Strategies for Correcting Market and Government Failures

Correcting Market and Government Failure Generic Policies PAI 897 Lecture 8

Correcting Market and Government Failure Generic Policies from Chapter 10 Of course, each situation has specific characteristics, so that a generic policy may not be appropriate. However, these are the fundamental tools we have to use in formulating policy to respond to market and government failure, so we should be familiar with how they work. We should reach for them first, and make sure they fit the context of the policy question we confront. Some we have seen before, so we are gathering them up while presenting variations on them as well.

MARKETS: Freeing markets (getting out of the way and allowing) Facilitating markets (supporting or creating) Simulating markets (creating by stepping back one level) Freeing markets by deregulation. Removal of barriers to entry, putting in place regulatory oversight. o A common story is that the technology has changed since the original regulation has passed. Land line phone systems giving way to cell phones. Broadcast networks giving way to cable television giving way to satellite TV. In the US, experience with trucking, banking, railroads, airlines o Note deregulation is not necessarily moving from regulation to no regulation, it is often a reduction in regulation. Freeing markets by legalization. o Removing criminal sanctions. o Decriminalization, removing criminal penalties and replacing with civil penalties such as fines. Why should we legalize marijuana? Why should we not? Why should we legalize gambling? Why should we not? Why should we legalize prostitution? Why should we not?

MARKETS: Freeing markets by privatization Switch from subsidized / public provision by an agency to provision through user fees by a private firm. o Contract out provision previously produced by a government agency to a private firm. o Denationalize, sell state owned enterprises to the private sector, let firms in the private sector operate on market principles. o Demonopolization (or demonopsonization) that allows multiple private firms to compete in a market that was filled by a single government entity. What about a case of a natural monopoly? What about a case of a basic need water, heat, power, ?

MARKETS: Facilitating / fostering / supporting markets. Create a market by establishing property rights (remember Coase example) or creating new marketable goods. o Allocate rights to existing goods. Use power of the state to create rights to resources that are assigned to private users. Fishing areas, grazing permits, water use permits . o Create markets for the right to use existing public goods. A common example is tradable permits for use of the good, like emissions. This creates a market so that the firms have an incentive to reduce use when the cost of abatement is less than the cost of the permit to use.

Markets: Simulate markets If it is not feasible to have competition within a market, use an auction to create competition for the market so people compete to have the right to run the monopoly (and pay for the monopoly profits up front to the benefit of the state). o Right to provide a monopoly good is allocated by an auction procedure. Right to drill, right to mine, right to sell food after the security check, Thruway rest stop restaurants and gas stations, Does government have people who can accurately assess the value of the resources? Do we know the extent and value of the externalities? Are the bidders really competitive? Is the decision making based on the best bid for society? Is it clear ex ante by what elements is the competition being judged? Is government powerful in relation to bidders?

Chart 10.1 Summary of Freeing, Facilitating, and Simulating Markets Generic Policies Perceived Market Failure (MF), Government Failure (GF), Distributional Issue (DI), Limitation of the Competitive Framework (LCF) Typical Limitations and Collateral Consequences Freeing Markets Deregulate GF: Allocative inefficiency from rent seeking LCF: Technological changes Distributional effects: windfall losses and gains, bankruptcies Transitional instability Legalize Privatize Facilitating Markets Allocate through Property Rights LCF: Preference changes GF: Bureaucratic supply MF Negative Externalities MF: Public Goods MF Open Access Goods Distributional effects: windfall gains and losses Create New Marketable Goods Thin Markets Simulating Markets Auctions MF: Natural Monopoly MF: Public Goods DI: Transfer of scarcity rents Collusion by bidders, opportunistic behavior by winning bidder, political pressure to change rules ex post

Tax and Subsidy Policies Review tax and subsidy graphs. Review tax and subsidy justifications. o Tax expenditure is a way to subsidize behavior. o Forgone tax income by government as a way to change the incentives facing consumers and producers. o Tax expenditure as effectively lowering the price of the targeted good. Why are charitable contributions deductible from income taxes? Why is mortgage interest deductible from income taxes? SALT? Why is wealth in the form in increased equity in a home not taxed? What are some distributional issues here? o Supply side subsidies. o Take the basic argument that the supply of the good leads to positive externalities. There is a public interest in having the commodity supplied at a lower price and have more of it. o Note that subsidies are different than taxes at some basic level as taxes generate revenue, subsidies require the use of revenue.

Table 10.2: Using Subsidies and Taxes to Alter Incentives Perceived Market Failure (MF), Government Failure (GF), Distributional Issue (DI), Limitation of the Competitive Framework (LCF) Typical Limitations and Collateral Consequences Generic Policies Supply-side taxes Output taxes MF: Negative externalities DI: Transfer of scarcity rent LCF: Market power of foreign exporters Frequent adjustment of tax levels required Import tariffs Deadweight loss for consumers, rent seeking by domestic producers Supply-side subsidies Matching grants MF: Positive externalities MF: Public goods DI: Increase equity MF: Positive externalities MF: Public goods Diversion to general revenue by reduction in effort Tax expenditures (business deductions and credits) Misallocation of resources across industries, horizontal tax inequity Demand-side taxes Commodity taxes User fees MF: Negative externalities MF: Information asymmetries MF: Public goods MF: Open access Deadweight losses and black markets Demand-side subsidies In-kind subsidies MF: Positive externalities LCF: Utility interdependence DI: Floors on consumption MF: Positive externalities DI: Increased equity GF: Bureaucratic supply failure MF: Positive externalities DI: Increase equity Restricts consumer choice, bureaucratic supply failure, lumpiness leads to inequitable distribution. Vouchers Informational asymmetries, short-run supply inelasticities, institutional resistance. Tax expenditures (personal deductions and credits) Poor targeting of subsidies, vertical and horizontal tax inequities

Establishing Rules and Regulations. Not using incentives to influence choices, but the coercive power of the state. o Can be civil or criminal sanctions that punish behavior. Frameworks that govern behavior. However, in contrast to the previous examples of markets as a solution, can markets exist without rules in the background? o What rules do we need to make markets function? o What set of rules do we need to allow government to make rules that influence markets?

RULES AND REGULATIONS: Command and control. Directive is given, compliance is monitored, noncompliance is punished. Price regulation. o Recall examples of price floors and price ceilings. o Recall example of regulating a monopoly. Regulations allowing Price Discrimination: o 10 wealthier households each WTP $10 for a cubic meter of water o 20 poorer households each WTP $5 for a cubic meter of water o Based on Perloff, Microeconomics, page 397 10 wealthy 10 wealthy $5*10=$50 $10*10=$100 $10*10=$100 20 poorer 20 poorer $5*20=$100 0 $5*20=$100 Total Revenue Total Revenue $150 $100 $200 Water Water 30 10 30 Uniform $5 Uniform $5 Uniform $10 Uniform $10 Price Discrimination Price Discrimination Quantity regulation. o Control amount of externality generating product that is supplied. o Control amount of the good that produces a negative externality o Control the number of livestock put on the commons. o Outright ban. Why is it illegal to buy or sell human organs in the US?

RULES AND REGULATIONS Control of the externality directly. Marginal cost of abatement, marginal cost of permit comparison. o Standards in production. Labor laws, occupational health and safety oversight. o Food and Drug administration. o USDA inspections o Health department inspections o Residential inspections Lead testing and abatement requirements. o Renters rights o Regulations that require direct information provision. Warning labels on products, o Calorie counts in restaurants, o Cereal box information o Country of origin labels, o Efficiency ratings o Organization report cards, Maxwell and US News and World Report Public school report cards, provision of information, graduation rates, spending per student, Indirect information provision. Licensure you have to have official authorization to provide a good or service. Less stringent, you have to meet certain standards to be in an association and they signal you have standards that meet the group s expectations.

10.3 Establishing Rules Perceived Market Failure (MF), Government Failure (GF), Distributional Issue (DI), Limitation of the Competitive Framework (LCF) Typical Limitations and Collateral Consequences Generic Policies Frameworks Civil laws (especially liability rules) MF: Negative externalities MF: Information asymmetries MF: Public goods DI: Equal opportunity LCF: Thin markets MF: Negative externalities MF: Public goods LCF: Illegitimate preferences Bureaucratic supply failure Opportunistic behavior Imbalance between compensation and appropriate deterrence Criminal laws Costly and imperfect enforcement. Regulations Price regulation MF: Natural monopolies DI: Equity in distribution of scarcity rent DI: Equity in good distribution MF: Negative externality MF: Public goods MF: Open access MF: Information asymmetries MF: Negative externalities MF: Information asymmetries MF: Negative externalities GF: Bureaucratic supply failure LCF: Cognitive limitations to rationality Allocative inefficiency X-inefficiency Quantity regulation Rent seeking Distorted investment Black markets Cognitive limitations of consumers Direct information provision (disclosure and labeling) Indirect information provision (registration, certification, and licensing) Rent seeking Cartelization Regulation of the circumstances of choice Few applications discovered so far beyond opt-out

Direct Provision by Government Rationale for direct government provision to minimize opportunistic behavior. o Note Blackwater / Wagner kinds of counterexamples. Direct supply, see the list from Leman on 249 of 10 functional categories for domestic government provision o Facilitating commerce o Managing public lands o Constructing public works and managing real property o Research and testing o Technical assistance o Laws and justice o Health care o Social services and direct cash assistance o Education and training o Marketing o Supporting internal administrative needs o International functions as well with defense and foreign policy / relations. Independent agencies o government corporations TVA, Port Authority of NY-NJ o Special districts watershed management, school districts Return to the idea of contracting out as a kind of direct provision by government. o Add in Public Private Partnerships as a model

10.4 Supply by non-market mechanisms. Perceived Market Failure (MF), Government Failure (GF), Distributional Issue (DI), Limitation of the Competitive Framework (LCF) Typical Limitations and Collateral Consequences Generic Policies Direct Supply Bureaus MF: Public goods MF: Positive externalities MF: Natural monopolies DI: Equity in distribution Rigidity; dynamic inefficiency; X-inefficiency Independent Agencies Government corporations MF: Natural monopolies MF: Positive externalities DI: Equity in distribution GF: Bureaucratic supply failure MF: Natural monopolies MF: Local public goods MF: Negative externalities DI: Universal provision Agency loss Special districts Agency loss; insensitivity to minorities with intense preferences Contracting Out Direct contracting MF: Public goods, especially local public goods. GF: Bureaucratic supply failures MF: Positive externalities GF: Bureaucratic supply failures DI: Diversity of preferences LCF: Endogenous preferences (behavior modification) Opportunistic behavior by suppliers; lock-in and low-balling. Week coordination of services Indirect contracting (nonprofits)

Table 10.5 Insurance and cushions. Perceived Market Failure (MF), Government Failure (GF), Distributional Issue (DI), Limitation of the Competitive Framework (LCF) Typical Limitations and Collateral Consequences Generic Policies Insurance Mandatory insurance Subsidized insurance LCF: Adverse selection MF: Information asymmetries DI: Equity in access LCF: Myopia LCF: Misperception of risk Moral hazard Cushions Stockpiling LCF: Adjustment costs GF: Price controls Rent seeking by suppliers and consumers Transitional assistance (buy-outs, grandfathering) LCF: Adjustment costs GF: Macroeconomic dynamics Inequity in availability Cash grants DI: Equality of outcome LCF: Utility interdependence Reduction in work effort; dependency

10.6 Primary (P) or Secondary (S) Sources for Solutions Market Mechanisms Incentives Rules Nonmarket Supply Insurance and Cushions Traditional Market Failures Public Goods Externalities Natural monopolies Information Asymmetries S S S S P S S P P P P S P S S Other Limitations of the Competitive Framework Thin markets Preference-related problems Uncertainty problems Intertemporal problems Adjustment costs Macroeconomic dynamics P P P S S S S P P S P Distributional Concerns S Equity of opportunity Equality of outcomes P S S P S Government Failures Direct democracy Representative government Bureaucratic supply Decentralization P S S P P S S P S S