At the Close of Chapter 3, We Saw That Adam Smith Envisaged the Task of Government As Highly

4 Market Failure and Government Failure

At the close of chapter 3, we saw that Adam Smith envisaged the task of government as highly limited and beneficent only in three areas: national defense, the administration of justice, and in certain large-scale infrastructural investments that private industry would not, or could not, assume. However, a glance at any modern market economy reveals that government activity is not confined to these areas but extends into production, regulation, and redistribution. In the wealthy countries of the Organization for Economic Cooperation and Development (OECD) governments take in and spend an average of about 40 percent of gross domestic product (GDP).1 Despite the common political rhetoric of the 1980s and 1990s on the need to downsize government, the trend, measured in terms of governments’ share of GDP, seems to be inexorably upward.2 How is such widespread interference in the market economy explained? There are two main answers: the correction of “market failure” and redistribution of the social product toward disadvantaged, primarily economically inactive, groups.

MARKET FAILURE

One general justification for government intervention in the operation of free enterprise economy is market failure. While many modern economies are characterized by highly competitive markets for some products and factors of production, the conditions necessary to establish perfect competition in all markets are seldomencountered. Four phenomena considered to lead to serious inefficiencies are briefly listed here:

1. Market power. The possession of substantial market power by a single or small group of market participants creates conditions under which prices deviate from marginal costs, an allocatively inefficient outcome. Similarly we might encounter market power in the supply of labor through unionization, implying that the price of labor will differ from the value of its marginal product.

2. Lack of information. Any inability of relevant market participants to access relevant information at reasonable cost prevents them from acting in an economically rational fashion.

3. Public goods. Goods that are nonrival in consumption and for which the marginal cost of supply is zero will not be produced in efficient quantities by a private market.

4. Externalities. Outcomes based on private costs and private benefits are inefficient when social costs and social benefits are economically significant.

Government intervention has frequently been seen as a corrective to these problems, but there is a growing criticism that such action is often more harmful than the market imperfections that occasioned it. In this chapter we will first examine the rationale for such intervention and then we will assess to what degree government action is likely to benefit, rather than harm, the general welfare.

SOURCES OF MARKET FAILURE: MARKET POWER

Markets function efficiently only when no participant has substantial market power. Such power may be found on either side of the market. However, it is power on the supply side, monopoly (a single seller) and oligopoly (a few sellers), that has been seen as the most injurious to economic welfare and has been the target of most governmental legislative, judicial, and regulatory activity. Market power on the buying side (monopsony) is considered less harmful to public welfare and is rarely a target of regulatory activity.3

The Problem of Monopoly

When markets are perfectly competitive, firms are price takers, facing a horizontal, or infinitely elastic, demand curve. Any deviation of price from that dictated by the market will result either in a lower than normal profit rate, untenable in the long run, or a total loss of sales to lower priced producers. Competitive pressures ensure that the market price is equal to the marginal cost of production. Whenever markets are not perfectly competitive, a firm’s demand curve is not horizontal but slopes downward; the firm becomes a price setter, having some control over the prices that it charges.

Confronted by downward sloping demand curves, profit-maximizing firms restrict production, raise prices, and, therefore, generate economic profits, returns above the normal rate for all industries. The existence of barriers to entry prevents these super-normal profits from serving their usual function, which should be to attract new entrants and capital into the industry that would, over time, return the profit rate to normal. Importantly, monopoly drives a wedge between the price that the buyer must pay and the marginal cost of production. Consumption is reduced and consumers’ surplus is lost creating economic inefficiency. This is illustrated in Figure 4.1. The monopolist maximizes profit by setting output at the point where marginal cost is equal to marginal revenue. This results in a lower output than might be the case under competition QM as opposed to Qc, and a higher price, PM as opposed to Pc. The loss of welfare is denoted by the triangle labeled deadweight loss in consumption.

Monopoly also results in a transfer of welfare from consumers to the monopolist. This is shown in the diagram by the rectangle labeled monopoly profit. Such a transfer is not a loss to society, since both consumer and monopolist are members, but it is often seen as inequitable and it can be at least as important as the deadweight loss in motivating government action. Correction of this form of market failure, in order to promote efficiency and protect consumers, is considered in many countries a reason for government action.

Natural Monopoly.Economists have traditionally distinguished between two forms of monopoly. One, usually termed natural monopoly, occurs because of high fixed costs and declining or constant marginal costs, which cause the long-run average cost curve to be falling across the relevant output quantities. If competition can be created, it is only at the cost of the expensive and wasteful replication of facilities. In such cases monopoly is generally tolerated, but it is modified by government action, generally through the control of prices by a public agency.

Natural monopoly is common in industries that require very high fixed costs due to extensive initial capital investment. Electricity supply, telephone networks, and TV cable distribution are frequently cited as typical examples of natural monopoly. The existence of natural monopoly in fact involves a dual problem. As shown in Figure 4.2, in the absence of price regulation, a profit-maximizing monopoly would fix output at QM and price at PM, thus earning profits in excess of the normal rate of return. This provides a rationale for government intervention to fix the price, usually through the activity of a public utility commission.

However, once the decision to regulate has been made, the appropriate price remains a subject of contention. From an efficiency point of view there is a case for regulators to fix the price at marginal cost. In Figure 4.2, we can see that in declining average cost industries marginal cost lies below average cost for all relevant output levels. Marginal cost pricing would give a price of PE, and would require an output of QE. However, at such a price revenues would fail to cover the total costs of the enterprise. Such policy would require the granting to the utility of a subsidy (ideally in the form of a block grant) from the government to cover fixed costs. Subsidies of this kind are often politically unattractive, and a common “compromise” solution is for regulatory commissions to fix the price at average total cost, as shown in the diagram as PR. This price is above the marginal cost and allows the utility to cover all fixed and variable costs including a “normal” rate of return on capital. This solution avoids the “gouging” potentiality of an unregulated monopoly, but it does dilute incentives to strive for optimal efficiency. It also presents the possibility of capture of the regulatory agency by the regulatee, a topic we will return to as an example of “government failure.”

Natural monopolies do not represent a fixed and unchanging set of industries but are a function of the state of technology. They are a much less significant phenomenon in the long run than in the short run, and economists now regard them as a less of an impediment to efficiently functioning markets than in the past. Changes in technology are capable of bringing about the emergence of competitors that may obviate the need for regulation, and sometimes regulation is a barrier to their emergence.

Consider, for example, long-distance telephone services. When all phone traffic had to be carried on fixed cables, the construction of the network was very expensive. There was an opportunity to earn monopoly profits because the high cost of establishing the network made the entry of a second or third supplier unlikely. Furthermore, in most people’s minds it would be socially wasteful to replicate the network. The emergence of satellite technology to replace cables has had a profound effect on competitive structure and eased entry, obviating the need for regulation. However, it took regulatory changes (in the United States there was the breaking up of ATT, the telephone monopoly, and in much of Europe there was the end of state-provided phone service) to allow the wind of competition to blow through the communications marketplace. In electricity supply, a similar change has occurred, due to the realization that, although the grid of cables itself is a natural monopoly, there can be vigorous competition among the suppliers who serve users connected to the grid. Thus, rather than regulating the delivered price of electricity, most of the benefits of competition might be grasped through regulating the price of conveyance on the grid and allowing electricity suppliers to compete on a price basis.

In some cases, government’s willingness to intervene in the market can lessen competition and act against the consumers’ interest. For example, all transportation modes are gross substitutes and are to some degree in competition with each other. In a market context they can act as a limit on the price behavior of each other. Regulating transportation on a mode-by-mode basis, with mode-specific agencies, can tend to reduce competition in the broader industry and be counterproductive to consumer welfare.

Antitrust Policy.The other form of monopoly (which can be termed unnatural or artificial) is created by the gathering of market share by a dominant enterprise, which then erects barriers to entry to forestall competition. This behavior is countered by what in the United States is termed antitrust policy, regulatory and legal action designed to promote freedom of entry and to prohibit the merger (or collusion) of competitive firms that would result in harm to consumers.

All developed nations have a government agency nominally charged with the maintenance of competition, although in some countries it is more vigilant than in others. In the United States the relevant agency is the Federal Trade Commission, an arm of the Department of Justice, empowered to investigate and bring suit in defense of trade. In the United Kingdom it is the Competition Commission, formerly known as the Mergers and Monopoly Commission. Such agencies are charged with reviewing competitiveness on an industry basis, assessing the impact of mergers on competition, and, in cases where the evidence merits, taking legal action because the public interest has been or might be harmed.

In doing so, such agencies are looking for accretion of economic power and its impact on economic welfare. In the past much attention tended to be focused on the existence of power as measured by “concentration ratios,” defined as the share of domestic market consumption represented by a given number of firms. The logic behind this is that the greater the domination of the market by a small number of firms, the less likely is competition to be intense. The most usual index is the four firm concentration ratio—that is, the amount of total sales accounted for by the largest four firms. In the United States, using this basis, the most concentrated industries reported in the Census of Manufacturing were chewing gum and cigarettes (96 and 92, respectively). Another measure is the so-called Herfindahl Hirschman index (HHI, named for its originators, O. C. Herfindahl and A. O. Hirschman),4 which takes account of the market composition among the four largest firms.

However, recent developments have led to a change of thought about how we should measure economic power or loss of welfare. First, there is skepticism of the view that either market share or concentration ratios are useful indices. Many economists today are of the view that what matters to keep a market functional, even if not perfect, is not how static market shares add up but the degree to which the market is contestable.5 The threat of a competitor may be as effective as the existence of one in moderating excesses in pricing behavior. If there are few firms in the market and high barriers to entry, potential competition is certainly choked. However, even a total monopolist may be subject to restraint, and behave therefore more like a competitor, if entry into the market is easy. The issue therefore becomes not one of the size of market share at any moment in time but rather the height of the barriers to entry that determine the level of contestability.

Consider the position of Microsoft, Inc. In many areas of personal computer software, the company has a near total monopoly. However, historically, entry into the industry has been relatively easy, and high product prices would serve to lure competitors into the industry. Consequently it is the threat, rather than the actuality, of competition that moderates Microsoft’s pricing behavior. If, as has been alleged in the current antitrust suit, Microsoft can use its market power to restrict entry, the market is no longer contestable and loss of welfare can result.