Shane Vallance, South West RDA / Economy Module, delivers a presentation on the economics of intervening as a result of market failure.

1. Rationale for intervening
in the economy
Market failure, equity or opportunity?
Shane Vallance - SWRDA

2. Reminder - how to increase economic output
Simple production function:
Y = f(T, K, L)
Therefore, you can increase economic output by:
Improving stock of technology
Increase the level/quality of capital
Increase the supply/quality of labour
Essentially the areas where public/private intervention
(should) take place

3. If markets function properly (‘perfect competition’)
Firms – maximisation of profit acts as ‘perfect’ incentive
Consumers - optimisation of utility drives behaviour
Multiple, all knowing, non powerful actors
Perfect information – consumers and producers (eBay?)
Perfect entry & exit (no barriers to entry)
No market rigidities – markets quickly adjust
Unrestricted flow of factors of production
Market costs reflect total cost to society – no externalities
No Government intervention (it distorts the market) – Adam Smith’s
‘invisible hand’

4. ‘The invisible hand’
Markets are (normally) the most effective mechanism to allocate
resources
Producers have an incentive to produce for consumers through their
willingness to pay (price) for a scarce resource
Consumers willingness to pay (price) will match the benefit that they
will derive from that product
Producers will earn a profit that will act as an incentive to produce
more
If they produce too much, the price will reduce because the resource
has got less scarce
This will reduce profits, meaning less will be produced – making the
resource less scarce, raising the price
and so on, and so on……

5. ‘Just let the market get on with it’
1. Productivity/efficiency argument – the importance of price signal
2. Ideological argument – ‘crowding out’
Or,
3. Market failure (a tale of farmers and lumberjacks)
4. Equity argument
5. Opportunity?

6. The Productivity argument
Lack of price signal means the public sector is not as effective
as the market in the allocation of resources (despite
Government attempt in some services)
Lack of profit means there is an ‘incentive gap’
As a result, public sector productivity performance lags rest of
economy (caveat – difficult to measure public sector
productivity because often lack of output to be measured)
Recent history is tale of falling output and rising inputs
Implications for long-term resource efficiency – public sector
too big, performance of economy suffers

7. The productivity argument – declining public sector productivity
Comparison of public sector productivity (% annual change)
-2
-1.5
-1
-0.5
0
0.5
1
1.5
2
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
Public sector productivity Whole economy productivity

8. The productivity argument – declining public sector productivity
Falling public sector productivity (% annual change)
0
1
2
3
4
5
6
7
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Public sector output Public sector input

9. The ideological argument
Based on same premise – that non-market actors are less
efficient at allocating resources than market actors
You will use £1 of earnings more efficiently (maximising your
utility) than if £1 were taxed and spent by Govt on your behalf
Leads to concept of ‘crowding out’ – usually refers to Govt
spending using financial & other resources that would
otherwise be used by private sector (firms & individuals)
Case 1 – Govt spend, Tax, Private consumption
Case 2 - Govt spend, Borrowing, Private investment
Case 3 - Govt spend, Wages, Private investment (a
Keynesian would argue this would also Private consumption)

10. However, markets are not perfect
A tale of farmers and lumberjacks….

11. and that is
economics…
it’s the allocation of
resources to meet
society’s (unlimited)
needs as effectively as
possible

12. Market Failure #1:
Lack of property rights
Intervention Type:
Fish Quotas, Public
Realm

13. Market Failure #2:
Lack of (or imperfect)
information
Intervention Type:
Overseas offices,
Tourism Marketing

14. Market Failure #3:
Lack of price signal
Intervention Type:
Direct development
(up to a point until
price signal
established)
Govt as the buyer?

15. Market Failure #4:
(Negative) Externalities
– price of production
does not reflect true
value to society
A < B (over production)
Intervention Type:
Taxation on airlines
A B

16. Market Failure #5:
(Negative) Externalities
– cost of consumption
does not reflect true
value to society
C < B (over consumption)
Intervention Type:
Congestion charging, tax
on petrol, cigarettes, air
travel; etc.
A B
C

17. Market Failure #6:
(Positive) Externalities
– private benefits of
production do not
reflect true value to
society
D < B (under production)
Intervention Type:
Renewable Energy
A B
CD

18. So there are benefits to intervening to address
market failures
However, should there be a role on the grounds of
equity?
Depends on your (macro or micro) viewpoint

19. The Equity argument – the macro view
Remembering that in perfect (and non-perfect) markets firms will
seek to maximise profit – therefore will seek to reduce costs
& increase benefits
Costs - therefore move to lower cost bases (i.e. offshoring)
Benefits – close to greatest demand (i.e. commercial property)
This is just the market allocating resources efficiently
In the long-term those areas ‘left behind’ will adjust (land &
labour costs will ) and economic activity will be attracted
back
Therefore there is no role for public sector – questions
(competitive) economic development approach

20. The Equity argument – the micro view
This is not a perfect market and the ‘structural adjustment’ takes
a long time
During this time the social costs are such that there is an
argument for justification of public sector support
Unlikely any role in  costs (unless we consider subsidies i.e. GBI
or indirect costs such as transport infrastructure)
However, role in benefits (improving skills, quality of R&D,
quality of environment etc.)
Therefore there is a role for public sector

21. The (lost) opportunity argument
Often held up as the argument for public sector intervention
Should there be a role for the public sector?
Linked to equity macro versus micro argument
Macro view is that if the opportunity was strong enough then
profit potential should act as incentive enough for market
provision
Micro view is that we would like that opportunity to be exploited in
a specific area – meeting equity and competitive advantage
needs
How to deal with opportunity cost (in a world of increasingly
scarce ‘public’ resources)?

22. Conclusion
Economics is allocation of scarce resources
Markets are the most effective way of allocating resources, price
signal is the oil in the engine
Even non-perfectly performing markets operate more efficiently
than public sector (or do they?)
Market failure justifies intervention to address imperfections
Are there grounds for intervention for equity purposes – depends
on viewpoint (short term versus long term argument)
Always will be an ideological argument about role of Government