Chapter 9: Market Power and Market Failure

Purpose of chapter – a detailed examination of how Pareto Optimality can be distorted in a market economy by Market Power and Market Failure.

Leads to Distortions between shares of the Social Endowment and Social Product of members of a society.

Market Power

Market Power – the process of exploiting an advantage to give an individual some control in the market.

-- Distributes a larger share of the social product (production) of the economy to the powerful. -- Makes the economy less efficient, producing less social product than under GCE.

Naturally Occurring Market Power

Naturally Occurring Market Power – market power resulting from either the consumer’s initial endowment (gifts, talents, attributes), or the natural competitive process of business.

Natural part of an economy.

Naturally Occurring Market Power in the Labor Market

Consider a labor market with a very high demand for a certain attribute.

Now consider individuals who have this attribute more than anyone else (and it doesn’t have to be a lot more).

The result – a large amount of market power for these individuals, and a very wage for them.

E.G. – Michael Jordan, Julia Roberts.

Naturally Occurring Market Power in Industry

Take an industry which undergoes great Economies of Scale – large purchases of physical capital, leading to a large region of downward sloping Average Cost (AC)

Significant increases in efficiency, lower average costs for high volume of production as a result.

Drives many other businesses out.Creates Barriers to Entry – difficult for other

businesses to enter to grab some of the positive economic profit.

The Extreme Case

Monopoly – industry characterized by one producer.

Producer has driven everyone else out through economies of scale, significant barriers to entry make it very difficult for firms to enter in.

Illegal in US (early 20th Century).

Naturally Occurring Market Power: Not Permanent

Consumers tend to lose attribute of being #1 in these highly competitive markets.

New technologies arise and produce superior products, bringing down original firms (e.g. IBM and Microsoft).

Artificially Occurring Market Power

Artificially Occurring Market Power – market power stemming from institutional restrictions or social perceptions.

“Most dangerous threat” to competitive economy (Adam Smith).

Can be long-term, not eroded naturally.

Rent-Seeking and Rent-Maintenance

Rent-Seeking – an attempt to seek market power by achieving an artificially created advantage.

Rent-Maintenance – an attempt to maintain market power by maintaining an artificially created advantage.

Application: Is this occurring through lobbying by special-interest groups in Congress?

Examples of Market Power

Key – protection or benefit of a segment of society at the expense of the competitive economy as a whole.

-- patents for inventors -- tariffs and trade restrictions -- laws to keep industries out of villages (e.g. Wal-Mart) -- discrimination (institutional laws and social perceptions)

Discrimination and Gender Pay Inequity

Consider two labor markets, with the same labor demand and requiring roughly equal human capital.

One is “man-sphere” jobs (MS).Other is “woman-sphere” jobs (WS).

Equilibrium wage in WS jobs (W*WS) < Equilibrium wage in MS jobs

(W*MS).

Discrimination and Gender Pay Inequity

No discrimination (institutional or social perception) migration from low-paying WS jobs to high-paying MS jobs.

Supply of labor decreases in WS market W*WS.

Supply of labor increases in MS market W*MS.

Continues until W*WS = W*MS.

Discrimination and Market Power

Discrimination – either prevents this adjustment from happening by law (institutional), or discourages it from happening (social perception).

Rent-Maintenance done by group imposing discrimination.

Market Failure

Market Failure – a market either doesn’t form when needed, or it doesn’t work smoothly and quickly to make necessary adjustments.

Market Failure and Public Goods

Public Good – a good which is non-partitionable (cannot be split up into pieces or degrees), and non-excludable (cannot exclude anyone from using it).

Examples – national defense, fire protection, police protection.

The Free Rider Problem

Free Rider Problem – since public goods are non-excludable, and non-partitionable, people can get full coverage for free. Therefore, everyone waits for someone else to pay for it. As a result, a market doesn’t form (market failure).

Market Failure and Externalities

Externality – when the actions of one economic unit (consumer, firm) affect another economic unit.

Positive Externality – affects in a positive way.

Negative Externality – affects in a negative way.

Externalities and (Lack of) Property Rights

Underlying reason for externalities – actions affect shared community resource where property rights can’t be assigned (e.g. air, water, environment).

Example – second-hand smoke from cigarettes.

Externalities – External Costs and Benefits

Negative Externality – imposes an external cost to society, due to spillover harm on other members.

Positive Externality – produces an external benefit to society, due to spillover benefit on other members.

Marginal Private Benefit and Marginal Private Cost

Marginal Private Benefit (MPB) – the benefit to an individual person of doing one more unit of an activity (similar to marginal utility).

Marginal Private Cost (MPC) – the cost to an individual person of doing one more unit of an activity (all economic costs).

Marginal Social Benefit and Marginal Social Cost

Marginal Social Benefit (MSB) – the benefit to society of the person doing one more unit of an activity (similar to marginal utility).

Marginal Social Cost (MSC) – the cost to society of the person doing one more unit of an activity (all economic costs).

Characteristics of MPB, MPC, MSB, and MSC

All are measured in dollars ($).MSB = MPB + EB, where EB are

External Benefits associated with a positive externality involving the action.

MSC = MPC + EC, where EC are External Costs associated with a negative externality involving the action.

Negative Externality – A Graphical Representation

Negative externality implies that External Costs > 0 and MSC > MPC.

MSC curve represented by an upward shift of the MPC curve.

Socially optimal level of activity (LS) < Privately optimal level of activity (LP).

Negative Externality – Conclusion

Inefficiency due to Market Failure.

Too much undesirable activity, shifts social costs to bystanders.

Positive Externality – A Graphical Representation

Positive externality implies that External Benefits > 0 and MSB > MPB.

MSB curve represented by an upward shift of the MPB curve.

Socially optimal level of activity (LS) > Privately optimal level of activity (LP).

Positive Externality – Conclusion

Inefficiency due to Market Failure.

Too little desirable activity.

Negative Externalities and Firms

Inherent problem in production.Examples -- acid rain and the environment. -- dumping chemicals in lakes, contaminating water supply -- noise pollution -- bars, adult places, and crime

Risk Externalities

Risk Externality – externality resulting from creating an unintended risk for innocent bystanders.

Example -- DWI.Technology to reduce incidence of

risk externality: breathalyzer/starter lock for car.

Market Power and Market Failure: The Next Step

Creates inefficiencies in society, deviation from GCE.

Very realistic and common.What can government do to remedy

these problems?When should government not try to

remedy these problems?Topic of next chapter.