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Market failures, part V april 28, 2008

Posted by Fredrik Gustafsson in Nationalekonomi, _In English_.
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I denna del kommer vi till slut in på saker som kan få marknaden att misslyckas. Först ut är skalfördelar som kommer att behandlas i en rad inlägg framöver. I och med att det är Valborg på onsdag kommer nästa inlägg först på fredag.

What can make the market fail?

In general, there are at least three things that can cause market failures: economies of scale; imperfect information; and externalities[1]. The following sections will in turn go through each of these three reasons for why the market might fail. Market failures that arise due to imperfect information and economies of scale will however only be briefly summarized.

The argument below will be that, if there are indeed any market failures that might reduce dynamic efficiency and that the government has a reasonable chance or resolving, they primarily arise due to externalities. After summarizing market failures arising due to imperfect information and economies of scale, the remainder of this article will therefore solely focus on market failures that arise due to externalities.

Economies of scale

Economies of scale have always been one of government’s favorite reasons for intervening in the economy and their popularity as an excuse for government intervention has persisted to this day. But does the claim that the market can fail due to economies do scale have any theoretical merit? Can economies of scale reduce an economy’s dynamic efficiency and, hence, its long-term economic growth? And if this is truly the case, can we expect that the government will be able to do anything about it?

Before anything else, economies of scale need to be defined since there are in fact two different kinds. First, there are economies of scale in the normal sense of the word: that is, a firm’s average cost of production decreases as the production of the firm increases (up to a certain level of production). This situation usually arises due a presence of large fixed costs. This is what we call internal economies of scale.

The other kind of economies of scale are, hardly surprising, called external economies of scale. They mean that the costs of the firm decrease (or that the revenues increase) as the total output of the industry (or other industries) increases. These economies of scale are also referred to as complementarities, economies of agglomeration, network effects, or whatever term might be in vogue at the moment.

But let us start with internal economies of scale. The most extreme case of economies of scale is when the increasing returns to scale continue beyond the production level that is equal to the total supply of the good on the entire market. This means that, since the economies of scale are so large, the lowest average cost per produced unit can only be attained if one single firm produces the entire supply of this particular good. In other words, the production can only be X-efficient if the industry is characterized by a true monopoly where one single firm produces all the output.

This very unique situation is called a natural monopoly. Libertarians usually take offense to the very term natural monopoly since they are of the opinion that monopolies only can exist by the virtue of government regulation or protection. However, the fact that a certain industry could be described as a natural monopoly does not necessarily mean that one single firm will dominate the entire industry. It only states that, in order for the industry to be X-efficient, the entire output has to be produced by one single firm.

Natural monopolies are usually thought to create market failures since it does not matter, it is claimed, whether one or several firms produce the product: the production will always be statically inefficient. Why this is the case if two firms or more produces the product is easy enough to understand since it means that the product is not produced as cheaply as it could be produced if the entire output was produced under one roof.

Whether a market monopoly automatically leads to inefficiencies is a trickier question. If we assume that the monopolist is actually able to restrict its production, and through this, increase prices, without a competitor entering the market, neoclassical economics teaches us that there will be inefficiency. This is because the monopolist is able to transfer some of the consumer surplus to itself while some of this surplus is lost due to the fact that production is restricted.

Now, it is indeed very temping to say that this situation is inefficient, especially if one looks at the graphic representation of this situation: it is perfectly clear that the area on the graph that represents the gain in surplus of the monopolist is smaller than the area in the same graph that represents the surplus loss of the consumers.

The problem is that we cannot compare producer and consumer surplus in this way. We know that the consumers experience a loss in welfare and the monopolist experience a gain in the same. We can also say that there is a deadweight loss (in welfare) due to the fact that the monopolist is successful in restricting production. We can even express these gains and losses in Dollars, Euros, blueberries or whatever.

The one thing we cannot do is to say whether the psychic loss of the consumers is in fact larger than the psychic gain of the monopolist. Value is purely subjective, and it is impossible to tell whether the psychic loss of the consumers is actually greater than the psychic gain of the monopolist. For all we know, the monopolist might attach extreme value to his surplus gain, whereas the opposite is true for the consumers.

At most, one can say that it is possible (partly due to the deadweight loss) that this monopoly leads to a real inefficiency. Perhaps one could even go as far as saying that it is likely that it leads to inefficiencies. But there is no way to say for certain that natural monopolies lead to static inefficiency. And besides, even if they do, it is clear beyond doubt that they do not reduce dynamic efficiency, and for this reason natural monopolies are of no interest to this article.

[1] Grand, “The Theory of Government Failure”; Gómez-Barroso and Pérez-Martínez, “Public Intervention in the Access to Advanced Telecommunication Services”.

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Kommentarer»

1. Jokke K - april 29, 2008

Fredrik, du är överväldigande produktiv, har inte hunnit läsa ordentligt dina inlägg. Men jag har ett förslag: varför skulle du inte kunna hålla i en läsekrets där de intresserade läser en bok var för sig och då skulle man kunna kommentera boken kapitel för kapitel. En sådan bok skulle kunna vara t.ex. denna nya handbook of institutional economics:

http://www.springer.com/economics/law+%26+economics/book/978-3-540-77660-4?cm_mmc=NBA-_-Apr-08_WEST_1746085-_-product-_-978-3-540-77660-4

2. Jokke K - april 29, 2008

Hejsan,

ingen kommentar till din text denna gång heller, utan ytterligare en länk som snuddar vid temat dynamisk effektivitet:

http://siteresources.worldbank.org/EXTPUBLICSECTORANDGOVERNANCE/Resources/governanceandgrowth.pdf

3. Fredrik Gustafsson - april 29, 2008

”varför skulle du inte kunna hålla i en läsekrets där de intresserade läser en bok var för sig och då skulle man kunna kommentera boken kapitel för kapitel.”

Jag har länge haft planer på detta. Problemet är att det är svårt att hitta en bok som tillräckligt många är intresserade av att läsa men som som tillräckligt få har läst innan. Inte det lättaste. Men jag kanske tar tag i idén efter att jag slutfört min artikel (som snart håller på att bli en bok) om marknadsmisslyckanden.

På tal om dynamisk håller jag att omarbeta delen om effektivitet. Jag byter ut exemplet jag använder samt integrerar det faktum att människor har olika tidspreferenser i min definition av deynamisk effektivitet. Får kolla länka för att se om det finns ngt matnyttigt…

4. Fredrik Gustafsson - april 29, 2008

”Comments for this post will be closed on 19 May 2008.”

Coolt att den nya versionen av Comment Timeout inkluderar datumet när kommentarerna stängs. Me like.

5. Jakob Lundberg - maj 1, 2008

Hur kan du bevisa att ett naturligt monopol minskar effektiviteten? Det faktum att producenten kan öka sin inkomst genom att sänka produktionen är ju givetvis inget bevis på minskad effektivitet. Tvärtom resulterar ju det i en ökning av producentens effektivitet. Och man kan inte, som jag tidigare nämnt, jämföra minskningen i effektivitet för kunderna med ökningen för producenten och därigenom kunna dra några slutsatser om den totala effektiviteten.

6. Fredrik Gustafsson - maj 1, 2008

Har du iofs rätt i. Men det ändrar ju inte slutsatsen att naturliga monopol kan leda till ineffektivitet (i det fall det finns fler än en producent).

7. Fredrik Gustafsson - maj 2, 2008

Det här är väl ett av de ställen neoklassikerna och österrikarna inte är överens. Som vi alla lärde oss på Nationalekonomi A innebär monopol att en viss andel av konusmentöverskottet flyttas över till producenterna, samt att en del av detta överskott försvinner på vägen i form av ineffektivitet (som kommer av produktionsminskningen). Problemet är dock att värde inte är objektivt och att vi inte kan säga om den totala nyttan har minskat: producenterna kan mycket väl värdera överskottet högre än konsumenterna.

8. producent drobi - augusti 7, 2017

This is the perfect website for anyone who really wants to find out about this topic.
You know so much its almost tough to argue with you (not that I
actually would want to…HaHa). You definitely put a fresh spin on a
subject which has been written about for a long time.
Wonderful stuff, just great!


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