method is the regulation of production, consumption, and exchange decisions undertaken by the private sector -- businesses and consumers. That is, governments set the rules of the game, a task they generally undertaken for society, but in this case directed specifically to the correction of market failures. Government regulations are commonly used to address the market failures of market control, externalities, and imperfect information. For example, the price of a firm with significant market control might be regulated by government. Or government might restrict the amount of pollution emissions from a particular productive activity. Regulations requiring sellers to provide information to buyers is a means of addressing the market failure of imperfect information.

  • Taxes: A third alternative is to make use of coercive government taxes. That is, governments impose to create disincentives and thus discourage undesirable activities. Taxes are well-suited for controlling externalities or encouraging the provision of information. For example, an industry the creates a pollution externality can be encouraged to efficiency if government imposes a tax equal to the external cost. Alternatively, government subsidies, effectively negative taxes, can be used to encourage activities and address the market failure external benefits.

Government Inefficiencies

While market failures can be corrected, in principle, only through some sort of government action, government intervention does not guarantee a solution nor an efficient allocation of resources. The reason is that governments are also imperfect. Governments have their own set of inefficiencies.
A list of government inefficiencies includes:

  • Voter Apathy: The whole point about efficiency and addressing the scarcity problem is to get the most satisfaction from available resources. When people don't vote, leaders don't know what really satisfies the public.

  • Special Interest Groups: In a related matter, when some people don't vote, those who do vote have a greater influence over an election. Leaders seek to provide satisfaction for those special interest groups with the greatest influence. And such groups do not necessarily promote what is best for the entire economy.

  • Re-election Minded Politicians: Leaders who only need to please a majority of those who vote can largely ignore the interests of others. Once again, any resulting economic policies are not necessarily in the best interest of the entire economy.

  • Complex Bureaucracies: Those who work in the large, complex bureaucracies that tend to make up governments, might not be held responsible for their actions, especially those actions that carry out economic policies. Even the "best" economic policies might not be effectively carried out by government employees.

Monopoly & Economic Efficiency

In this note we evaluate the costs and benefits of businesses with industry muscle, monopoly pricing power in markets. The standard economic and social case against monopolistic businesses is no longer straightforward. Markets are changing all of the time and so are the conditions in which businesses must operate regardless of whether they have any noticeable market power.
The economic case against monopoly
The usual textbook argument against monopoly power in markets is that existing monopolists can continue to earn abnormal (supernormal) profits at the expense of economic efficiency and the welfare of consumers and society.
The standard case against monopoly is that the monopoly price is higher than both marginal and average costs leading to a loss of allocative efficiency and a failure of the market mechanism. The monopolist is extracting a price from consumers that is above the cost of resources used in making the product and, consumers’ needs and wants are not being satisfied, as the product is being under-consumed.
The higher average cost of production if there are inefficiencies in production also means that the firm is not making optimum use of its scarce resources. Under these conditions, there may be an economic case for some form of government intervention to limit or reduce the scale of monopoly power, for example through the rigorous application of competition policy or by a process of market deregulation (liberalisation).
X Inefficiencies under Monopoly
X inefficiency is a term first coined by Harvey Libenstein. The lack of real competition may give a monopolist less of an incentive to invest in new ideas or consider consumer welfare. It can also be argued that even if the monopolist benefits from economies of scale, they will have little incentive to control production costs and 'X' inefficiencies will mean that there will be no real cost savings.
Comparison between Monopoly and Perfect Competition
A competitive industry will produce in the long run where market demand = market supply. Consider the diagrams below. Equilibrium output and price is at Q1 and Pcomp on the left hand diagram and Pcomp and Q1 on the right hand diagram. At this point, Price = MC and the industry meets the conditions for allocative efficiency.
Comparison between Monopoly and Perfect Competition
Comparison between Monopoly and Perfect Competition

If the industry is taken over by a monopolist the profit-maximising point (MC=MR) is at price Pmon and output Q2. The monopolist is able to charge a higher price restrict total output and thereby reduce economic welfare. The rise in price to Pmon reduces consumer surplus. Some of this reduction in consumer welfare is a pure transfer to the producer through higher profits, but some of the loss is not reassigned to any other economic agent. This is known as the deadweight welfare loss and is equal to the area ABC.
deadweight welfare loss
deadweight welfare loss

A similar result is seen in the next diagram which makes the working assumption of constant long run average and marginal costs under both competition and monopoly. The deadweight loss of economic welfare under monopoly (whose profit maximising price is P1 and Q1) is shown by the triangle ABC. The competitive price and output is Pc and Qc respectively.
iagram which makes the working assumption of constant long runaverage and marginal costs under both competition and monopoly.
iagram which makes the working assumption of constant long runaverage and marginal costs under both competition and monopoly.

Potential Benefits from Monopoly
A high market concentration (fewness of sellers) does not always signal the absence of competition; sometimes it can reflect the success of leading firms in providing better quality products, more efficiently, than their smaller rivals
It is important in essays and data questions when you are analyzing imperfectly competitive markets where the concentration ratio is high to mention some of the potential advantages of suppliers having monopoly power.
One difficulty in assessing the welfare consequences of monopoly, duopoly or oligopoly lies in defining precisely what a market actually constitutes! In nearly every industry the market is segmented into different products, and the impact of globalisation makes it difficult to gauge the true degree of monopoly power that might exist in an industry at any moment in time. Increasingly markets where a monopoly appears to exist are actually becoming more contestable because of the effects of growing international competition.
So what are the main advantages of a market dominated by a few sellers?
Economies of Scale
A monopolist might be better positioned to exploit economies of scale leasing to an equilibrium which gives a higher output and a lower price than under competitive conditions. This is illustrated in the next diagram, where we assume that the monopolist is able to drive marginal costs lower in the long run, finding an equilibrium output of Q2 and pricing below the competitive price.
Economies of Scale
Economies of Scale

Monopoly Profits, Research and Development and Dynamic Efficiency
As firms are able to earn abnormal profits in the long run there may be a faster rate of technological development that will reduce costs and produce better quality products for consumers. This is because the monopolist will invest profits into research and development to promote dynamic efficiency.
Monopoly power can be good for innovation, according to research by Professor Federico Etro, published in the April 2004 edition of the Economic Journal. Despite the fact that the market leadership of firms like Microsoft is often criticised, their investments in research and development (R&D) can be beneficial to society because they expand the technological frontier and open new ways to prosperity. Many technological innovations are developed by firms with patents on the leading-edge technologies. These firms perpetuate their leadership and their market power through innovations. Etro's research argues that providing that a market is characterised by free entry, then the market leader will actually have more incentives than any other firm to invest in R&D.
Baumol – Oligopoly and Innovation
William Baumol an economist from Princeton University in the USA published a book in 2002 “The Free Market Innovation Machine” in which he analysed the conditions best suited for markets and countries to achieve a faster pace of innovation. Baumol argues that the structure that fosters productive innovation best is oligopoly. The Baumol hypothesis is that oligopolists compete by making their products differ slightly from their rivals. Highly innovative firms are often quick to license new technology or to become members of technology-sharing consortia.
Natural Monopoly
A natural monopoly occurs in an industry where LRAC falls over a wide range of output levels such that there may be room only for one supplier to fully exploit all of the internal economies of scale, reach the minimum efficient scale and therefore achieve productive efficiency.
The major utilities such as gas, electricity and water are often put forward as examples of industries with strong "natural tendencies" towards being a natural monopoly in part because of the huge fixed costs of building and maintaining nationwide networks** of cables and pipes. In fact we can make an important distinction between the supply and distribution of services such as gas and electricity. The retail market for the supply of gas and electricity to homes and businesses is also fully competitive. However, the businesses which transport gas and electricity to the final consumer are closer to being natural monopolies. The industry regulator Ofgem regulates these companies through price controls and monitoring of quality of service.
The natural monopoly through the exploitation of economies of scale can in theory undercut any actual or potential rivals purely on the grounds of cost. If the monopolist loses market share (for example by the competition authorities acting to split up an existing monopoly) there is the risk that smaller-scale suppliers will produce at higher average total cost which would represent a waste of scarce resources. Forcing such a company to price at marginal cost would also inflict inevitable losses and threaten the long term financial viability of the supplier.
Natural Monopoly
Natural Monopoly

natural monopoly

A natural monopoly exists when there is great scope for economies of scale to be exploited over a very large range of output. Indeed the scale of production that achieves productive efficiency may be a high percentage of the total market demand for the product in the industry.

external image natural_monopoly1.gif

Natural monopolies tend to be associated with industries where there is a high ratio of fixed to variable costs. For example, the fixed costs of establishing a national distribution network for a product might be enormous, but the marginal (variable) cost of supplying extra units of output may be very small. In this case, the average total cost will continue to decline as the scale of production increase, because fixed (or overhead) costs are being spread over higher and higher levels of output
The telecommunications industry has in the past been considered to be a natural monopoly. Like railways and water provision, the existence of several companies supplying the same area would result in an inefficient multiplication of cables, transformers, pipelines etc. However the perception of what constitutes a natural monopoly is now changing - in part because of the impact of new technology in reducing traditional barriers to entry within markets.
In the case of the telecommunications industry in the UK, British Telecom has faced increasing levels of competition from new telecommunications service providers during the 1990s - not least the rapid expansion of mobile and cable services. This has led to a change in the role of the industry regulator (OFTEL). Its main role now is not necessarily the introduction of even more competition into the telecommunications industry - but a policing role to ensure fair competition between service providers.
In the United States, the debate continues to rage over whether Microsoft can be considered a natural monopoly!

A "natural monopoly" is defined in economics as an industry where the fixed cost of the capital goods is so high that it is not profitable for a second firm to enter and compete. There is a "natural" reason for this industry being a monopoly, namely that the economies of scale require one, rather than several, firms. Small-scale ownership would be less efficient.
Natural monopolies are typically utilities such as water, electricity, and natural gas. It would be very costly to build a second set of water and sewerage pipes in a city. Water and gas delivery service has a high fixed cost and a low variable cost. Electricity is now being deregulated, so the generators of electric power can now compete. But the infrastructure, the wires that carry the electricity, usually remain a natural monopoly, and the various companies send their electricity through the same grid.
To prevent utilities from exploiting their monopolies with high prices, they are regulated by government. Typically, they are allowed a fixed percentage of profit above cost. But this type of regulation can lead to inefficient high costs, since the monopoly is guaranteed a profit. Economists call this a "lazy monopoly." To get around this problem, some municipalities and government districts own the local utility and provide the service at cost. Another way to handle the natural monopoly is to periodically put the delivery service up for bidding, with the lowest cost firm getting the contract.

Equality and Equity

Equality is when people are treated equally and have the same outcome.

Equity means justice or fairness. This may require differential treatmrnt to gain a more equal outcome. Equity is also concerned with equality of opportunity.

Horizontal equity requires equals are treated equally eg people in the same income group should be taxed at the same rate.

Vertical equity requires unequal treatment of unequals to promote greater fairness eg higher income groups taxed at higher rates.

Income Distribution

In economics, income distribution is how a nation’s total economy is distributed amongst its population .Income distribution has always been a central concern of economic theory and economic policy. Classical economists such as Adam Smith, Thomas Malthus and David Ricardo were mainly concerned with factor income distribution, that is, the distribution of income between the main factors of production, land, labour and capital.

Good article by an nz economist:

Personal income distribution

Total income, 2006
Total income, 2006

external image res-icon-image.gif Total income, 2006
Shares of income by decile, 1951–2006
Shares of income by decile, 1951–2006

external image res-icon-image.gif Shares of income by decile, 1951–2006
Woman road marker
Woman road marker

external image res-icon-image.gif Woman road marker
How rich or poor is your household?
How rich or poor is your household?

external image res-icon-image.gif How rich or poor is your household?
Income equality in the OECD countries (1st of 2)
Income equality in the OECD countries (1st of 2)

external image res-icon-image.gif Income equality in the OECD countries (1st of 2)

2006 census data

In the 2006 census – as in other censuses since 1981 – New Zealanders aged 15 and over were asked to provide information on their personal income. This was their total income before tax – their market income plus social security benefits and pensions.
In 2006 the distribution of income among individuals had a similar pattern to that in previous census years. The greatest number of the adult population were in the $10,000 to $15,000 per annum range. Many in this category would be on New Zealand superannuation or a social security benefit. The unemployment benefit in that year was $8,800.
There were a few people with losses of income (typically self-employed and investors) and some (such as students or stay-at-home mothers) had zero or very low incomes. One-tenth adults made less than $280. The bottom half of the population had only about a sixth of the total income.
There were also people with very high incomes (the top tenth had incomes of over $64,800). Over half of the country’s personal income went to the top fifth of the adult population. The average (or mean) income was $32,500, but the median (the middle income, with half the adult population above this figure and half below) was only $24,500.

Changes in income distribution


From 1951, census statistics for personal incomes included Māori. From 1951 to 1981, personal income distribution became increasingly equal. The share of the top tenth of the adult population fell from 38.5% in 1951 to 34.9% in 1981. One reason was that immediately after the Second World War a large proportion of women did not earn income. As they entered the workforce – initially part-time for many, but increasingly full-time – those with zero incomes in the past began to report market incomes.
However, income distribution was also getting narrower. This was probably partly because the rising labour-market share of earnings reduced the relative incomes of capitalists, and because margins for skill (the difference in income between skilled and unskilled workers) was decreasing.

Since 1981

After 1981 social security benefits and pensions were included in the statistics. The distribution of income continued to become more equal until the mid-1980s, but reversed after that. The earnings of capital rose, and margins for skill began to increase (especially at the top end of the market for managerial and professional occupations). By the 1980s and 1990s most women were already in the paid workforce, so there was no further reduction in those without incomes. The 1991 cuts in many social security benefits reinforced the increasing inequality.
After 1996 the distribution did not change radically, although in the early 2000s there was some evidence of a slight reduction in the inequality in personal income distribution – probably as people who had been out of work entered the workforce.

International comparison

It is notoriously difficult to compare income distributions across countries, but OECD data suggest that New Zealand has become comparatively less equal over time. In the mid-1980s New Zealand’s income distribution was more egalitarian than the OECD average, but by the mid-1990s it was considerably less equal than the OECD average. Since 2000 there has been a slight narrowing of the difference.
In terms of poverty rates in 2004 New Zealand was in the middle of the OECD.

The distribution of wealth is a comparison of the wealth of various members or groups in a society. It differs from the distribution of income in that it looks at the distribution of ownership of the assets in a society, rather than then current income of members of that society.

* Remember wealth is a stock e.g. assets, investments, property, resources that you own at a point in time. Where income is a flow received over time.

Lorenz Curves and Gini Coefficients

Lorenz curves are an effective way of showing inequality of income within and between countries. The cumulative percentage of population is plotted along the horizontal axis whilst the cumulative percentage of income is plotted along the vertical axis. The curve shows the actual relationship between the percentage of income recipients and the percentage of income that they did in fact actually receive.
The 45 degree line shows the situation when there is a even distribution of income i.e. 20% of the population earns 20% of the income and 50% of the households earn 50% of the income and so on. This is called the line of absolute equality.

external image lorenz_curve.jpg
external image gini.gif

The closer the Lorenz curve of a country is to the 45-degree line the more equal the distribution of income is. In the case of the Lorenz curve in the diagram above 20% of the population earns 5% of the income and 50% of the population earns 20% of the income. The more the Lorenz curve bends away from the 45-degree line of absolute equality, the less equal is the distribution of income. In reality no country exhibits a totally equitable distribution of income.
The ratio between the areas A and B (B being the whole triangle under the line of absolute equality) is called the Gini Coefficient. If a country had a completely even distribution of income the areas A and B would be the same and the Gini Coefficient would be zero. If the income were distributed so unevenly that one person had 100% of all the countries income and the rest of the population had nothing the Gini Coefficient in this case would be one.

The closer the Gini Coefficient to one the greater the inequality of income distribution. Countries with Gini Coefficients between 0.5 and 0.7 are regarded as having unequal income distributions whilst countries having Gini Coefficients between 0.2 and 0.35 are considered to have relatively equitable.
One use of Gini coefficient is to examine how the distribution of income varies between sectors of the population. In Zambia the Gini Coefficient differs between the rural and urban populations. The table below shows that the distribution of income in rural areas is more unequal than urban areas.
Gini Coefficient
It can also be used to indicate how the distribution of income has changed within a country over a period of time.

Whilst level of GDP per capita is a measure of economic growth one should also keep an eye on the Gini Coefficient. A country showing evidence of economic growth, but with an increasing Gini Coefficient, means that income is becoming less evenly distributed indicating that development and poverty are not necessarily improving.

area ratio
area ratio

Lorenz curves
Lorenz curves

The further away the curve is away from the 45 degree line of absolute equality the more unequal the distribution of income is.


New Zealand’s Tax system

You must pay tax if you stay in New Zealand for more than 6 months (183 days ) in any 12-month period, even if you’re a student. Employers will deduct PAYE (pay as you earn) tax from your wages or salary.

NZ has a progressive tax system. A progressive tax is a tax by which the tax rate increases as the taxable base amount increases. "Progressive" describes a distribution effect on income or expenditure, referring to the way the rate progresses from low to high, where the average tax rate is less than the marginal tax rate. It can be applied to individual taxes or to a tax system as a whole; a year, multi-year, or lifetime. Progressive taxes attempt to reduce the tax incidence of people with a lower ability-to-pay, as they shift the incidence increasingly to those with a higher ability-to-pay.

The financial year

The financial year runs from 1 April to 31 March. Tax is payable by 7 February, or 7 March if an accountant or tax agent helps you with your tax return.

Tax rates

Income tax varies dependent on income levels in any specific tax year (personal tax years run from 1 April to 31 March).


Tax rate
$0 - $14,000
$14,001 - $48,000
$48,001 - $70,000
Over $70,000
No-notification rate
Rates are for the tax year 1 April 2009 to 31 March 2010, and are based on tax code M (primary income without student loan).
In New Zealand, the income is taxed by the amount that falls within each tax bracket. For example, if a person earns $70,000, they will only pay 33% on the amount that falls between $48,001 and $70,000 rather than paying this on the full $70,000. Consequently, the corresponding income tax for that specific income will accumulate to $16,150 or about 23% of the entire amount.

New Rates from October 2010

On 20 May 2010 the Government announced new income tax rates that will come into effect on 1 October 2010. The new lower tax rates aim to stimulate productivity in the economy and mean that people earning the average wage in New Zealand will soon pay lower effective tax rates than people in Australia and the United Kingdom, easing concerns about economic emigration.
Tax rate
$0 - $14,000
$14,001 - $48,000
$48,001 - $70,000
Over $70,000
No-notification rate

Tax credits

The amount of tax actually payable can be reduced by claiming tax credits, e.g. for donations, childcare and housekeeper, independent earners, payroll donations, income under $9,880, and children, through working for families.

Tax deducted at source

In most cases employers deduct the relevant amount of income tax from salary and wages prior to these being paid to the individual. This system, known as Pay-as-you-earn, or PAYE, was introduced in 1958, prior to which employees paid tax annually.
In addition, banks and other financial institutions deduct the relevant amount of income tax on interest and dividends as these are earned. This is known as Residents Withholding Tax.
At the end of each tax year individuals who may not have paid the correct amount of income tax are required to submit a personal tax summary[10[[|]]], to allow the IRD to calculate any under or overpayment of tax made during the year.

Taxes can be structured equitably.

Horizontal equity is achieved where those on the same income are taxed the same amount.

Vertical tax equity relates to the taxpayers ability to pay e.g. higher income earners are able to pay higher tax.

for example (US)