Chapter 16

Markets are like European cars. When they work they are magnificent; when they fail the results are inconvenient, expensive, and not always amenable to straightforward solutions.

The power of markets is their capacity to use price signals to allocate scarce resources efficiently. But what if there cannot be price signals? And what if the resources are not scarce?

In this chapter we look at two properties of markets concerned with price signals and scarcity. In economists' terms these are the concepts of excludability and rivalry. This leads to a classification of markets based on these properties, integrating the theory of costing and pricing developed in the preceding chapters. Finally we look at a general normative approach to market failure.

Excludability and Rivalry

The main function of prices is to ration the supply of scarce goods to those who can offer scarce resources in exchange. Those who cannot pay, or who do not wish to pay, are excluded.

Sometimes, however, non-payers cannot be excluded. It may simply be impractical to exclude non-payers. For example, most Australian national parks are vast areas with many points of entry; it would be absurdly expensive to put toll gates on every possible entrance. (By contrast, there is a small park south of Sydney with toll gates; because it has only two road entrances and is near a large population center it is excludable.) In other cases it is technically impossible to exclude non-payers, it would be impossible to provide national defense to some people and communities and not to others, based on individual payments. In some cases the concept of non-excludability is another way of referring to positive externalities associated with production or consumption. When a business invests in research many of the benefits of that research enter the public domain, where non-payers cannot be excluded. In some cases goods are non-excludable for moral reasons. Access to emergency wards and search and rescue services is based on such a principle. Sometimes there are mixed principles; access to immunisation is based both on moral grounds and on positive externalities.

When non-payers cannot be excluded private markets generally fail to provide, except perhaps in those rare cases where the providers can capture sufficient private benefits to be happy about letting other parties take the benefits for no return. For example, a large pastoral firm may find it economical to introduce new plant species, or new strains of fleas as myxomatosis vectors, accepting that neighboring properties will also gain the benefits. Such cases, however, are rare. In general non-excludability ensures markets will not develop, even though there are potential benefits to consumers and to producers, if only they could be paid. There is economic loss because desirable transactions cannot take place.

Rivalry is about scarcity. A good is rival if my consumption detracts from your capacity to enjoy that good. If scarce resources are involved in producing that good, then, by definition, it is rival. When there is no shortage of the good concerned, it is non-rival.

For example, a beach may be non-rival; the Ninety Mile Beach on the Southern Ocean is a reasonable example; my use of it does not detract from another person's use of it. By contrast, however, Bondi Beach is definitely a rival good. Free to air broadcasting is a typical case of a non-rival good.

The problem with non-rival goods is that if they are also excludable there can be deadweight loss. For example computer software, sound recordings and pharmaceuticals are essentially non-rival, in that once the fixed investment is made, the marginal cost of extra production is very small. If left to unregulated private markets non-rival goods tend to be under-produced, with all the problems of loss of consumer benefits, deadweight loss, and technical inefficiency associated with monopoly.

Public Goods and Public Policy

When we combine the concepts of excludability and rivalry, we can develop a 2 x 2 matrix of classification, as shown over the page. The classifications are less rigid than such a matrix may imply. For example goods can have non-rival characteristics because of low, but not necessarily zero, marginal cost; that is the case with most output of natural monopolies or declining cost industries, discussed in the previous chapter. For example, electricity and water supply are hard to classify unambiguously as "rival" or "non-rival". Goods may be only partially excludable; computer software is legally excludable, but piracy is technically easy and is a major problem. Within the matrix roads provide examples; depending on location and use roads can belong in all four quadrants.

Classification of Goods, With Examples.
	Rival - MC > 0. Costly supply.	Non-rival - MC very low or 0, Low cost supply
Excludable Pricing system can exclude non-payers	Most goods produced and sold in private markets. *private goods.* Example - congested toll roads.	Goods with very low or zero marginal cost. May be supplied in private or public markets. Sometimes called *impure public goods*. Example - uncongested toll road
Non-excludable Pricing system cannot work.	Public provision Example - congested open access road.	Public provision. Example - uncongested open access road.

To take each quadrant in turn, starting in the top left hand corner and working clockwise:

Much heat is wasted in political debate because of a lack of distinction between public funding and public provision. We are told, for example, that the private health care system is in danger of extinction because of the demise of private health insurance. (In reality, while the private funding system may wither away, the private provision of health care seems to have a well entrenched and accepted place in the system.)

For non-excludable goods there is generally little option other than public funding. But that doesn't mean the government will necessarily provide the service itself. It may contract the private sector to provide all or part of the goods or services involved.

In the case of excludable but non-rival goods the private sector will often be very keen to fund and provide. By their nature, because of low variable costs, they often offer the opportunity of monopoly profits. If the private sector does provide, then a régime of price control and oversight will be necessary.

When it comes to asset sales governments face conflicting objectives. There is a short term budgetary desire to maximize the proceeds of the sale. This means, possibly, letting the sale go through with a very loose régime of price control. The sale price will be dependent on the present value of future earnings, and the higher the opportunity for monopoly profits, the higher the price the private bidder will offer. When privatization is driven by short term fiscal expediency, it may simply involve selling the present value of future monopoly profits. There is no benefit to the community; in fact a new private tax is introduced, and there is the probability of deadweight loss.

Private provision with regulatory oversight is common in the USA, where power generation and telecommunications have been private for a long time, but not in Australia. (Here it will probably become more common with extensive privatization. One of our earliest initiatives is the authority Austel, to oversee telecommunications pricing.) Benchmark competition, where there is part public provision, has been a particularly Australian solution, with arrangements like the former two airline policy, Medibank Private, and government banking.

Sometimes communities get together to provide goods for their own collective use. These are not strictly public goods, as they are provided only for the benefit of a restricted group. For example, there is a levy on livestock transactions in Australia to finance meat research and promotion. Such goods are often known as toll goods; a group pays the toll for free access from there on.

Such arrangements often present free rider problems, as the goods are not always excludable. Non-payers often free-ride on these goods. For example, a network of navigation aids is provided for large regular public transport aircraft, and they are paid for by airlines out of their air navigation charges. Light aircraft operators, who pay much lower charges, can literally free ride on these navigation systems. They argue that they never required the systems; they were provided for another party (the large regular public transport operators). The marginal cost of using these services is zero, so they should not have to pay. The light aircraft operators say it's nice to have access to them, but they never asked for them in the first place. There is logic in their argument; private markets normally do not force people to buy things they don't ask for.⁽⁴⁾ When governments institute user pay systems, they need to ask whether they are levying the beneficiaries of the system, or incidental, sometimes non-voluntary, users of the system. There is a story that in Stalin's time the KGB used to send families of political prisoners accounts for their accommodation. In Britain, in the 16th Century, political prisoners were expected to pay their executioners for the service rendered. Some user pay systems are not far from this principle; for example the Australian Customs Services charges customs clearing fees on all imports, even though the beneficiaries of tariff protection are the clothing and motor vehicle industries.

Free rider situations carry an incentive to bluff; if enough people argue that they really don't want the service, hoping someone else will pay for it. This is an example of the prisoners' dilemma, a point to which we return in Chapter 17. Free rider problems are often associated with market development; often the first player in a new market incurs all the product and market development costs and a small undeveloped market. Second and subsequent entrants can free ride of the efforts of the first party. Because of this dynamic, no one is going to take the initiative and develop the market. This is one of the arguments in favor of public support for research and development, export market development, and, sometimes, promotion of new products, such as consumer information technology.

General Market Failure Theory

The foregoing Section covers market failure mainly under the headings of excludability and rivalry. There are other conditions which cause markets to fail. That is, not to develop the benefits of competitive outcomes.⁽⁵⁾ Briefly, these are situations where, if pricing and allocation decisions were left to the 'invisible hand' of the market, there would not be the benefits of competition, with its attendant benefits of efficient production and benefits of consumer surplus.

In these situations there needs to be a public policy in response. A normative model is to apply a hierarchy of decisions, as in the figure on the next page. This assumes that governments prefer to leave markets to operate when they can; in other words they are averse to intervention. (A different situation may exist in a centrally planned economy.)

At each step the benefits of action need to be weighed against the costs of that action. It may be that the market for pizzas in Canberra is not perfectly competitive, but the cost of having a pizza regulatory agency would be far greater than the few benefits which it could achieve.

Regulatory costs are hard to measure. The easy part is to measure the costs incurred in the regulatory agency. There are also compliance costs - costs incurred in the regulated industry, such as licence fees, administrative time etc. Also regulations can lock an industry into a particular structure. Existing players can live with the regulatory régime, which tends to lock out other potential entrants with lower costs or innovative products. This is sometimes known as the theory of regulatory capture.⁽⁶⁾

That's the first level of government intervention. An unregulated market is not necessarily a competitive market. Regulations may be necessary to remove barriers to entry - impediments raised by existing operators in the market to suppress competition through maintaining restricted supply.

Vigorous trade practices legislation and enforcement is a commonly used instrument to prevent closed shops, collusion on prices and other uncompetitive behavior.

Information failure is common. Markets work well in situations where consumers can easily judge for themselves the quality and value of products on the market. They may be able to tell before purchase, as most buyers can when buying fresh fruit. Or they may rely on experience for goods with low cost and short life, such as shampoo and T shirts.

When it comes to goods with complex qualities which are not immediately discernible to the consumer, information may be hard to obtain. A classic example is provided by the market for used cars, in which it is almost impossible for quality to command a premium. Left to their own devices such markets often fail to provide quality goods, and reach equilibrium at a low quality level. (For a complete treatment of this issue see George Akerlof's essay The Market for Lemons - Quality Uncertainty and the Market Mechanism.⁽⁷⁾) For products like food consumers have limited opportunities to judge purity and safety. For long-life products like life insurance one cannot detect a poorly performing product until it's too late.

To overcome such market failures regulations exist to provide consumer information (e.g. disclosure rules on investment products), to provide comparative data (e.g. fuel consumption guides), to require warranties (as in the Trade Practices Act and in used car warranty laws), and to provide standards, as with building and food codes. Standards are examples of contracts, which we cover when we look at prisoners' dilemma in Chapter 17.

Information has many public good characteristics, so tends to be under-provided in markets. Likewise with credibility; government regulation is often necessary to give consumers confidence in the market. Statutory warranties on used cars, for example, help consumers and producers by establishing credibility in a situation where it may otherwise be absent.

Markets often fail to provide property rights. Developers of literary works, inventions, computer software, music, and pharmaceuticals, would find that their products could not be sold at a reasonable price without some protection against copying, as provided through patents and copyright. All these products have low unit cost, but high upfront fixed cost for the first producer.

Sometimes markets never really reach a stable equilibrium, but prices swing around the equilibrium level. This is sometimes known as market failure through instability, and often results in calls for industry regulation to create stability. Such regulations often take the form of production quotas to stop production over-expanding and maintenance of stockpiles to regulate the flow of the commodity on to the market. Wool, tin, and other basic commodities have all, at various times, had such stabilization schemes, and the most extensive government stabilization interventions have been in countries' own currencies.

One of the most problematic cases of market failure occurs when there are many players, few barriers to entry, no overt collusion, but still no effective competition. This can occur in industries where firms consistently seek objectives other than profit maximization. These objectives may typically be growth or market share. Life insurance, banking, and health insurance all exhibit such characteristics.

A key assumption of economics is that supply and demand are independent functions. The consumer's demand function is independent of the supplier's supply function. The consumer is indifferent to the cost of production.

In reality, consumers are interested in the supply side of markets. Consumers seek fairness in market transactions; if they think they are being overcharged they will object.⁽⁸⁾ Commercially that will mean people will reduce their demand for the good or service if they feel ripped off; in extreme cases a boycott is possible. When it comes to government produced goods and services there is a political dimension to consumers' reactions. This means that user pay systems must be transparent, and costs have to be explained.

A second-best solution to market failure is to accept that markets will not work, but to develop conditions which emulate the operation of markets. Sometimes, even vigorous competition policy cannot stop development of monopolies, especially where natural monopoly is involved, or where the benefits of incumbency are high.

In some cases where there is seller concentration, the government may set itself up in a position of countervailing power to purchase goods and services on behalf of consumers. Most commonly we see such policies in national health schemes where governments countervail the power of pharmaceutical companies and closely organized medical trade unions. The government accepts the monopoly of supply, and countervails it with its own monopsony.

Notes

William C Apgar and H J Brown Microeconomics and Public Policy (Scott, Foreman and Co 1987)

John L Mikesell Fiscal Administration - Analysis and Applications for the Public Sector (Brooks/Cole CA 1991)

Public Sector Management Institute, Monash University The Role of the Public Sector in Australia's Economy and Society (Monash University 1990)

1. National Committee of Inquiry (Frederick Hilmer) National Competition Policy (AGPS 1993)

2. Industries Assistance Commission Inquiry into Government (Non-Tax) Charges: Pricing and Provision of Government Provided Goods and Services (IAC Information Paper #3, 1988)

3. Naomi Caiden "Patterns of Budgeting" in A Schick Perspectives in Budgeting (American Society for Public Administration, 1987)

4. There are exceptions, however, in markets like insurance, where there is often "bundling" of wanted and unwanted products.

5. Some commentators define market failure not in terms of market outcomes, but in terms of market structure; are there enough players, is there an absence of collusion etc?

7. George Akerlof "The Market for Lemons: Quality Uncertainty and the Market Mechanism" Quarterly Journal of Economics Vol 84 May 1970

Chapter 16 - Market Failure and Public Goods

Market Failure

Excludability and Rivalry

Public Goods and Public Policy

General Market Failure Theory

Notes