Role of Government in Market

This content is meant for the students of MBS Managerial Economics of Far Western University

1. ROLEOFGOVERNMENT INMARKET
BY: KHEMRAJSUBEDI
ASSOCIATEPROFESSOR
For Managerial Economics
Far Western University Nepal
MBS

2. 6.1 Concept and sources of market failure,
6.2 Government response to market failure; natural monopoly
regulation, antitrust policy, patent system, operating control,
subsidy and tax policy regulation, regulation of environmental
pollution.

3. INTRODUCTION
Inthepast,theroleofthegovernmentwasthoughttobelimitedin
maintaininglawandorder,andprovidingnationaldefence.Butin
themodernage,theroleofgovernmentisincreasingandthe
government'srules,regulationandpolicieshaveinfluenceson
industries,firmsandconsumers.Therefore,itisimportantfor
managerstobesufficientlyfamiliarwiththebusinesslawsand
regulationstoknowwhentoseeklegalhelpintheconductoftheir
businessandtobeabletorecognizewhencompetitorsareharming
thefirmthroughillegalbusinesspractices.

4. ROLEOFGOVERNMENT INTHEECONOMY
Thegovernmentisplayingimportantroleinalltypesofeconomic
systems.Thegovernmenthasbeenprovidingthefacilitieslike
education,health,peaceandsecurity,waterandelectricitysupply,
transportandcommunication,andsoon.Therolesofgovernment
areexplainedbrieflybelow:
1.Roleofgovernmentinthemarketeconomy
2.Roleofgovernmentinthesocialisteconomy
3.Roleofgovernmentinthemixedeconomy

5. TYPESOFGOVERNMENT ROLE
1.Regulatoryrole:Regulatoryroleofthegovernmentincludes
alldirectandindirectpolicymeasureswhichthegovernment
employsfromtimetotimetocontrolandregulatetheprivate
sector'seconomicactivities.
2.Promotionalrole:Promotionalroleofthegovernment
includesalltheactivitiesthatareundertakenandallthe
policiesthatareadoptedtobuilduptheinfrastructure(i.e.
economicandsocialoverheadcapital)necessaryforoverall
developmentofthecountry.

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

7. MARKETANDEFFICIENCY
CONT.
1.Productiveefficiency
Thisoccurswhenoutputis
producedatthelowestpossible
costandoccurswheremarginal
cost(MC)equalstoaveragecost
(AC).Thisisachievedonlyinthe
perfectcompetitioninthelong
run.In the imperfect
competition,itisimpossibleto
achieveproductiveefficiency
becausethefirmsdonotproduce
atthebottomoftheaveragecost
curve.Thisisshowinthe
Figure6-1:
Figure 6-1: Productive Efficiency
O
Y
Quantity of Output
Price, Cost and Revenue
X
P
Q
LMC
LAC
E
MR = AR
Productive
Efficiency (MC = AC)

8. MARKETANDEFFICIENCY
CONT.
2.X-efficiency
Thisisachievedwhenaverage
costandmarginalcostareaslow
aspossible.Thisisusually
occursundertheconditionof
perfectcompetition,wherethe
forcesofcompetitionwilldrive
downcosts.Thisconceptisshow
intheFigure6-2.
Figure 6-2: X-Efficiency
O
Y
Quantity of Output
Price, Cost and Revenue
X
AC
3
AC
2
AC
1

9. MARKETANDEFFICIENCY
CONT.
3.Allocativeefficiency
Allocativeefficiencyisconcerned
withthehowmuchquantityis
produced.Allocativeefficiencyis
achievedwhenmarginalutilityof
thegoodequalstothemarginal
cost,i.e.MU=MC.Thefirms
operating under imperfect
competitiondonotachieve
allocativeefficiencybecausethey
produceoutputlevelwhereprice
ishigherthanmarginalcost,i.e.
P>MC.Thisconceptcanbe
explainedbythehelpofFigure
6-3.
Figure 6-3: Allocative Efficiency
O
Y
Quantity of Output
Price, Cost and Revenue
X
Q
1
P
Q Q
2
D
D (MU)
S (MC)
S
E
Loss of Welfare
(Deadweight loss)

10. EFFECTSOFGOVERNMENT POLICYIN
MARKETEQUILIBRIUM ANDMARKETEFFICIENCY
Theeffectofgovernmentpoliciesinmarketequilibriumandmarket
efficienciescanbeexplainedasfollows:
1.EffectofTaxPolicyinMarketEquilibriumandEfficiency
Basically,therearetwotypesoftaxes:directtaxesandindirect
taxes.Directtaxesareimposedontheincomeandwealthwhere
asindirecttaxesareimposedongoodsandservices.Here,wewill
studytheeffectofindirecttaxes(e.g.valueaddedtax,excise
duty,salestax,etc.)onmarketequilibriumandefficiency.When
taxesareleviedongoodsandservices,ithasthesameeconomic
effectsasincreaseincostofproduction.Theindirecttaxwill
causefallinsupply.

11. EFFECTOFTAXPOLICYINMARKETEQUILIBRIUM AND
EFFICIENCYCONT.
Consequently,therewillbechange
inmarket equilibriumand
efficiency.Thisconceptcanbe
clearlyexplainedbythehelpof
Figure6-4.
Figure 6-4: Effect of Tax Policy
P
O
Y
Quantity of Output
Price
X
Q
P
1
Q
1
D
D
S
1
S
1
S
S
E
1
E
a
b
A
B
Tax
DWL

12. EFFECTOFTAXPOLICYINMARKETEQUILIBRIUM AND
EFFICIENCYCONT.
Consequently,therewillbechange
inmarket equilibriumand
efficiency.Thisconceptcanbe
clearlyexplainedbythehelpof
Figure6-4.
Figure 6-4: Effect of Tax Policy
P
O
Y
Quantity of Output
Price
X
Q
P
1
Q
1
D
D
S
1
S
1
S
S
E
1
E
a
b
A
B
Tax
DWL

13. EFFECTSOFGOVERNMENT POLICYIN
MARKETEQUILIBRIUM ANDMARKET
EFFICIENCY CONT.
2.EffectofSubsidyPolicyinMarketEquilibriumand
Efficiency
Subsidesmayberegardedasthenegativetaxes.Subsidiesare
providedbythegovernmenttotheproducersandconsumersinorder
toencourageproductionandconsumptionofthegoodsandservices
whichhavepositiveexternalitiesorwhichareunderproducedbythe
market.
Products,suchashealthcareandeducationareunder-producedby
thefreemarket.Subsidiesreducemarketpriceandhelptocorrect
marketinefficiencycreatedbypositiveexternalities.Inotherwords,
subsidieshelptoenhancemarketefficiency.

14. EFFECTOFTAXPOLICYINMARKETEQUILIBRIUM AND
EFFICIENCYCONT.
Theeffectofsubsidiescanbeshown
thehelpofFigure6-5.
Figure 6-5: Effects of Subsidies
P
1
O
Y
Quantity of Output
Price
X
Q
1
P
Q
D
D
S
S
S
1
S
1
E
E
1
a
b
Subsidies

15. EFFECTSOFGOVERNMENT POLICYIN
MARKETEQUILIBRIUM ANDMARKET
EFFICIENCY CONT.
3.EffectofPriceControlPolicyinMarket
EquilibriumandEfficiency
Pricecontrolpolicyisthegovernmentrestrictiononprices
ofgoodsandservicesinthemarket.Thepricecontrol
policieshaveadverseeffectsinthemarket.Thedifferent
typesofpricecontrolpoliciesandtheireffectsarediscuss
below:

16. EFFECTOFTAXPOLICYINMARKETEQUILIBRIUM AND
EFFICIENCYCONT.
i.Priceceiling(Maximum
price):Priceceilingisthe
maximumpricefixedbythe
governmentforaparticular
productproducedbythefirms.
TheFigure6-6showsthe
effectofintroducingceiling
price.
Figure 6-6: Effect of Price Ceiling
O
Y
Quantity of Output
Price, Cost and Revenue
X
Q
1
P
Q Q
2
D
D
S
S
E
Price
Ceiling
Shortage
A B
P
1

17. EFFECTOFTAXPOLICYINMARKETEQUILIBRIUM AND
EFFICIENCYCONT.
ii.Pricefloor(Minimumprice):
Ifthepriceissetabovethe
equilibriumprice,itisknown
asthepricefloor.Itisalso
knownastheminimumprice.
Themainobjectiveofsetting
priceflooristoprotectsmall
producers,raisewages,and
reducestheconsumptionof
harmfulgoods.TheFigure6-7
showstheeffectofsettingfloor
price.
Figure 6-7: Effect of Price Floor
O
Y
Quantity of Output
Price, Cost and Revenue
X
Q
1
P
Q Q
2
D
D
S
S
E
Price
Floor
Surplus
A B
P
1

18. EFFECTOFTAXPOLICYINMARKETEQUILIBRIUM AND
EFFICIENCYCONT.
iii.Bufferstock:Ifpriceisset
betweentheupperandlower
boundaries,itisknownasthe
bufferstock.Itmakesuseofboth
minimumandmaximumprices.
Ifthemarketpricestartstomove
outsidetheupperandlower
boundaries,thegovernmentwill
intervene.Such kind of
governmentinterferencecreates
marketinefficiency.Theconcept
ofbufferstockcanbeexplained
bythehelpofFigure6-8.
Figure 6-8: Effect of Buffer Stock
O
Y
Quantity of Output
Price, Cost and Revenue
X
P
Q
D
D
S
S
E
Upper
Boundary
P
2
Lower
Boundary
P
1

19. MARKETFAILURE
Marketfailureisdefinedasthesituationofallocativeinefficiency.It
ariseswhenthefreemarketforcesofdemandandsupplyfailto
producethequantitiesofgoodsandservicespeoplewantatprices
whichreflecttheirmarginalcostandbenefits.Themajorcausesof
marketfailureareexistenceofmarketpower,publicgoods,
incompleteinformationandexternalities.

20. SOURCES OFMARKETFAILURE
Therearevarioussourcesorcausesofmarketfailure.Amongthem,
themostcommonsourcesofmarketfailureareasfollows:
1.Market Power
2.Incomplete Information
3.Externalities
4.Public Goods

21. SOURCES OFMARKETFAILURECONT.
1.MarketPower
Marketpowerisdefinedasthedegreeofcontrolthatafirmoragroupoffirms
hasoverthepriceandproductiondecisioninanindustry.Intheperfectly
competitivemarket,thereisnomarketpowerbutinthemonopoly,thereis
highdegreeofmarketpower.Thefirmsunderoligopolyandmonopolistic
competitionalsoenjoymarketpowerbutinthesmallextent.Itmeansthe
monopolyhaspowertosetthepriceinthemarketwhereasfirmunderperfect
competitiondoesnothavepowertosetpriceoftheirproduct.
MarketPowerandDeadweightLoss
Themarketfailurearisingduetomarketpowercanbeunderstoodthroughan
economicconceptknownasdeadweightloss.Deadweightlossreferstotheloss
ofeconomicwelfareduetothefactthatpotentiallydesirableproductionand
consumptiondonottakeplace.Economicwelfareisthesumofproducersurplus
andconsumersurplus.

22. SOURCES OFMARKETFAILURE
CONT.
Theconceptofdeadweightlosscan
beclearlyunderstoodbythehelpof
Figure6-9.
Figure 6-9: Deadweight Loss
P
1
O
Y
Quantity of Output
Price, Cost and Revenue
X
Q
1
AR (D)
P
2
S = MCB
E
2
E
1
Q
2
C
MR
Deadweight loss
A

23. SOURCES OFMARKETFAILURECONT.
2.IncompleteInformation
Incompleteinformationisasourceorcauseofmarketfailurewhich
occurswhenpeoplecannotmaximizetheirsatisfactionduepooror
lackofcompleteinformationaboutthethingstheyarebuyingor
selling.Marketworksbestwheneveryoneiswellinformedorhas
completeinformation.Thesituationofincompleteinformationis
alsoknownastheinformationasymmetryorinformationfailure.

24. SOURCES OFMARKETFAILURECONT.
Basically, there are two situations which cause incomplete information:
Firstly, incomplete information exists when some or all of the
participants in an economic exchange do not have perfect knowledge.
Secondly, incomplete information exists when one participant in an
economic has better information than other. This situation is also
known as the asymmetric or unbalanced information.
Inthesebothsituation,thereisinefficientallocationofresources,which
causesmarketfailure.Completeinformationisimpossibleinthe
imperfectmarkets.Itispossibleonlyintheperfectlycompetitivemarket
becauseitisbasedontheassumptionofperfectmarketinformationto
bothbuyersandsellers.

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

26. SOURCES OFMARKETFAILURECONT.
3.Externalities
Anexternalityisdefinedasacostorbenefittothird
parties,i.e.tothosenotdirectlyinvolvedintheproduction
orconsumptionofthegoodsandservices.
Theyarealsoknownasthethirdpartyeffectsand
sometimesneighbourhoodeffects,becausepartiesother
thanprimaryparticipantsinthetransaction(the
consumersandproducers)areaffected.Externalitiesare
theimportantsourcesorcausesofmarketfailure.

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

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

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

30. SOURCES OFMARKETFAILURECONT.
1.Overproduction causedby
NegativeExternalities:
Theexistenceofnegative
externalities causes
overproductionofgoodsand
services.Thisconceptcanbe
explainedbythehelpofFigure
6-10.
Figure 6-10: Overproduction caused by Negative
Externalities
P
1
O
Y
Quantity of Output
Price
X
Q
1
P
2
Q
2
D
D
S
1
S
1
S
S
E
2
E
1

31. SOURCES OFMARKETFAILURECONT.
2.Underproduction causedby
PositiveExternalities:
Theexistenceofpositive
externalitiesalsocausesmarket
failure.Duetoexistenceof
positiveexternalities,therewill
beunderproductionofgoods
andservices.Thisconceptcan
beexplainedbythehelpof
Figure6-11.
Figure 6-11: Underproduction caused by Positive
Externalities
P
2
O
Y
Quantity of Output
Price
X
Q
2
P
1
Q
1
D
D
S
S
S
1
S
1
E
1
E
2

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

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

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

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

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

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

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

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

40. TYPESOFGOVERNMENT RESPONSE TOMARKET
FAILURECONT.
Undertheperfectcompetition,afirmsetspriceofitsproductequaltomarginal
cost(MC).Atthissituation,therewillbeeconomicefficiency.Butunderthe
monopoly,thereisunderproductionorthemonopolyfirmproduceslessthan
sociallydesirableoutputandsetspricehigherthanmarginalcostofproduction
(P>MC).
Governmentuseseitherofthefollowingtwomethodsinordertocorrectmarket
failurecausedbymonopolypower:
Settingpriceequaltomarginalcost.
Settingthepriceequaltoaveragecost

41. TYPESOFGOVERNMENT RESPONSE TO
MARKETFAILURECONT.
Themethodofmonopolyregulation
canbeexplainedbythehelpof
Figure6-12.
Figure 6-12: Monopoly Regulation
P
1
O
Y
Quantity of Output
Price, Cost and Revenue
X
Q
1
P
2
Q
2
MC
AC
E
1
E
AR (D)
MR

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

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

44. TYPESOFGOVERNMENT RESPONSE TOMARKET
FAILURECONT.
Accordingtoantitrustlaw,followingpracticesareillegal:
Monopoliesorattempttomonopolise
Useofunfairmethodofcompetition
Engageinparticularformofpricediscrimination
Degradationofqualityofproducts
Enteracontracttorestraintatrade
Enterexclusiveandtyingcontracts,i.e.makingbuyers
purchasingotheritemtogettheproducttheywant.

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

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

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

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

49. TYPESOFGOVERNMENT RESPONSE TOMARKET
FAILURECONT.
1.PatentSystem
Patentrightisdefinedasanexclusiverighttoproduce,useorsell
aninventionorinnovationforalimitedperiodoftime.
Nepal'slawhasalsograntedprotectionofpatentforit'sexclusive
rightsforaperiodof7years.
Hence,patentistherighttotheinventortobuild,useandtransfer
orkeephis/herinventionwithhimself/herself.Patentsystem
promotesinventionprovidingtemporarybutlegalmonopolytothe
inventors.

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

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

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

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

54. TYPESOFGOVERNMENT RESPONSE TOMARKET
FAILURECONT.
Subsidesareimplementedthroughavarietyoffinancial
techniques,suchas,directpaymentincashorkind,
governmentprovisionofgoodsandservicesatpricesbelow
thenormalmarketprice,governmentpurchaseofgoods
andservicesinexcesstothemarketprice,taxconcession
andsimilarinducements.

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

56. TYPESOFGOVERNMENT RESPONSE TOMARKET
FAILURECONT.
ProductionandConsumptionSubsidies
Productionsubsidyisthefinancialgrantofthegovernmenttothefirminorder
toencouragetheproductionofparticularcommodity.Itincludessubsideson
agriculturalloan,subsidiesonfertilizer,electricity,etc.Ontheotherhand,
consumptionsubsidyisthefinancialgrantofthegovernmenttotheconsumer
inordertoencouragetheconsumptionofaparticularcommodity.Itincludes
subsidesonfood,water,education,healthcare,etc.

57. PRODUCTION SUBSIDIES
Ifsubsidyonproductionisgiven,
productionwillincreaseand
equilibriumpricewilldecrease.This
canbeshownbythehelpofFigure
6-13.
Figure 6-13: Production Subsidy
P
1
O
Y
Quantity of Output
Price
X
Q
1
P
Q
D
D
S
S
S
1
S
1
E
E
1

58. CONSUMPTION SUBSIDY
Ontheotherhand,subsidieson
consumptionlikeeducation,health
care,etc.willincreasethedemand.
Thisconceptcanbeshownbythe
helpofFigure6-14.
Figure 6-14: Consumption Subsidy
P
1
O
Y
Quantity of Output
Price
X
Q
1
P
Q
D
D
S
S
E
E
1
D
1
D
1

59. TYPESOFGOVERNMENT RESPONSE TOMARKET
FAILURECONT.
4.TaxPolicy
Taxisdefinedasthecompulsorypaymentmadebypeopletothe
government.Itisthemajorsourcesofgovernmentrevenue.
Subsidypolicygivesfirmspositiveincentivefordesirable
performancewhereastaxpolicyislikepenaltyanditisdesigned
tolimitundesirableperformance.Governmentusestaxpolicyin
ordertodiscourageoverproductionofundesirablegoodsand
services.Taxpolicycanalsobeusedtocontroloverconsumptionof
harmfulgoodsandservices.

60. TAXPOLICY
TheindirecttaxeslikeVAT,sales
tax,customs,etc.reduceproduction
andconsumptionofgoodsand
services.ThisisshowninFigure6-
15.
Figure 6-15: Effect of Tax Policy
P
O
Y
Quantity of Output
Price
X
Q
P
1
Q
1
D
D
S
1
S
1
S
S
E
1
E

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

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

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

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

65. OPTIMUMLEVELOFPOLLUTIONCONTROL
TheFigure6-18showsthe
optimumlevelofpollutioncontrol.
Itshowsthatoptimumlevelof
pollutioncontrolisdeterminedfrom
theinteractionbetweenSMCand
PMC.
Figure 6-18: Optimum Level of Pollution Control
Q
E
C
Quantity of Pollutions
Emitted
Cost of Pollution Control
O
X
Y
E
PMC (Private
marginal cost)
SMC(Social
Marginal Cost)

66. TYPESOFGOVERNMENT RESPONSE TOMARKET
FAILURECONT.
MethodsofRegulatingEnvironmentalPollution
Governmentusesvariousmethodstocontrolenvironmental
pollution,whichareasfollows:
1.Directregulation
2.Pollutiontax
3.Issueoftransferableemissionspermits
4.Publicawareness
5.Regulationsthroughsubsidies

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

68. REGULATION OFINTERNATIONAL COMPETITION CONT.
Thenationalsocollectstariff
revenues.Thisconceptcanbe
explainedbythehelpofFigure6-
19.
Figure 6-19: The Effect of Import Tariff
Q
1
E
Q
2 Q
3 Q
4
Quantity of Output
Price
O
X
Y
P
1
P
2
DS (Domestic
Supply)
WS'
DD (Domestic
Demand)
WS
A
B C
D
t

69. REGULATION OFINTERNATIONAL COMPETITION
CONT.
ObjectivesofRegulationofInternationalCompetition
Themajorobjectivesregulatinginternationalcompetitionortrade
areasfollows:
Toincreasedomesticoutput.
Toincreaseemploymentopportunitieswithinthecountry.
Toincreaserevenueofthegovernment.
Todiscourageimportandencourageexport.
Topromotewell-beingofpeopleinthecountry.

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

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

72. PROBLEMS ANDEFFECTSOFREGULATION ON
EFFICIENCY
EffectsofRegulationonEfficiency
Themainobjectiveofgovernmentregulationistoovercometheproblemof
marketfailureandtopromoteeconomicefficiency.
Theregulatorybodyofthegovernmentmakeseffortstocontrolmarketpower
suchasmonopolybycreatingcompetitiveenvironmentthroughanti-trust
policy.Ifthispolicyisnotimplementedefficientlyandinthejustifiedmanner,
itmaycreatecartelinthemarketwhichchargeshigherpriceandrestrict
competition.
Taxesandsubsidiesaretheinstrumentsofgovernmentregulation.Taxesare
imposedtocorrectnegativeexternalities.
Theregulationsintheformofpatentrightsandoperatingcontrolsalsocause
economicinefficiency.Operatingcontrolmayleadtoeconomicinefficiencydue
topoorlydefinedregulationsandpatentrightmayalsoleadtoeconomic
inefficiencyduetocreationofmonopolyandbarrierstoentrynewfirms.

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

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

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

76. THEORYOFPUBLICCHOICECONT.
ParticipantsinthePoliticalSystem
Publicchoicetheoryexamineshowgovernmentdecisionsare
madeandimplementedbyanalyzingthebehaviouroffour
broadgroupsofparticipantsinthepoliticalsystem,whichare
asfollows:
1.Voters
2.Politicians
3.Specialinterestgroup
4.Bureaucrats

77. THEORYOFPUBLICCHOICECONT.
PolicyImplicationsofPublicChoiceTheory
Thecharacterizationofthepoliticalprocessbypublicchoice
theoristsissometimesviewedassuspicious.Manyvotersarewell
informedandunselfishintheirpoliticalbeliefs.Politiciansalso
sometimesrefusetocompromisebasicprinciplessimplyto
maximizechancesforconfirmation.Collectivelyimportantpublic
interestsprevailmoreoftenthanonemightexpect;powerful
special-interestgroupsaresometimesdefeated.Government
bureaucraciesareoftensupervisedbywell-intentionedand
committedpublicservants.

78. THEORYOFPUBLICCHOICECONT.
Nevertheless,thesecontradictionsdonotunderminethetheoryof
publicchoice.Althoughpublicpolicycanimprovetheeconomic
systeminthepresenceofmarketfailures,thepublicpolicy
processitselfissubjecttosystematicinfluencesthatcanleadto
governmentfailure.Thetheoryofpublicchoicecanbeusedto
suggestinstitutionalchangesthatcanleadtoimprovementsin
public-sectorperformance.Onemethodthatpublicchoicetheory
suggestsforimprovingpublic-sectorperformanceistosubject
governmentdepartmentsandorganizationstoprivate-market
competitionwheneverpossible.

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

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

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

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

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

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

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

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

87. Thank You