Govt Intervention and Market Failure

8/3/2019 Govt Intervention and Market Failure

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TUTOR 2 U. NET

ECONOMICS

NOTES

GOVERNMENT

INTERVENTION

AND MARKET

FAILURE


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Market Failure- Introduction

An introduction to the idea of market failure, drawing on concepts first introduced at AS level.

What is market failure?

Market failure occurs when freely-functioning markets, fail to deliver an efficient allocation ofresources. The result is a loss of economic and social welfare. Market failure exists when the

competitive outcome of markets is not efficient from the point of view of society as a whole. This isusually because the benefits that the free-market confers on individuals or businesses carrying out aparticular activity diverge from the benefits to society as a whole.

There are many instances when the free market fails to deliver an efficient allocation of resources.

Markets can fail because of:

1. Negative externalities (e.g. the effects of environmental pollution) causing the social cost ofproduction to exceed the private cost.

2. Positive (or beneficial) externalities (e.g. the provision of education and health care) causingthe social benefit of consumption to exceed the private benefit

3. Imperfect information means merit goods are under-produced while demerit goods are over-produced or over-consumed

4. The private sector in a free-markets cannot profitably supply to consumers pure public goodsand quasi-public goods that are needed to meet peoples needs and wants

5. Market dominance by monopolies can lead to under-production and higher prices than wouldexist under conditions of competition

6. Factor immobility causes unemployment hence productive inefficiency

7. Equity (fairness) issues. Markets can generate an unacceptable distribution of income andconsequent social exclusion which the government may choose to change

Market failure results in

Productive inefficiency: Businesses are not maximising output from given factor inputs. This isa problem because the lost output from inefficient production could have been used to satisfymore wants and needs

Allocative inefficiency: Resources are misallocated and producing goods and services notwanted by consumers. This is a problem because resources can be put to a better use makingproducts that consumers value more highly

Options for government intervention in markets

There are many ways in which intervention can take place some examples are given below


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Government Legislation and Regulation

Parliament can pass laws that for example prohibit the sale of cigarettes to children, or ban smoking inthe workplace. The laws of competition policy act against examples of price-fixing cartels or otherforms of anti-competitive behaviour by firms within markets. Employment laws may offer some legalprotection for workers by setting maximum working hours or by providing a price-floor in the labourmarket through the setting of a minimum wage.

The economy operates with a huge amount of regulation. The government appointed regulators whocan impose price controls in most of the main utilities such as telecommunications, electricity, gas andrail transport.

Regulation may be used to introduce fresh competition into a market for example breaking up theexisting monopoly power of a service provider. A good example of this is the attempt to introduce morecompetition for British Telecom and also for the postal service industry. This is known as marketliberalisation.

Direct State Provision of Goods and Services

Because of privatization, the state-owned sector of the economy is now much smaller than it wastwenty years ago. The main state-owned businesses in the UK are the Royal Mail which is still subjectto direct price controls and Network Rail. State funding can be used to provide merit goods andservices and public goods directly to the population e.g. the government pays private sector healthfirms to carry out operations for NHS patients to reduce waiting lists or it pays private businesses to

operate prisons and maintain our road network.Fiscal Policy Intervention

Fiscal policy can be used to alter the level of demand for different products and also the pattern ofdemand within the economy.

1. Indirect taxes such as changes in VAT and excise duties can be used to raise the priceof demerit goods and products with negative externalities designed to increase theopportunity cost of consumption and thereby reduce consumer demand towards asocially optimal level.

2. Subsidies to consumers will lower the price of merit goods such as grants to students toreduce the internal costs of staying on in full-time education and subsidies tobusinesses employing unemployed workers on the New Deal programme. They aredesigned to boost consumption and output of products with positive externalities asubsidy causes an increase in market supply and leads to a lower equilibrium price (seethe separate revision focus article on producer subsidies).

3. Tax relief: The government may offer financial assistance such as tax credits forbusiness investment in research and development. Or a reduction in corporation taxdesigned to promote investment and employment.

4. Changes to taxation and welfare payments can be used to influence the distributionof income and wealth for example higher direct taxes on rich households or anincrease in the value of welfare benefits for the poor to make the tax and benefitsystem more progressive.

Intervention designed to close the information gap

Often market failure results from consumers suffering from a lack of information about the costs andbenefits of the products available in the market place. Government action can have a role in improvinginformation to help consumers and producers value the true cost and/or benefit of a good or service.

Examples might include:1. Compulsory labelling on cigarette packages with health warnings to reduce smoking.

2. Improved nutritional information on high-fat foods to counter the risks of growing obesity.

3. Anti-speeding television and cinema advertising to reduce road accidents.

4. Advertising health-screening programmes / information campaigns on the dangers of drug andalcohol addiction.

These programmes are really designed to change the perceived costs and benefits of consumptionfor the consumer. They dont have any direct effect on market prices, but they seek to influence
http://www.news.royalmailgroup.com/news/inthenews.asphttp://www.royalmailgroup.com/portal/rmg/content1;jsessionid=KRZ0K34U0ASUUFB2IGFEPLQUHRAYWQ2K?mediaId=23700548&catId=23200532http://www.networkrail.co.uk/http://www.jobcentreplus.gov.uk/JCP/Customers/New_Dealhttp://www.royalmailgroup.com/portal/rmg/content1;jsessionid=KRZ0K34U0ASUUFB2IGFEPLQUHRAYWQ2K?mediaId=23700548&catId=23200532http://www.networkrail.co.uk/http://www.jobcentreplus.gov.uk/JCP/Customers/New_Dealhttp://www.news.royalmailgroup.com/news/inthenews.asp


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demand and therefore the level of final output and consumption.

The effects of government intervention

Decisions on our future energy sources government policy intervention can have huge effects on boththe short term and the long term allocation of resources in the future

One important point to bear in mind is that the effects of different forms of government interventionin markets are never neutral since financial support given to one set of producers rather than anotherwill always create winners and losers. Taxing one product more than another will similarly havedifferent effects on different groups of consumers.

Judging the effects of intervention a useful check list

To help your evaluation of government intervention it may be helpful to consider these questions:

1. Efficiency of a policy: i.e. does a particular intervention lead to a better use of scarceresources among competing ends? E.g. does it improve allocative, productive and dynamicefficiency? For example - would introducing indirect taxes on high fat foods be an efficient wayof reducing some of the external costs linked to the growing problem of obesity?

2. Effectiveness of a policy: i.e. which government policy is most likely to meet a specificeconomic or social objective? For example which policies are likely to be most effective inreducing thescale of the UK road congestion problem? Which forms of intervention are mosteffective in improving the incentives of consumers to actively search for work in the labourmarket? Which policies are more effective in preventing firms from exploiting their monopolypower and damaging consumer welfare? Evaluation can also consider which policies are likelyto have an impact in the short term when a quick response from consumers and producers isdesired. And which policies are likely to prove most cost-effective in the longer term? Forexample, how best to encourage recyclingin the long run and also provide incentives toincrease the supply of energy in the long run that comes from renewable sources such as windpower.

3. Equity effects of intervention: i.e. is a policy thought of as fair or does one group in societygain more than another? For example it is equitable for the government to offer educationalmaintenance allowances for 16-18 year olds in low income households to stay on in educationafter GCSEs? Would it be equitable for the government to increase the top rate of income taxto 50 per cent in a bid to make the distribution of income more equal?

4. Sustainability of a policy: i.e. does a policy reduce the ability of future generations to engagein economic activity? Inter-generational equity is an important issue in many current policy
http://news.bbc.co.uk/1/hi/health/5051248.stmhttp://www.cfit.gov.uk/http://www.cfit.gov.uk/http://www.wastewatch.org.uk/http://www.wastewatch.org.uk/http://www.dti.gov.uk/energy/reviewhttp://www.res-ltd.com/http://www.res-ltd.com/http://www.dfes.gov.uk/financialhelp/emahttp://www.dfes.gov.uk/financialhelp/emahttp://news.bbc.co.uk/1/hi/health/5051248.stmhttp://www.cfit.gov.uk/http://www.wastewatch.org.uk/http://www.dti.gov.uk/energy/reviewhttp://www.res-ltd.com/http://www.res-ltd.com/http://www.dfes.gov.uk/financialhelp/emahttp://www.dfes.gov.uk/financialhelp/ema


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topics for example decisions on which sources of energy we choose to rely on in future years

Government Failure

Government intervention can sometimes fail to meet the desired outcomes, or can make existingpolicy problems worse. In this note we look at the idea of government failure.

The idea of government failure

Even with the best of intentions governments seldom get their policy application correct. They cantax, control and regulate but the eventual outcome may actually be a deepening of the market failureor even worse a new failure may arise which requires corrective action. Government failure mayrange from the trivial, when intervention is merely ineffective, but where harm is restricted to thecost of resources used up and wasted by the intervention, to cases where intervention produces newand more serious problems that did not exist before. The consequences of this can take many years toreverse.

Over the last fifty or sixty years, Western governments have intervened to try to improve the socialand economic life of their countries on a scale unimaginable to previous generations. Yet social andeconomic problems persist. Policies fail.Adapted from Why Most Things Fail, Paul Ormerod

Government failure in a non-market economy

The collapse of the Soviet Union in the late 1980s and early 1990s marked, for many people, the finalfailure of command or planned economies as a means of allocating resources among competing uses.The essence of a command economy was that the state-operated planning mechanism would decidewhat to produce and how to produce it and for whom to produce.

Government failure occurred when the central planners supplied products that were simply notwanted by consumers showing a loss of allocative efficiency, since there was no price mechanism tosignal changes in consumer preferences and demand. John Kays book The Truth about Markets hasexcellent sections on the basic fault-lines in the planning process. Another fundamental failing of thepure command economy was that there was little incentive for workers to raise productivity; fewincentives to prevent poor quality control; and little innovation by firms as no profit motive existed.

Command economies also suffered environmental de-gradation because they did not posses structuresfor valuing the environment and giving consumers and producers the right incentives to protect theirenvironmental heritage.

All of these economies are now moving towards the western mixed economy, though at varying speedsand with varying success. Eight former eastern Bloc countries joined the European Union in May 2004,some of them former state-run economies in the Eastern Bloc. Countries such as Hungary, the CzechRepublic and Poland are all moving towards a market based system for the allocation of resources forexample through programmes of privatisation and market liberalisation. Many of them have enjoyedfast rates of economic growth and a rise in relative living standards both before and since theiraccession to become members of the European Union.

Possible Causes of Government Failure

Government intervention can prove to be ineffective, inequitable and misplaced. There is a growingbody of research in the economics literature on this topic some of which uses highly mathematicaltechniques to analyse public policy-making. We will focus instead on the underlying reasons andconsider some topical examples along the way.

(a) Political self-interest

The pursuit of self-interest amongst politicians and civil servants can often lead to a misallocation ofscarce resources. For example decisions about where to build new roads, by-passes, schools andhospitals may be decided with at least one eye to the political consequences.

The pressures of a looming election or the influence exerted by special interest groups can create anenvironment in which inappropriate government spending and tax decisions are made. - e.g. boostingthe level of welfare spending in the run up to an election, or bringing forward major items of capitalspending on infrastructural projects without the projects being subjected to a full and proper cost-benefit analysis to determine the likely social costs and benefits. Critics of current government policytowards tobacco taxation and advertising, and the controversial issue ofgenetically modified foods
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argue that government departments are too sensitive to political lobbying from the majorcorporations.

(b) Policy myopia

Critics of government intervention in the economy argue that politicians have an in-built tendency tolook for short term solutions or quick fixes to difficult economic problems rather than makingconsidered analysis of long term considerations. The risk is that myopic decision-making will only

provide short term relief to particular problems but does little to address structural economicdifficulties. Consider for example the long term problems facing the UKs transport network. To whatextent has transport suffered from a lack of long-term planning and joined up thinking about how tocreate a properly integrated transport network which can provide proper solutions to the issues oftraffic congestion and the environmental consequences of rising transport use.

Critics of government subsidies to particular industries also claim that they distort the properfunctioning of markets and lead to deeper inefficiencies in the economy.

(c) Regulatory capture.

This is when the industries under the control of a regulatory body (i.e. a government agency) appearto operate in favour of the vested interests of producers rather than consumers. Some economistsargue that regulators can prevent the ability of the market to operate freely.

Olive growing in Spain has the CAP encouraged over-production, a waste of resources and causeddamage to the economies of many developing countries?

For example, to what extent has the European Unions Common Agricultural Policy operated mainly inthe interests of farmers? Has the CAP worked against the long-term interest of consumers, theenvironment and developing countries who claim that they are being unfairly treated in worldmarkets by the effects of import tariffs on food and export subsidies to loss-making Europeanfarmers? The CAP is widely criticised as a classic example of government failure and there are manywho claim that the current reform process does not go far enough.

(d) Government intervention and disincentive effects

Free market economists who fear government failure at every turn argue that attempts by thegovernment to reduce income and wealth inequalities can actually worsen incentives and productivityin the economy. They would argue against the National Minimum Wage because they believe that itcan lead to real-wage unemployment. They would also argue against raising the higher rates ofincome tax because it is deemed to have a negative effect on the incentives of wealth-creators in theeconomy and generally acts as a disincentive to work longer hours or take a better paid job. They arecritical of the government focusing welfare benefits on the poorest using means-tested benefitsbecause they might damage the incentive to find work.
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The opposite point of view is that a lack of effective government policies to reduce the scale ofincome and wealth inequality is also a cause of government failure since inequality can, over thelonger term; create many deep-rooted problems for society once social cohesion starts to break down.

(e) Government intervention and evasion

A decision by the government to raise taxes on de-merit goods (such as cigarettes) might lead to anincrease in attempted tax avoidance, tax evasion, smuggling and the development of grey markets

where trade takes place between consumers and suppliers without paying tax. Equally a decision tolegalize and then tax some drugs might lead to a rapid expansion of the supply of drugs and asubstantial loss of social welfare arising from over consumption.

(f) Policy decisions based on imperfect information

How does the government establish what citizens want it to do in their name? Can the governmentever really know the true revealed preferences of so many people? Our current electoral system is notan ideal way to discover this! Turnout in every type of election, (local, national, European etc) isfalling, there is general disinterest in the political process. Furthermore, people rarely vote purelyout of their own self-interest or on the basis of a well informed and rational assessment of the costsand benefits of different government policies.

Proponents of government failure argue that the free market mechanism is, in the long-run, the bestway of finding out(a) What consumer preferences are and

(b) Aggregating these preferences based on the number of people that are willing and able to pay forparticular goods and services.

Often a government will choose to go ahead with a project or policy without having the full amountof information required for a proper cost-benefit analysis. The result can be misguided policies anddamaging long-term consequences.

How does the government know how many extra houses need to be built in the UK over the nexttwenty years? Is building thousands of extra homes in an already congested South-east the rightoption? Are there better solutions? There have been plenty of instances of government housing policyhaving failed in previous decades!

(g) The Law of Unintended Consequences!

This law lies at the heart of many of the possible causes of government failure in markets!

The law of unintended consequences says that a government policy will always lead to at least onereaction from either consumers or producers that are unanticipated or unintended. Economic agentsdo not always act in the way that the economics textbooks would predict this is of course theessence of a social, behavioural science we do not live our lives in sanitised laboratories where all ofthe conditions can be controlled. The law of unintended consequences is often used to criticise theeffects of government legislation, taxation and regulation. People find ways to circumvent laws;shadow markets develop to undermine an official policy; people act in unexpected ways eitherbecause or ignorance and / or error.Unintended consequences can add hugely to the financial costs of some government programmes sothat they make them extremely expensive when set against their original goals and objectives.

(h) Costs of administration and enforcement

Government intervention can prove costly to administer and enforce. The estimated social benefits ofa particular policy might be largely swamped by the administrative costs of introducing it.

A summary of the arguments

Free market economists are naturally distrustful of government intervention in the economy

They believe that the signalling, incentive and rationing functions of the price mechanismshould be given more freedom to operate

They believe that government failure can occur at a microeconomic level (e.g. introducingminimum prices in markets, rent controls, producer subsidies etc) and at a macroeconomiclevel (pursuing inappropriate exchange rate, tax or interest rate policies etc)

When government failure exists, the result can be a deepening of an existing market failure

The result is a further loss of allocative and productive efficiency because of the waste ofscarce resources leading to a reduction in consumer and producer welfare


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Often we can accuse the government of policy failure only with the benefit of hindsight

Limited information - no government has the resources and information available to it tomake fully-informed, objective judgements. That is the nature of politics.

Government failure is most likely to occur when decisions are made in the vested interest ofspecial interest groups, at the expense of other groups (the result is a loss of equity)

But government failure is rarely total. Policies may be ineffective, expensive and inefficient but providing that policies are flexible and adaptable, (i.e. lessons are learned) thenintervention can often work in the interests of the majority

Advances in our understanding of how consumers and businesses behave and respond tochanging incentives are helping government policies to evolve. For example the growinginterest in auctions and traded permits as a means of controlling pollution and other forms ofenvironmental damage

Externalities Overview

We now consider in more detail than at AS level, the economics of externalities and policy approachesto controlling and correcting for market failure caused by the existence of externalities.Environmental economics is now a huge area of the subject.

The economic importance of the environment

The environment plays an absolutely essential role in shaping our economic and social welfare. Theenvironment

Provides services to consumers in the form of living and recreational spaces and theopportunity to enjoy utility from experiencing natural landscapes and habitats

It provides us with the natural resources necessary to sustain production and consumptionincluding the basis for renewable and non-renewable sources of energy

It is a dumping ground for the waste products of our society - be it waste from producers indifferent industries or from households and consumers

The link between economic activity and our environment is fundamental. We hear constantly aboutthe need for sustainable economic welfare, for growth to take into account the direct and indirecteffects on our resources. And increasingly we, as producers and consumers, are affected by manygovernment policies and strategies designed to promote environmental protection and improvement.

What is the commonly accepted definition of sustainability?Development which meets the needs of the present without compromising the ability of futuregenerations to meet their own needsWorld Commission on Environment and Development Our Common Future (1987)

Externalities and the environment the basics

For environmental economics, one of the most important market failures is caused by negativeexternalities arising from either production or consumption of goods and services.

A negative externality occurs where a transaction imposes external costs on a third party (not thebuyer or seller) who is not compensated by the market. The result is a loss of allocative efficiency andshown by a reduction in economic welfare

Environmental externalities generally arise for three reasons:

Common resources (not privately owned - e.g. ocean fisheries) commonly owned resourcesmay lack the protection of property rights and are susceptible to over-exploitation because

the marginal cost of extracting the resource for a private economic agent is close to zero. Thisis known as the tragedy of the commons

Public goods (indivisible common resources - e.g. the air)

Future generations (sources of externality including carbon emissions greenhouse effects contributions to global warming which threatens future sustainability)
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Dead fish on a polluted beach the external costs of pollution but who should pay?

In these cases, the private equilibrium of supply and demand is not the same as the social equilibriumwhich includes all costs. In a completely free market, a producer will have no incentive to controlpollution because it is external i.e. the producer only considers his/her own private costs andbenefits. The market failure arising from negative externalities is shown in the diagram below.

Economists argue that market failures provide a rationale for policy intervention to improve economicefficiency. But since market failures are pervasive, intervention is only justified if the benefits exceed


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the costs

The Tragedy of the Commons

The contribution of each economic agent is minute, but summed over all agents, these actionsdegrade the resource and may cause severe long term damage

The tragedy of the commons is a metaphor used to illustrate the potential conflict betweenindividual self-interests of producers and consumers and the common or public good.

In the original version of the term, the example is used of a stock of common grazing land used by alllivestock farmers in a small village. Each farmer keeps adding more livestock to graze on theCommons, because the marginal cost of doing so is zero. But because the commonly-owned resource isthen over-exploited, the result is a depletion of the soil and a fall in the value of the resource for allusers. The resource may become irretrievably damaged, an example of apublic bad.

The root cause of any tragedy of the commons is that when individuals use a public good, they do notbear the entire social cost of their actions. If each seeks to maximize individual benefit, he or sheignores the external costs borne by others. The absence of well defined and legally protectedproperty rights lies at the heart of the problem.

A tragedy of the commons can occur even without complete and permanent destruction of a resource the term can be used to describe any situation where what was perceived as a renewable resourcebecomes less valuable because of over-exploitation.

Good examples of the tragedy of the commons:

Burning of fossil fuels carbon emissions contributing toglobal warming

Pollution of waterways - creating other externalities for users of waterways furtherdownstream

Logging of forests e.g. the long-term impact on the Brazilian rain forest and the effects ofillegal logging see http://news.bbc.co.uk/1/hi/business/4842808.stm

Over-fishing of the oceans e.g. the current crisis in the EU fishing industry seehttp://news.bbc.co.uk/1/hi/sci/tech/4996268.stm

Fly-tipping of waste products on public land perhaps a response to the landfill tax?

E-mail spamming on the internet!

Game theory and the tragedy of the commons

The tragedy of the commons can be linked to the prisoner's dilemma that is a core part of gametheory. Individuals within a group have two options: cooperate with the group or defect from thegroup. Cooperation happens when individuals agree to protect a common resource. Defection happenswhen an individual decides to use more than his share of a public resource.

Cooperation has the potential to maximize every individual's benefit in the long run (i.e. the 'tragedy'does not happen, the commons are preserved and can be used indefinitely), while defectionmaximizes an individual's benefit in the short run at the expense of destroying it in the long run. Thusin the case of fish stocks, suppliers need to cooperate over a period of time so that fish stocks canstart to rise again. This is the essence of attempts to reform the European Union Common FisheriesPolicy.

An alternative to regulation by government is to create a market in property rights in order to controlthe impact of economic activity on the environment for example establishing a carbon tradingemissions scheme or introduction tradable fishing permits for the EU fishing industry.

The Economics of Waste

The UK government wants more waste being disposed of through incinerationrather than dumped inlandfill sites. It has restated its strategyand at the top of the waste hierarchy is the desire to reducethe amount of waste created in the first place from the production and consumption of goods andservices. The main aim is for the volume of waste to grow less quickly than GDP, in other words toachieve a de-coupling of waste generation from rising economic activity. Because waste is normallyregarded as a de-merit good creating external costs, there is justification for some form ofgovernment intervention in the market to change market prices, alter incentives and, hopefully, causea change in the behaviour of consumers and producers.

Over two million tonnes of edible food is dumped by retailers in Britain each year, usually into landfill
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sites

According to data released byDEFRA, less waste in the UK is being land-filled down from 82% to 72%for municipal waste between 1999 and 2004 and from 50% to 44% for industrial and commercial wastebetween 1999 and 2003. A successful waste strategy will bring about sizeable increases in wasterecycling and composting. Some local authorities have a superb record in raising awareness andinterest in recycling products. But in other areas of the UK, recycling rates are abysmally low and well

below the levels needed to meet UK and European Union targets. Government policy needs to be moreeffective inenhancing the incentives for individuals and businesses to recycle more of their wasteproducts.

The vast majority of UK household and industrial waste is disposed of in landfill sites

Hierarchy of principles of waste management:

o Prevention of waste - reduce the amount of waste created in the first placeo Reuse the product

o Recycle or compost the product

o Recover the energy by incinerating

o Disposal of the product using landfill
http://www.defra.gov.uk/environment/waste/index.htmhttp://www.letsrecycle.com/http://www.letsrecycle.com/http://www.defra.gov.uk/environment/waste/index.htmhttp://www.letsrecycle.com/


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What are the best incentives for households and businesses to reduce the amount of waste created?

Externalities - Government Policy Options

Government intervention to reduce market failure from negative externalities

Traditionally, government policy towards the environment has concentrated in two main areas

Intervention in the price mechanism for example through environmental taxes

Command and control measures for example direct regulation and legislation

These policies are designed to:

o Achieve a more efficient use of resourceso Promote substitution between resources (e.g. abundant for scarce, renewable for non-

renewable)

o Provide incentives for a reduction of pollution emissions or change from harmful to benign

Environmental taxation

An environmental tax is a tax on a good or service which is judged to be detrimental to theenvironment. It may also be a tax on a factor input used to produce (supply) that final product.The main aim of environmental taxation is to:

Increase the private cost of producing goods and services so that the producer / consumeris paying for some of the negative externalities that their actions are creating (i.e. theexternality is internalised) this promotes allocative efficiency

In this way, the government is providing a continuous incentive for the producer /

consumer to take the externalities into account, thereby correcting a failure of thesignalling function of the price mechanism

Raise the price of the product so that the level of demand contracts (there is normally adirect link between the level of output / consumption and the total pollution created)

Reduce output levels towards the estimated social optimum level of production whichcontributes to a more sustainable economy in the long term

Well designed environmental taxes may encourage innovation and the development ofnew technology which reduces the dependency of an economy on pollution inefficientforms of energy. This can help to promote dynamic efficiency


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government achieving an accurate reduction in total pollution. This is because nogovernment can ever predict how consumers and or producers will respond to higher costsand prices. The elasticity of demand may vary over time.

Income distribution: Taxes on some de-merit goods (for example cigarettes) may have aregressive effect on low-income consumers and lead to greater inequalities in thedistribution of income. Having said this, it should be possible for authorities to develop

smart tariffs or taxes where account is taken of the impact of pollution taxes onvulnerable households such as low low-income consumers. The current Labour governmenthas reduced the rate of VAT on domestic fuel to the EU minimum rate of 5%, but thegovernment has no plans to introduce a domestic energy tax (which would be an explicitenvironmental tax) because of the huge numbers of low-income households that currentlylive in fuel poverty. In the UK, the poorest 10% of households spends 13.2% of income onenergy whereas the richest spends 3.5%.

Employment and investment consequences: If pollution taxes are raised in one country,producers may shift production to countries with lower taxes. This will not reduce globalpollution, and may create problems such as structural unemployment and a loss ofinternational competitiveness. Similarly, higher taxation might lead to a decline in profitsand a fall in the volume of investment projects that in the long term might have beneficialspill-over effects in reducing the energy intensity of an industry or might lead to innovation

which enhance the environment More efficient alternatives? It might be more cost effective for governments to switch

away from pollution taxation to direct subsidies to encourage greater innovation indesigning cleaner production technologies. Eco-tax reformers often argue that pollutiontaxes should be revenue neutral so for example, an increase in environmental taxationmight be accompanied by reductions in employment taxes such as National InsuranceContributions so that the employment consequences of higher taxation are minimised. Theimpact of green taxes depends crucially on what is done with the revenues. If they arebalanced by reducing other taxes through revenue re-cycling, research suggests thatgreen taxes could result in an overall economic improvement

Alternatives to environmental taxes

An effective use of environmental taxationMost power stations are surrounded by coal tips or pipes carrying gas. But round the plant that

powers the Swedish town of Enkping, some 70 kilometres west of Stockholm, there is willowcoppice stretching as far as the eye can see. Enkping is probably the only town in Europe that ispowered by bio-fuels. The plant's director, Eddie Johansson, says willow is as economic as coal orgas because Sweden levies a tax on carbon emissions from most power plants. Under thegovernment's rules, he does not have to pay the tax because for every tonne of carbon dioxide thatdisappears up the stack, the plant's willow trees soak up a tonne from the air as they grow.Hundreds of willow-powered plants could operate across Europe, he says if power companies hadsimilar incentives to cut carbon emissions.Source: Business Week, September 2005

Carbon Emissions Trading

Emission trading is regarded by many as the future of environmental protection and improvementin the UK, European and international economy. Carbon trading is another form of pollution controlthat uses the market mechanism to change relative prices and the incentives of producers and

consumers. There is also growing interest in the idea of personal carbon trading, the UKgovernment is currently looking at the issue .

Carbon allowances for consumers!The environment minister, David Milliband has unveiled a radical plan to cut greenhouse gasemissions by charging individuals for the amount of carbon they use. Under the proposals,consumers would carry bank cards that record their personal carbon usage. Those who use moreenergy - with big cars and foreign holidays - would have to buy more carbon points, while thosewho consume less - those without cars, or people with solar power - would be able to sell theircarbon points. Under the scheme, all UK citizens would be allocated an identical annual carbon
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allowance, stored as points on an electronic card similar to Air Miles or supermarket loyalty cards.Points would be deducted at point of sale for every purchase of non-renewable energy. People whodid not use their full allocation, such as families who do not own a car, would be able to sell theirsurplus carbon points into a central bank. High energy users could then buy them - motorists whohad used their allocation would still be able to buy petrol, with the carbon points drawn from thebank and the cost added to their fuel bills. To reduce total UK emissions, the overall number of

points would shrink each year.Source: Adapted from the Guardian, July 2006

The basics of cap and trade - emissions trading

A fixed number of emission permits is allocated each year to polluting factories

Usual denomination: 1 permit = 1 tonne (e.g. of CO2 emissions)

Total number of permits is the limit on pollution the cap

Annual emissions of each factory must be less than or equal to permit holdings

Permits can be traded i.e. cap and trade

Factories which can reduce (abate) pollution for less than the price of a permit can sellspare ones for a profit

Factories which find it more expensive to reduce pollution can buy extra permits instead

Gradually the supply of permits is reduced the market price rises. This gives firms who

find it expensive to cut pollution, more of an incentive to seek new technologies / processthat will reduce their pollution emissions

A marketable pollution permit gives a business the right to emit a given volume of waste orpollution into the environment. Ideally, the number of permits that are issued corresponds with thetotal level of pollution that is admissible at the social optimum level of output i.e. where the MSB= MSC. Once this has been determined the permits are issued by auction and firms that pollutethe environment can bid for them and then buy and sell them amongst themselves.

Pollution permits should, in theory, give firms an incentive to control pollution emissions for lessthan it would cost to buy permits, and there is evidence from cap and trade pollution permitschemes in the UK and the United States that the costs of monitoring pollution reduction andadministration of the permits system is smaller than when an industry is subject to directregulation. In the United States cap and trade scheme, it was found that many high-pollutingbusinesses invested in fitting new pollution control equipment (e.g. Flue Gas Desulphurisation) and

other polluters switched from high to low sulphur coal.Consequently the use of marketable permits allows the cost of pollution control to be minimised.Another advantage is that the revenue from a traded pollution permits scheme can be re-cycledinto other schemes for environmental improvement.

Incentives matter create a market in the right to pollute - The basic idea behind tradedpollution permits is to through the incentive to cut pollution directly to the producers themselves.Companies can then make their own decisions about the costs and benefits to them of particularroutes to emission reductions. In other words, market forces are brought to bear on the issue ofpollution and potential market failure.

Emission trading is likely to be most effective when:

There is an easily measurable pollutant

The government sets a clearly defined and stable emissions target

There are a large number of participant firms, with companies sufficiently sophisticated todeal with the technicalities of trading at auction

Wide variation in costs of reducing pollution so that trading of surplus permits can takeplace

The transactions costs of trading permits are low and there is clear pollution dataavailability at the start and during trading

Strict enforcement of permits (i.e. a high compliance rate among participating businesses)

Kyoto

Emission trading was a key feature of the Kyoto Protocol as a strategy to address some of the
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threats posed by climate change in 1997. Kyoto allows trading of permits for carbon dioxidebetween industrialised countries but the United States withdrew from the agreement in 2001 andsince the USA represents 32% of emissions amongst developed countries with emission targets, theabsence of the USA from an embryonic trading system will seriously reduce demand for permits andtherefore drive down their price and effectiveness.

Pollution regulation

Instead of relying on intervention in the market mechanism by using taxation, subsidies or pollutionpermits, the government and its appointed agencies can regulate the level of output and pollutionin a market. In theory, the government could set a quota so that output is set at the socialoptimum. More frequently, minimum or environmental / emission standards are widespread inmany industries. This requires regulatory bodies to monitor (inspect) and fine firms that do notmeet the standards set for water and air quality.

The 1989 Environmental Protection Act for example set standards on emissions for firms thatcarried out chemical processes, waste incineration and oil refining. There will be a ban on smokingon public places in England from the summer of 2007. A ban came into force in Scotland in March2006.

Compliance with environmental regulations can be very costly to enforce and it may be impossibleto monitor all firms accurately because of imperfect information. Regulation also does not bring inany direct tax revenue flows that can be used to fund environmental improvement schemes or

compensate those who have been negatively affected by pollution.Suggestions for further reading on carbon emissions trading

o Carbon trading, what price a pollution solution? (Green Biz)

o Carbon tradings real colours (BBC)

o Power tool (Guardian)

o Questions are raised over carbon trading (Guardian)

o Scale of industrys impact on the environment (Guardian)

Airlines and environmental policy

Over the past 20 years, there has been huge growth in the airline industry. The number ofpassenger kilometres has risen from 125 billion worldwide in 1990 to 260 billion in 2000, while airfreight grew even faster, at 9% per year. In 1970, British airports were used by 32 million people. In2004, the figure was 216 million. In 2030, according to government forecasts, it will be around 500

million.Several factors have contributed to rising demand for airline travelThe emergence of low-cost flying, such as EasyJet and Ryanair which have brought prices downallowing lower-income families to fly and creating a new effective demand for flyingNew technologies have also made long-haul flights with flagship-carriers, such as BA, cheaper andmore enjoyableIncreased demand for business air travel

Aviation creates external costs. The main external cost of flying is the damage to the environment.It is estimated that one return flight to Florida produces as much carbon dioxide as a yearsmotoring, while a return flight to Australia the same amount as 3 cars in one year. And flying fromLondon to Edinburgh produces 8 times as much carbon dioxide as taking the train. Aviationcurrently contributes 5% to the UKs carbon dioxide emissions. With air travel growing at 3-5%, it isexpected that planes will contribute 15% to the UKs carbon dioxide emissions in the next ten years

For some time, there has been a debate over the merits and de-merits of introducing an aviationtax on airlines. Is this the best way of controlling the environmental damage created by the rapidexpansion of the UK and European airline industry? Or will it simply create more problems anddamage the competitiveness of the European airline sector? Are there better more effective waysof reducing pollution? For example bringing the airlines into the newly established EU carbonemissions trading scheme?
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Public Goods

When the market fails to provide certain goods and services, there is a clear case for governmentintervention.

The nature of public goods

Public goods are services which must be provided collectively for two main reasons:

Non-excludability - the goods cannot be confined to those who have paid for it

Non-rivalry in consumption - the consumption of one individual does not reduce theavailability of goods to others

Examples of pure public goods include flood control systems, street lighting and national defence. Aflood control system, such as the Thames Barrier, cannot be confined to those who have paid for theservice. Also, the consumption of the service by one household will not reduce its availability to others.If left to the free market mechanism, no public goods would be provided and, as a result, there wouldbe a clear market failure. No individual consumer would pay for a product that could be consumed forfree if another household decided to purchase it.

The benefits of the Thames Barrier cannot be confined only to those people who have paid for it

Quasi-public goods: These are products that are essentially public in nature, but do not exhibit fullythe features of non-excludability and non-rivalry. The road network in the UK is currently available toall, but could be made excludable via a system of electronic road pricing. There is also non-rivalry inconsumption, but only up to an extent. Once the road becomes congested there is rivalry inconsumption.

Environmental public goods: An example of an environmental public good is public open space, which

nobody would provide on their own, even though everybody benefits from it being available. Streetlighting is another example of a public good.

The Air-Waves a Quasi Public GoodThe airwaves are essentially owned by the government of a particular country. Do they count as a purepublic good? Normally the answer would be yes. One persons use of the airwaves rarely reduces theextent to which other people can benefit from utilising them. But when demand for mobile phoneservices is high at peak times, the airwaves become crowded and access to the networks provided bythe main mobile phone companies can become slow. In this sense the airwaves can be treated acrowded non-pure public good.


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The government controls the issue of licences needed to operate mobile phone services using theairwaves in the UK. In 2000, they auctioned off five licences for 3rd generation mobile phone servicesand raised 22 billion in doing so. The government was using the auction process to ration the airwavesthrough a licence system. Although the government has monopoly control in the sense that it controlsthe issue of licences, it did not set the market price. This was determined by the auction process, andthe fact that at the end of a bidding war, the major mobile phone companies were prepared to pay

such a high price for a licence to allow them to operate in the market, is evidence of the privatebenefit (or anticipated future profit) that the companies expected to make from selling 3rd generationcontracts to customers.The fact that these telecoms companies may have greatly misjudged the actual market demand forthird generation mobile phone services is not the result of the auction process itself. The governmentdecided that the income from the sale of these licences would be used to repay a slice of the nationaldebt, providing a bonus for current and future generations in terms of reducing the annual interestpayments on government debt.

An example of a quasi public good - the air-waves can become congested

Finding an Equilibrium Allocation of Public Goods that Maximises Social Welfare

Finding the socially efficient level provision of public goods is a hugely difficult process. First we mustseek a valuation of the willingness and ability of consumers to pay for public goods which involvesestimating the individual demand curves for each consumer and then aggregating to find the marketdemand curve a reflection of the social marginal benefit (or valuation) that consumers place on eachextra unit of a public good that is made available.In the diagram below we consider a non-pure public good whose marginal cost of supply does risegently as output is increased. If the market fails to provide a sufficient quantity of a public good, thenthere is a loss of economic (social) welfare.


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Case Study: The BBC as a public goodBroadcasting is a good example of a public good. Let us remind ourselves of the three maincharacteristics of a public good.

Firstly it is non-rival, meaning that the consumption of a public good or service by one individual doesnot preclude consumption by another individual. Secondly, consumption is non-excludable. This meansthat consumption by one individual makes it impossible to exclude any other individual from having theopportunity to consume. Effectively the marginal cost of providing a pure public good to an extra useris zero, and this implies that, in order to achieve allocative efficiency, the charge for the productshould be zero. Of course, in this situation, private sector businesses are unlikely to consider providingpure public goods because they will not be able to make any profit at a zero price, and manyconsumers can take a free ride on such goods because of non-excludability. The provision of pure publicgoods is therefore a cause of market failure. Left to the free market, public goods are under-providedand under-consumed leading to a loss of social welfare.

Traditional analogue broadcasting differs from encrypted digital broadcasting in the sense that digitalbroadcasters can now exclude non-payers using set-top boxes. But even when Britain moves fully todigital when the analogue signal is turned off in a few years, the broadcasting services will continue tobe completely non-rival and it is this that really matters in the context of the services that the BBCprovides. One extra person consuming programmes on BBC1 or BBC2 has no effect at all on the abilityof people to consume other services provided by the BBC.

Paying for a public good - the licence fee debate

At the moment, around 23 million households in Britain pay an annual licence fee. All of these peopleare stakeholders in the debate about the future funding of the BBC and the vast majority use one or
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more BBC services at least once a week. The fee is a means of providing collective payment for apublic good. We know that there are fee-dodgers who try to take a free-ride by avoiding payment, butthere are well established although costly means to enforce the licence fee and take non-payers tocourt.

According to research undertaken by the BBC as part of the Charter Review, on rough estimates, about17 million households value BBC television, radio and internet services at more than the current licence

fee of 122. These are gainers from the existence of the BBC. In contrast, the study finds that 6 millionpeople value the BBC at less than the current licence fee. These are losers they are paying more thanthe utility that they get and many such people may resent having to pay the licence fee when theyhave paid for their BSkyB subscription and have already deserted the BBC for other digital orcommercial channels. The BBC study estimates that the net consumer surplus created by the BBC iswell over 2bn/year, or % of GDP.

The most likely groups to think the licence fee represents good value for money for their household arethose aged over 60 and those in the higher AB social groups. Groups more likely to think the feerepresents poor value for money are those with multi-channel television access, people aged 31-45,people in the C2DEs social groups and younger people of Black or Asian origin. People in C2DE socialgroups are far more likely to have an income below the median, and therefore the question of raisingthe licence fee becomes important because a sharp rise in its level would affect peoples ability to pay.

Television Radio Other

BBC 1 Radio 1 BBC Online

BBC 2 Radio 2 World Service

BBC 3 Radio 3 BBC Scotland

BBC 4 Radio 4 BBC Northern Ireland

Cbeebies Radio Five Live BBC Wales

CBBC Five Live Extra BBC English Regions

BBC News 24 1Xtra

BBC Parliament 6 Music

BBC 7

Asian Network

6 Nations services

40 local and regional services

For millions of people, the value that they derive from the BBCs output does exceed the price theycurrently have to pay via the licence fee. Would they be happy to pay a significantly higher fee in thefuture? Much would depend on the quality and range of broadcasting that the BBC is able to deliver.Assuming a constant range, reliability and quality of services, a large rise in the BBC licence fee wouldreduce total consumer surplus. The BBC study estimates that if the fee was raised by forty per centfrom 122 to 170, up to four million people would no longer value BBC services as much as the highercompulsory fee, consumer surplus would be reduced and the BBCs services might end up being under-consumed.

This, in a nutshell, is the argument against the introduction of a subscription-based system for fundingthe BBC. It would exclude several million people from consuming their services and would probably

result in a net loss of social welfare.
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What is the best way to finance broadcasting? Should the licence fee remain compulsory?

Criticisms of the licence fee

Opponents of the licence fee argue that

1. It is a regressive form of taxation everyone pays the same flat charge, regardless of theirdisposable income, the number of televisions they own or the extent to which they watchtelevision in general and BBC services in particular

2. As fewer people watch the BBC, the case for a licence fee diminishes. Indeed as technologydevelops, it become even harder to sustain a compulsory licence fee when people have movedpredominantly to alternative sources of information through the internet, digital channels,

broadband and their mobile phones3. The costs of collection and evasion are high including 150 million per year chasing licence-

fee evaders

What are the alternatives for funding the BBC?

Moving to a subscription base system (technology may allow this in the future).

Allowing advertising and sponsorship of programmes similar to the ITV model.

Greater emphasis on selling BBC programmes overseas through BBC Worldwide and sales ofDVDs to generate increased revenue for the BBC.

Funding the BBC entirely through direct taxation and scrapping the licence fee.

A tax on the revenues of other commercial broadcasters to part-fund the BBCs services reflecting the public service nature of much of the BBCs output.

Of these alternatives, introducing advertising is least preferred among people surveyed. A sizeable

majority of viewers (over sixty per cent according to a recent MORI poll) regard advertising as anintrusion to their enjoyment of programmes, and few think that the BBC should move to this form offinance. And there are worries that the total size of the TV advertising market is not large enough toabsorb the entry of the BBC as a supplier of advertising slots. It might well damage the financialviability of ITV for example. In any case, advancing technology now allows viewers to skip advertisingwhen they have pre-recorded programmes.

On the whole, there is a preference for keeping the licence fee (a system of funding used in manyother countries) although there are concerns among older groups about their ability to pay for it. Butwithout a sizeable increase in its value, there is little doubt that BBC revenues will soon be overtaken
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permanently by Sky and this will damage the BBCs ability to bid for live television events including therights for sports such as soccer, cricket and golf.

Public Goods and the Free Rider Problem

Consumers have an incentive to not reveal their willingness and ability to pay for public goods if theybelieve that they will be expected or required to contribute to financing the public good accordingly bythe government. After all, if the public good is supplied, it will be available to them just as it would be

to anyone else because pure public goods are non-excludable. This is the essence of the free riderproblem: the incentive which consumers have to avoid contributing to financing public goods inproportion to their valuation of such good.

Good examples to use include TV licence dodgers and people who choose to evade the Council Tax butwho still receive local authority services. Another example might be a group of residents in a block offlats who all stand to benefit from the refurbishment of an adjacent playground or better lighting andsecurity systems, but who individually might try to avoid payment and benefit once the improvedamenities are in place.

Given the nature of the free rider problem, public goods are often financed through some form ofenforcement, notably the compulsory nature of the TV licence fee, management fees for residentsliving in blocks of accommodation or the signing of international treaties on the environment. .

Market Failure Universities and Tuition Fees

The introduction of tuition fees for students in England and Wales has been controversial. It raisesimportant issues about the economics of higher education some of these issues are raised andevaluated in this note.

Market failure in education

Market failure occurs when markets operating without government intervention, fail to deliver anefficient or optimal allocation of resources - Therefore - economic and social welfare may not bemaximised leading to a loss of allocative and productive efficiency (i.e. welfare losses for society).

Market failure exists when the outcome of markets is not efficient from the point of view of theeconomy. This is usually because the benefits that the market confers on individuals or firms carryingout a particular activity diverge from the benefits to society as a whole (i.e. there are externalitiesnot taken into account within the market). This is particularly relevant to the concept of education asa merit good
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An aerial view of Oxford should higher education be regarded as a merit good which the governmentshould subsidise directly for students?

The idea of positive educational externalities is that the benefits of individually acquired educationmay not be restricted to the individual but might spill over to others as well, meaning that there willbe macroeconomic advantages from a higher level of education spending and attainment.

For example, there is compelling evidence that human capital increases productivity and therebyincreases an economys trend rate of growth and international competitiveness. Education is foundto yield additional indirect benefits to growth for example by stimulating physical capital investmentsand technological development and adoption across many different industries (creating the potentialfor gains in dynamic efficiency)

The free spill-over effects of improved educational provision can be said to take education awayfrom being purely as a merit good and more towards meeting the characteristics of a public good.

The social returns to increasing the average length of time that people spend in education depend inpart on the stage of economic development recent studies suggest that an expansion oftertiary/higher education is the most important for growth in countries such as the UK.

Imperfect information

Markets can also fail when the individual or firm does not have sufficient information to recognise thefuture returns from undertaking an action again this is relevant to decisions that individuals take asto how much education they should consume or purchase at different stages of their life. Manyyoung people are myopic when making university and degree course decisions. Or they may be averseto taking on debts even though it might be in their long-term financial interest to do so. In this case,there might be an economic case for the government to adopt a paternalistic view on what is bestor for younger people.

Equity

Markets can generate what is perceived to be an unacceptable distribution of income and too high alevel of social exclusion where people on low incomes are denied access to essential goods andopportunities considered normal by a society. Education comes into this category not least on theissue of whether students should make a financial contribution to the cost of their own tuition whenthey are in higher education.

Merit Goods and Market Failure

A merit good is a product that the government believes consumers undervalue and under-consumebecause of imperfect information. A merit good is deemed to be socially desirable and also better


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for a consumer than the consumer realises a value judgement is involved whenever we talk of meritgoods.

How can a monetary value be placed on the additional social value of education overlooked byconsumers suffering from information failure? Is it simply the present value of higher income?

How can the value to society of a well educated and more skilled and productive work force be

estimated both in the short term and the long run?The Private and Social Benefits of Education

Private Benefits of Education Social Benefits of Education

The fun and enjoyment of learning (personal satisfactionand fulfilment)

More literate and intelligent society lower crime rates?

Accumulation of human capital (qualifications andexperience) that will reduce the risk of unemployment andallow people to hurdle over entry barriers to certainoccupations

Contributes to international competitiveness of economy importance of high-knowledge sectors in international tradecontinues to grow expansion of scientific research etc

Higher expected earnings in work a university degree is asignalling mechanism for employers e.g. in promoting fast-track promotion

Higher tax revenues in the long run can be used to fundother socially beneficial government spending programmes

Blundell (2000) estimated that the average return tocompletion of a first degree for a cohort of 33-year-olds in1991 was around 17% for men and 37% for women comparedwith people with A levels as their highest qualification

Social benefits from having more doctors and teachers andscientists increased provision of public and merit goods

There is no such thing as a free lunch. Higher education involves costs the main issue is really howbest it should be funded. Clearly there are many normative judgements involved but we should alsotry to bring economic arguments into the discussion. A recent research piece by the Institute for FiscalStudies made the situation clear:

It is important to be clear that higher education is never free, whether the costs are met upfront by


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students, later in life by graduates or in an ongoing way by taxpayers in general. Altering the system ofHE finance changes the incidence and the timing of payments but does not change the fact that thecost of university education must be paid for in one way or another.Adapted fromwww.ifs.org.uk

Summary of some of the arguments on tuition fees and the funding of universities

Arguments for introducing tuition fees Arguments against tuition

feesThe benefit-pay-principleA university education is a valuable and expensive privilege. Why should something that isso rewarding and costly be free?It is equitable for students to make a financial contribution to their degree teaching theystand to gain financially from a degree education is an investment and it is rational forstudents to borrow at this stage of their life-cycle to finance such investment. It is rationalto forgo current earnings in return for higher future earnings

A tax on learning? EquityissuesOnly 7% of children fromfamilies in the lowest socialclass currently go touniversity tuition fees willmake it harder for relativelypoor families to fund adegree. This will wideneducational inequality andcreate a further widening ofthe two-tier educationsystemTop up tuition fees or a

graduate tax will raise extrarevenue but they are notan alternative for a higherlevel of government fundingdesigned to increaseeducation spending as ashare of GDP

Extra funding for facilities, teaching & researchTuition fees will provide extra finance that will allow the government to fund an expansionof the number of students able to enter higher education promoting wider access to HE.

Student debt may deterpoorer studentsTuition fees will lead to ahuge surge in student debtand hardship which in turnwill have negative economicand social consequences inthe long run

Means-testing is costly tomonitor and can createdisincentive effects

Means testing to protect access for poorer studentsAccess to higher education to people from less privileged backgrounds can be protected.Tuition fees can be means-tested to offset the danger that fees will hit lower incomestudents hardest. Maintenance grants can also be means-tested

Social benefits(externalities) argumentThe benefits to participationin higher education accruenot only to the individualgraduate but also to societyat large.And seeking to expand highereducation too much maywork against the bestinterests of the economy the graduate market may

become over-crowdedImprovements in dynamic efficiencyFees will encourage students to be more selective in the courses they choose and willstimulate an improvement in teaching quality if universities are to keep student numbershigh and remain viable - tuition fees make parents and students ask hard questions aboutthe purposes of higher education

Limits to the market tuition fees no answerA graduate tax exhibits norelationship between thecost of the course attendedand the amount repaid bythe student. It thereforeintroduces no `market-based'
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element into the highereducation sector in terms ofstudents choosing betweencourses and institutionsbased on the various pricesof attending them

Research and international competitivenessExtra funding is needed for universities to maintain high levels of research offering longterm macroeconomic benefits for the economy

Uncertain flow of taxrevenueThe amount that tuition feeswill raise is uncertainbecause it depends on thefuture earnings of graduatesonce they enter employment and it will take years forthe extra funding to comethrough

Progressive system of tuition fee repaymentRepayment through the income tax system introduces a progressivity into the system higher income earners will repay their debt more quickly.Specifying that the loans need only be repaid when incomes rise above a certain levelshould help overcome students reluctance to borrow when they cannot be confident abouttheir future earnings. It is a pay-roll deduction scheme rather than a tax

Education as a basiceconomic and social rightBelief that access touniversity should beavailable to all people whoqualify independent of theirability to pay (a valuejudgement) i.e. educationas a right not a commodityIs education fundamentallydifferent from providinghealth care free at thepoint of need?

Fees are more equitable than general taxationFunding tuition from general taxation is an expensive and poorly targeted way ofintervening in the market, because graduates, who are predominantly found towards thetop of the income distribution, benefit at the expense of everyone else i.e. why should non-graduates pay for the degrees of graduates?The argument that education should be provided free is much stronger for the case ofprimary and secondary education than for higher education.

Impact on demand forcertain degreesIt is feared science andengineering - among themost expensive courses torun because of equipmentcosts and specialist staff will see a fall in demand threatening long termdamage to ourmanufacturingcompetitiveness


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Competitition Policy

Competition policy covers the different ways in which the competition authorities of nationalgovernments and also the European Union seeks to make markets work better and achieve ahigher level of economic efficiency and economic welfare.

The Main Aims of Competition Policy

The aim of competition policy is promote competition; make markets work better and contributetowards increased efficiency and competitiveness of the UK economy within the European Unionsingle market. Competition policy aims to ensure:

Wider consumer choice in markets for goods and services.

Technological innovation which promotes gains in dynamic efficiency.

Effective price competition between suppliers.

Investigating allegations of anti-competitive behaviour within markets which might have anegative effect on consumer welfare.

There are four pillars of competition policy in the UK and in the European Union:

Antitrust & cartels: This involves the elimination of agreements which seek to restrictcompetition (e.g. price-fixing agreements, or cartels) and of abuses by firms who hold adominant position in a market.

Market liberalisation: Liberalisation involves introducing fresh competition in previouslymonopolistic sectors e.g. energy supply, telecommunications, air transport and postalservices together with new arrangements for car retailers inside the single market.

State aid control: Competition policy analyses examples of state aid measures by MemberState governments to ensure that such measures do not artificially distort competition inthe Single Market (e.g. the prohibition of a state grant designed to keep a loss-making firmin business even though it has no prospect of long-term recovery).

Merger control: This involves the investigation of mergers and take-overs between firms(e.g. a merger between two large groups which would result in their dominating themarket).

"Ronald Coase said he had gotten tired of anti-trust because when the prices went up the judgessaid it was monopoly, when the prices went down they said it was predatory pricing, and when they

stayed the same they said it was tacit collusion."Source: William Landes, "The Fire of Truth: A Remembrance of Law and Econ at Chicago", JLE(1981)

Anti-Trust Policy - Abuses of a Dominant Market Position

A firm holds a dominant position if its economic power enables it to operate within the marketwithout taking account of the reaction of its competitors or of intermediate or final consumers.

In appraising a firm's economic power in the marketplace, the EU Commission considers its marketshare and other factors such as whether there are credible competitors, whether the firm hasownership and control of its own distribution network and whether it has favourable access toraw materials. Note here that market share is not the sole determinant of economic power in anindustry

Holding a dominant position is not wrong in itself if it is the result of the firm's own effectivenessand competitiveness against other businesses. But if the firm exploits this power to stifle

competition, this is deemed to be an anti-competitive practice.A recent example of this has been the long investigation and legal battle by the EU Commission intothe alleged abuse of market power by Microsoft. Microsoft was accused of continuing to abuse itsmonopoly in the software market. The investigators alleged that Microsoft bundled Media Playerwith Windows, unfairly damaging rival programs such as Real Networks RealPlayer and AppleComputers QuickTime. The investigation and fall-out has now lasted more than eight years. InMarch 2004 the EU fine Microsoft 497m levied in March 2004 for its alleged abuse of its dominantposition in the operating software and server software market. In July 2006, a Guardian UnlimitedBusiness | | EU fines Microsoft 280mfurther fine of 194m was imposed.
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Anti-Competitive Practices:

Anti-competitive practices are best defined as strategies designed deliberately to limit the degreeof competition inside a market. Such actions can be taken by one firm in isolation or a number offirms engaged in explicit or implicit collusion. Since 1998 there have been numerous investigationsin industries such as chemicals, banks, pharmaceuticals, airlines, beer, and paper, plasterboard,food preservatives and computer games!

Examples of anti-competitive practices Predatory pricing financed through cross-subsidization (not all price discrimination is anti

competitive though much of it is simply a genuine attempt to remain competitive in amarket). An example of an allegation of predatory pricing came in 2005 when Wal-Mart wasaccused of using this strategy as it tried to break into the German food retail market. Wal-Mart faced accusations that it was using short-term predatory pricing to put smallshopkeepers out of business. In July 2006, it was announced that Wal-Mart was pulling outof Germany having sold its stores to another business.

Vertical restraint in the market:

o Exclusive dealing: This occurs when a retailer undertakes to sell only onemanufacturer's product and not the output of a rival firm. These may be supportedwith long-term contracts that bind or lock-in a retailer to a supplier and can onlybe terminated by the retailer at high financial cost. Distribution agreements may

seek to prevent instances of parallel trade between EU countries (e.g. from lower-priced to higher priced countries)

o Territorial exclusivity: This exists when a particular retailer is given the solerights to sell the products of a manufacturer in a specified area

o Quantity discounts: Where retailers receive progressively larger price discountsthe more of a given manufacturer's product they sell - this gives them an incentiveto push one manufacturer's products at the expense of another's in order to widentheir own profit margins

o A refusal to supply: Where a retailer is forced to stock the complete range of amanufacturer's products or else he receives none at all, or where supply may bedelayed to the disadvantage of a retailer

Creation of artificial barriers to entry: Through advertising and marketing and brand

proliferation which increase the costs of a new firm successfully entering a market Collusive practices: These might include agreements on market sharing, price fixing and

agreements on the types of goods to be produced.

Price Fixing The Office of Fair Trading

UK competition law now explicitly prohibits almost any attempt to fix prices - for example, youcannot:

Agree prices with your competitors, e.g. you can't agree to work from a shared minimumprice list

Share markets or limit production to raise prices

Impose minimum prices on different distributors such as shops

Agree with your competitors what purchase price you will offer your suppliers

Cut prices below cost in order to force a smaller or weaker competitor out of the market

The law doesn't just cover formal agreements. It also includes other activities with a price-fixing effect. For example, you shouldn't discuss your pricing plans with your competitors.If you then all "happen" to raise your prices, you are fixing prices.

Cartels and the law in the UKCartels are a particularly damaging form of anti-competitive behaviour - taking action against themis one of the OFT's priorities. Under the Competition Act 1998 and Article 81 of the EC Treaty,cartels are prohibited. Any business found to be a member of a cartel could be fined up to 10 percent of its worldwide turnover. In addition, the Enterprise Act 2002 makes it a criminal offence forindividuals to dishonestly take part in the most serious types of cartels. Anyone convicted of the
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offence could receive a maximum of five years imprisonment and/or an unlimited fine.Source: OFT web site

There have been many examples of allegations of and investigations in price fixing and other formsof collusive behaviour in UK and European markets in recent years. They all provide interestingevidence of how the competition authorities both in the UK and in the European Union are usingtheir enhanced powers under new competition laws to investigate possible instances of price fixing

or anti-competitive behaviour.House of Fraser and Oakley price fixing for sunglassesThe House of Fraser department store group is facing accusations that it colluded with Oakley tofix the price of its sunglasses, which sell for between 50 and 200 a pair. Following a two yearinvestigation, the Office of Fair Trading (OFT) has published a provisional report claiming that bothHouse of Fraser and Oakley have breached the 2002 Competition Act. Both companies now have theopportunity to make submissions to the OFT in defence of their position.The OFT believes that between November 2001 and March 2004, Oakley supplied House of Fraserwith sunglasses on the condition that the department store sold them at no lower than the Oakleysuggested minimum selling price. The investigation was instigated after complaints from rivalretailers and complaints from some customers. If the findings are confirmed, the OFT has thepower to fine a firm up to ten per cent of its turnover.Dual pricing Sony versus the internet retailers

The UK Office of Fair Trading is investigating accusations of possible illegal price discrimination bythe global electronics giant Sony. Some online retailers have complained that Sony isdiscriminating against them by offering cheaper (discounted) prices to established high streetretailers and making the online retailers pay more for their supplies of many of Sony's top sellingproducts.The complaint came from the Interactive Media in Retail Group (IMRG) and their claim was thatdual pricing acts as an anti-competitive strategy which is damaging to consumer welfare. DualPricing is a mechanism recently introduced by electrical consumer goods manufacturers wherebytheir dealers pay more for goods if sold online.The IMRG claimed that there is no economic justification for dual pricing and that the defence thatit costs more to run a "bricks and mortar" retail business compared to an online business is bothirrelevant and open to dispute. In a press release they claim thatSony have been exposed in the newspapers as one of the manufacturers being looked at but othersincluding Panasonic, Sharp, Phillips and Hitachi may also have their dual-pricing tactics considered.Price fixing in the dairy industryThe Office of Fair Trading is investigating claims that some of the UK's top dairy processingbusinesses have been involved in a price fixing agreement. Dairy Crest and Robert Wiseman, two ofthe UK's top three dairy processors are under the microscope and Arla Foods may also be part ofthe broader scope of the investigation which centers on a decision by the dairy processors tojointly increase the price paid to milk farmers in the UK. But this investigation is coming underquite fierce criticism from supporters of the farming industry who believe that unless effectivesteps are taken to raise the prices and incomes flowing to milk producers, the industry itself maycollapse with the loss of thousands of jobs.

Suggestions for wider reading on price fixing and cartelsBreach of competition law by 50 independent schools (November 2005)Chemical firms face price fixing probe:Competition Commission of the European UnionEnquiry begins into the price of school uniforms (July 2006)EU smashes acrylic glass cartel (March 2006)Fine for European chemical companies involved in price fixing cartel (2006)OFT to refer grocery market to Competition Commission (June 2006) see also Inquiry spells troublefor the Big 4 retailers (Guardian)and Supermarkets in competition probe (BBC)OFT to study market structure of UK airports (June 2006)Samsung in price fixing admissionScottish roofing contractors f

Govt Intervention and Market Failure

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