Economic Policy and Regulatory Environment in India

Market Failure and Need for Government Regulation

Rachna Gangwar Institute of Management Technology Ghaziabad

Learning Objectives
Why do markets fail to produce efficient outcomes? Why is governments role important? What is the trade-off between efficiency and equity?

Market Failures
A situation where free markets fail to Allocate resources efficiently Provide goods beneficial to society Stop production and consumption of harmful goods

Examples of Market Failure

Pollution - air, water, soil Deforestation and loss of biodiversity Traffic congestion Health problems associated with consumption of tobacco, alcohol, and drugs Depleted fish stock Global warming

Reasons for Market Failure

Imperfect competition Public goods Externalities Incomplete markets Imperfect information Unemployment, inflation, and disequilibrium

Imperfect Competition

Imperfect competition
For markets to work efficiently, there should be perfect competition a sufficiently large number of firms that each believes it has no effect on prices.

Imperfect competition
Monopoly: E.g. city-wide electrical distribution
Competitive advantage High transportation costs Barriers to entry

Oligopoly: automobile manufacturing Monopsony: employment in a company town Oligopsony: employment in professional sports Patents
Xerox, Kodak

Imperfect Competition
Private airports (Delhi, Mumbai etc) Toll roads Un-viable markets (rural telecom, air connectivity to north eastern routes etc) Power distribution companies Governments sometimes regulate prices and profits Competition commission of India

Airport Operator Revenue Streams

Aeronautical

Non-Aeronautical

Aero Related

Commercial (Terminal)

Commercial (Other)

Landing charges

Cargo handling

Advertising fee Revenue from concessionaires Rental from airlines, business, shops Car parking, public admission fee

Real estate development Hotel, business and industrial parks

Parking charges

Aircraft refueling

Passenger service fee

Aircraft maintenance

Retail and entertainment, residential

Catering services

[Source: Communication from GMR, 2006]

Delhi Airport
Awarded to GMR in 2006 though competitive bidding Airport development fee (ADF) and user development fee (UDF)

AERA Constituted
Airports Economic Regulatory Authority (AERA) was constituted in December 2008: To determine the tariff for the aeronautical services To determine the amount of the development fees To determine the amount of the passengers service fee To monitor the set performance standards relating to quality, continuity and reliability of service

Public Good

Public Goods
Private good: A good or service whose consumption by one person excludes consumption by others Public good: A good or service whose consumption by one person does not exclude consumption by others

Public Goods
Non-rival competition (one persons consumption does not prevent other persons consumption) Non-excludability (difficult to exclude anyone from the benefits) E.g. National defence, lighthouse, public health (international vaccine prgramme), street light etc Free rider problem

Public Goods
Pure public goods
Marginal cost is zero E.g. National defence

Impure public goods

Marginal cost very small but not zero Though expansive, possible to exclude E.g. un-crowded highways

Public Goods
Congested highway Marginal cost of use Pure private good Health services, Education

Pure public good National defence Ease of exclusion Fire protection

A local park College education Sewage collection Water Electricity Telephone service Medicine Police protection Cable service Applied research

 What happens to the efficient allocation between public and private goods as an economy becomes wealthier?

 Think of an example of a free rider problem in your city. Think of a way for your local government to overcome this problem.

Merit Goods
Goods that government compels individuals to consume E.g. seat belts, helmets, elementary education

Demerit Goods
A demerit good is a good or service whose consumption is considered unhealthy, degrading, or otherwise socially undesirable due to the perceived negative effects on the consumers themselves. It is over-consumed if left to market forces.

Club Goods
Club goods (also artificially scarce goods) are a type of good that are excludable but nonrivalrous, at least until reaching a point where congestion occurs. e.g. golf courses, cinemas, cable television, access to copyrighted works, and the services provided by social or religious clubs to their members.

Excludable Rivalrous Nonrivalrous Private goods food, clothing, cars, personal electronics Club goods cinemas, private parks, satellite television

Non-excludable Common goods fish stocks Public goods national defense, air

Externalities

Externalities
Costs (or benefits) of a market activity borne by a third party; the difference between the social and private costs (benefits) of a market activity When externalities are present, market prices are not a valid measure of a goods value to society

Externalities
Positive Externalities
Third parties benefit from production of goods and services

Negative Externalities
Third parties bear spillover costs of the production of goods and services Third parties bear spillover costs of the consumption of goods and services

Third parties benefit from consumption of goods and services

Externalities
Negative externalities. Positive externalities.
e.g flower garden e.g. air, water, noise pollution, smoking, garbage

Overproduction of goods generating negative externalities Undersupply of goods generating positive externalities Environmental policy

Pollution related New Items

Delhi's air pollution level is up by five times in eight yrs, says study (India today, July 08, 2012) Indian coal power plants kill 120,000 people a year, says Greenpeace (http://www.guardian.co.uk/world/2013/mar/10/ind ia-coal-plants-emissions-greenpeace) India River Pollution: 80 Percent of Indian Sewage Flows Untreated Into Country's Rivers (http://www.huffingtonpost.com/2013/03/05/indiariver-pollution-sewage_n_2810213.html)

Social Demand
Market demand Social demand Externalities
Social Demand Market Demand Externalities
Subtract external costs, a negative impact Add external benefits, a positive impact

The optimal production mix is where the social demand curve intersects the supply curve

Negative Production Externalities

When an firms consumption reduces the well-being of others who are not compensated by the firm

Negative Production Externality

Negative Production Externality

When a firms production reduces the well-being of others who are not compensated by the firm
Private marginal cost (PMC) The direct cost to producers of producing an additional unit of a good. Social marginal cost (SMC) The private marginal cost to producers plus any costs associated with the production of the good that are imposed on others. Private marginal benefit (PMB) The direct benefit to consumers of consuming an additional unit of a good by the consumer. Social marginal benefit (SMB) The private marginal benefit to consumers plus any costs associated with the consumption of the good that are imposed on others.

Negative Consumption Externalities

When an individuals consumption reduces the well-being of others who are not compensated by the individual.

Negative Consumption Externalities

Externality of SUVs
The typical driver in 2008 was in a car that weighed about 4,117 pounds. The major culprits in this evolution of car size are sport utility vehicles (SUVs) with an average weight size of 4,742 pounds. The consumption of large cars such as SUVs produces three types of negative externalities:
Environmental Externalities: The contribution of driving to global warming is directly proportional to the

amount of fossil fuel a vehicle requires to travel a mile. SUV drivers use more gas to go to work or run their errands, increasing fossil fuel emissions. Wear and Tear on Roads: Each year, federal, state, and local governments spend $33.1 billion repairing our roadways. Damage to roadways comes from many sources, but a major culprit is the passenger vehicle, and the damage it does to the roads is proportional to vehicle weight. Safety Externalities: One major appeal of SUVs is that they provide a feeling of security because they are so much larger than other cars on the road. Offsetting this feeling of security is the added insecurity imposed on other cars on the road.

Positive Production Externalities

Global Warming

CO2 Emmission

 Can an activity generate both positive and negative externalities at the same time?

Others

Incomplete markets
Complete market will provide all goods and services for which the cost of provision is lees than what individuals are willing to pay E.g. insurance and loans. life insurance, crop insurance, education loan etc Underinvestment in innovation Enforcement costs

 Imperfect information
Imperfect information prevents consumers from making utility-maximizing decisions. E.g. Insurance policies, loans

Unemployment, inflation and disequilibrium

Government Inventions
Taxes Subsidies Regulation

Taxes
07_08A

PRICE
New supply curve Old supply curve

Deadweight loss New price Amount of sales tax

Price rises by this amount. Old price Price received by sellers after sending tax to government Demand curve

QUANTITY
New quantity Old quantity Quantity declines by this amount.

Deadweight Loss from a Sales Tax