Rationale for intervening in the economy

Market failure, equity or opportunity?

Shane Vallance - SWRDA

Reminder - how to increase economic output

Simple production function:

Y = f(T, K, L)

Therefore, you can increase economic output by:

Improving stock of technology

Increase the level/quality of capital

Increase the supply/quality of labour

Essentially the areas where public/private intervention

(should) take place

If markets function properly (‘perfect competition’)

Firms – maximisation of profit acts as ‘perfect’ incentiveConsumers - optimisation of utility drives behaviour

Multiple, all knowing, non powerful actors

Perfect information – consumers and producers (eBay?)

Perfect entry & exit (no barriers to entry)

No market rigidities – markets quickly adjust

Unrestricted flow of factors of production

Market costs reflect total cost to society – no externalities

No Government intervention (it distorts the market) – Adam Smith’s

‘invisible hand’

‘The invisible hand’

Markets are (normally) the most effective mechanism to allocate resources

Producers have an incentive to produce for consumers through their willingness to pay (price) for a scarce resource

Consumers willingness to pay (price) will match the benefit that they will derive from that product

Producers will earn a profit that will act as an incentive to produce more

If they produce too much, the price will reduce because the resource has got less scarce

This will reduce profits, meaning less will be produced – making the resource less scarce, raising the price

and so on, and so on……

‘Just let the market get on with it’

1. Productivity/efficiency argument – the importance of price signal

2. Ideological argument – ‘crowding out’

Or,

3. Market failure (a tale of farmers and lumberjacks)

4. Equity argument

5. Opportunity?

The Productivity argument

Lack of price signal means the public sector is not as effective as the market in the allocation of resources (despite Government attempt in some services)

Lack of profit means there is an ‘incentive gap’

As a result, public sector productivity performance lags rest of economy (caveat – difficult to measure public sector productivity because often lack of output to be measured)

Recent history is tale of falling output and rising inputs

Implications for long-term resource efficiency – public sector too big, performance of economy suffers

The productivity argument – declining public sector productivity

Comparison of public sector productivity (% annual change)

-2

-1.5

-1

-0.5

0

0.5

1

1.5

2

Public sector productivity Whole economy productivity

The productivity argument – declining public sector productivity

Falling public sector productivity (% annual change)

0

1

2

3

4

5

6

7

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Public sector output Public sector input

The ideological argument

Based on same premise – that non-market actors are less efficient at allocating resources than market actors

You will use £1 of earnings more efficiently (maximising your utility) than if £1 were taxed and spent by Govt on your behalf

Leads to concept of ‘crowding out’ – usually refers to Govt spending using financial & other resources that would otherwise be used by private sector (firms & individuals)

Case 1 – Govt spend, Tax, Private consumption

Case 2 - Govt spend, Borrowing, Private investment

Case 3 - Govt spend, Wages, Private investment (a Keynesian would argue this would also Private consumption)

However, markets are not perfect

A tale of farmers and lumberjacks….

and that is economics…

it’s the allocation of resources to meet society’s (unlimited) needs as effectively as possible

Market Failure #1:

Lack of property rights

Intervention Type:

Fish Quotas, Public Realm

Market Failure #2:

Lack of (or imperfect) information

Intervention Type:

Overseas offices, Tourism Marketing

Market Failure #3:

Lack of price signal

Intervention Type:

Direct development (up to a point until price signal established)

Govt as the buyer?

Market Failure #4:

(Negative) Externalities – price of production does not reflect true value to society

A < B (over production)Intervention Type:

Taxation on airlines

A B

Market Failure #5:

(Negative) Externalities – cost of consumption does not reflect true value to society

C < B (over consumption)

Intervention Type:

Congestion charging, tax on petrol, cigarettes, air travel; etc.

A B

C

Market Failure #6:

(Positive) Externalities – private benefits of production do not reflect true value to society

D < B (under production)

Intervention Type:

Renewable Energy

A B

CD

So there are benefits to intervening to address market failures

However, should there be a role on the grounds of equity?

Depends on your (macro or micro) viewpoint

The Equity argument – the macro view

Remembering that in perfect (and non-perfect) markets firms will

seek to maximise profit – therefore will seek to reduce costs

& increase benefits

Costs - therefore move to lower cost bases (i.e. offshoring)

Benefits – close to greatest demand (i.e. commercial property)

This is just the market allocating resources efficiently

In the long-term those areas ‘left behind’ will adjust (land &

labour costs will ) and economic activity will be attracted

back

Therefore there is no role for public sector – questions

(competitive) economic development approach

The Equity argument – the micro view

This is not a perfect market and the ‘structural adjustment’ takes

a long time

During this time the social costs are such that there is an

argument for justification of public sector support

Unlikely any role in costs (unless we consider subsidies i.e. GBI

or indirect costs such as transport infrastructure)

However, role in benefits (improving skills, quality of R&D,

quality of environment etc.)

Therefore there is a role for public sector

The (lost) opportunity argument

Often held up as the argument for public sector intervention

Should there be a role for the public sector?

Linked to equity macro versus micro argument

Macro view is that if the opportunity was strong enough then

profit potential should act as incentive enough for market

provision

Micro view is that we would like that opportunity to be exploited

in a specific area – meeting equity and competitive advantage

needs

How to deal with opportunity cost (in a world of increasingly

scarce ‘public’ resources)?

Conclusion

Economics is allocation of scarce resources

Markets are the most effective way of allocating resources, price

signal is the oil in the engine

Even non-perfectly performing markets operate more efficiently

than public sector (or do they?)

Market failure justifies intervention to address imperfections

Are there grounds for intervention for equity purposes – depends

on viewpoint (short term versus long term argument)

Always will be an ideological argument about role of Government