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ECONOMIC ANALYSIS OF

PUBLIC DECISIONS
Economics of the Public Sector

Course outline
1.

2.
3.
4.
5.
6.
7.

Introduction to Public Sector Economics


The system of public economics
The state, actor of public economy
The Public Sector structure, reform
The market failure
Labour market
Competition

References
Matei A. (2003) Economie public. Analiza economic a deciziilor publice, Editura Economic, Bucureti.
Andrei L. C. (2007) Economie, Editura Economic, Bucureti, pp. 366-393.

Dinu I.T. (2012) The Economics of Public Affairs, Bucureti,

http://store.ectap.ro/externe/The_Economics_of_Public_Affairs_2012l.pdf
Stiglitz J. E. (1999) Economics of the Public Sector, Ediia a treia, W.W. Norton & Company, New York.
Lipsey R. G. i Chrystal K. A. (1999) Economia pozitiv, Editura Economic, Bucureti.
Lipsey R. G. i Chrystal K. A. (2002) Principiile economiei, Editura Economic, Bucureti, pp. 371-434.
Stiglitz J. E. i Walsh C. E. (2005) Economie, Editura Economic, Bucureti, pp. 302-326, 722-739.

Additional references:
Friedman M. (1995) Capitalism i libertate, Editura Enciclopedica.
McConnell C. R. i Brue S. L. (1996) Economics. Principles, Problems, and Policies, ediia a 13-a,
McGraw-Hill, SUA.
Friedman M. i Friedman R. (1998) Liber s alegi. Un punct de vedere personal, Editura Bic All.
Smith A. (2011) Avuia naiunilor, Editura Publica, Bucureti.
Keynes J. M. (2009) Teoria general a ocuprii forei de munc, a dobnzii i a banilor, Editura Publica,
Bucureti.
Schumpeter J. A. (2010) Zece mari economiti. De la Marx la Keynes, Editura Publica.
Stiglitz J. E. (2010) n cdere liber. Editura Publica, Bucureti.

Why does PS economics interest us? (1)


Public economics is a branch of economics that aims at

analysing public decisions in economic terms (Matei


2003)
Reason: the need for organising the public activities
Regulation

Price setting
Supply of public goods and services
-

Taxes and
tariffs/duties
Income from
capital
Income from
states private
goods
Borrowing

Public
revenues

Public
expenditures

Transfers
Expenditures
with public
policies
Capital
expenses
Interest

Why does PS economics interest us? (2)


Mixed economy the role of the two sectors
Defining the public-private frontier
Privatisation Vs. Nationalisation
Mercantilism invisible hand Laissez-faire Marxism
Positive economics versus normative economics
Positive economics (What is) An analisys limited to facts that can be
verified, be them true or false: Should the unemployment rate on a national
level increase by 8 per cent, the youth unemployment rate decreases by 80 per
cent.
Normative economics (What should be) an analysis based on value

judgments, which does not include verifiable facts: is necessary, should be,
would be wrong, better, more important
Economists concern
The problem of CHOICE
The problem of SCARCITY
Production Possibility Frontier (PPF)

What is our aim? (1)


Introduce aspects of public economics, economic tools

and so on
- concepts, notions
Substantiate these elements through theories in the field

of public economics
Strengthen your knowledge of public economics with

special reference to the European states economy,


American or Asian economy if relevant to the subject
upon debate public intervention, market failure and so
on.

What is our aim? (2)


State your expectations
Course (?)
Seminar (?)
Understanding the public economics features
Mixed economy
Privatisation
Nationalisation
Laissez-faire
Deregulation
Recession
Resources
Tax
Deficit

Public Economy economic sub-system


Cybernetic system the capacity to self-regulate
Reacts to disturbances (internal or external factors)
Maintains self-control on different periods (cyclical nature of
economic activity)
Mixed system public sector + private sector
Economic activities - undertaken both by the state and by
companies (their behaviour can be influenced by the state through
regulation, taxes/duties, subsidies)
State involvement
Strong (former USSR, North Korea, Cuba)
Medium (Europe before the privatisation wave)
Low (USA has evolved over time: from privately held highways
and railways to public roads and state transport companies)

The cyclical nature of economic activities


The economic activity does not have a linear path

economic growth vs. recession


How do we establish this alternation?
Answer: macroeconomic indicators (GDP, Inflation rate,

Unemployment rate, etc.)

The time between recession (crisis depression) and

growth (recovery boom)


Old Testament: 7 good years vs. 7 bad years
Short cycles Kitchin 3-5 years Joseph Kitchin (1861 1932)

Medium cycles Juglar 10-12 years Clement Juglar (1819

1905)
Long cycles Kondratief 40-50 years Nikolai Kondratieff (1892
1938)

State involvement - outlook


17th century mercantils promoting trade and industries

by the state
Classics Smith (1776) limiting the states role; the
individuals, by aiming at satisfying their own interests
(competition, profit) will thus serve the public interest invisible hand
19th century laissez faire lack of state involvement in
the private sectors activities (through regulation or
control) best responds to the societys interests
19th century increased role of the state in controlling the
means of production (collective farming)
20th century transition to market economy, though the
private-public frontier still remains an open subject

Triple view of public economy

Facts, phenomena
and economic
processes

Public
administrations and
enterprises (or
privately held
enterprises
engaged in the
production of public
goods or services)

Science the
economic analysis
of public decisions
(ECONOMICS)

The object of public actions

Regulation

Consequences

Price setting
(through taxes, duties,
subsidies)

Public
revenues

Production of public goods


and services

Public
expenditures

The public economics principle


Human needs are always greater

Needs

Scarcity

than the available resources.


Resources = factors of production
(land La, labour L and capital K).
La (Land) = natural resources.
L (Labour) = physical and

mental
capacity of workers to produce goods
and services.
K (Capital) = goods that do not directly
satisfy
human
needs:
factories,
machineries, equipment used to
produce other goods.
Is money considered capital in
economics ?

Choice

The concerns of the public decision-

maker:
What is to be produced?
How is to be produced?
For whom is it to be produced?
How are these decisions made?

What is to be produced?
Production possibility

Resource allocation in

frontier

between the two


industries (public goods,
private goods)
Efficient allocation: A, B
A B public goods
private goods
Inefficient allocation: C
Infeasible allocation: D

Private
goods
A

B
C

Public
goods

How is to be produced?
Production
Public
Private

Factors of production
More k, less L?
Less k, more L?
Public policy making
Environmental (can have an
impact upon technology)
Fiscal (can influence labour
factor)

For who is to be produced?

The distribution problem is


influenced by:

Fiscal policy;
Social policy;
Provided public goods (satisfy the needs
of certain groups).

Free rider issue (linking the payment


with the benefits the tendency to
lie about the benefits)

Wagner Law (law of public activity


increase in the developed countries
through corelation with the
national income) an economic
development pushes for more public
spending laissez faire

Redistribution (matching the needs


for social aid to the financing
obtained through taxes)

How are these decision made?


Collectively
David Hume - tragedy of the

commons
Stages of collective (public) decision:
Knowing the public sector activities
and organization:
Financing method;
Expenditures and taxes (on a
central and local level);
Anticipating the consequences:
The effects of a tax on return
(price increase, wage cut);
Increasing the retirement age;
Assessing the alternatives;
The influence of the political factor.

Utility and preference


Let us remember
Utility real/assumed capacity of a good to satisfy a need.
Economic utility = satisfaction felt by an individual after consuming a
good.
Marginal utility = the value of the last consumed quantity of a good; the
gain in satisfaction after consuming an additional quantity from an
economic good.
Indifference curve (isoutility) = combinations of goods from which the
consumer hopes to receive the same level of satisfaction.
Why does it interest us?
In the analysis of public economy the four pillars:
Optimum;

Public goods;
Collective choices;
Justice.

Optimum
A balanced situation preferred by everyone (equilibrium);
Is reached by the presence of other individuals producing

spillovers (externalities) positive or negative (beneficial or


harmful);
The value of an old house in a new neighborhood;
Pollution;
E.g. (Stiglitz, 2010) situations in which a trade involves certain costs

and benefits for third parties (non-participants).

Pareto Optimum no individual can be made better off

without someone being made worse off efficient resource


allocation

Public goods
Some goods will either not be supplied by the market or, if

supplied, will be supplied in insufficient quantity.


Pure public goods:
It costs nothing for an additional individual to enjoy their benefits;
It is difficult or impossible to exclude individuals from the enjoyment of

a pure public good.

As more individuals join the group consuming the public

good its quality could decrease. The optimum size of a


groups consuming a certain good is analyzed by the theory
of clubs Buchanan, 1965.

Collective choices
Example of collective decision-making the voting paradox (Marquis de Condorcet)
Voting preferences

As preferences

Bs preferences

Cs preferences

First choice

Shrek

Twitty

Tom

Second choice

Twitty

Tom

Shrek

Third choice

Tom

Shrek

Twitty

2:1
tranzitivity

NO !

2:1

The majority vote can only


compare two preferences and
2:1
cannot decide the order of all
preferences!

Justice
Socially acceptable objective of the Government:
Protecting life and property;
Economic efficiency (obtaining the best result with limited resources);
Reaching a standard of justice (equity) (income distribution equal
vs. differentiated);
Economic growth;
Economic stability.
Tradeoff between equity and efficiency
leaky bucket
Economic policy fulfilling the criteria of economic efficiency;
Social policy aims at fair income distribution.

The return of rationing


The difficult decisions needed in an age of austerity
POLICYMAKERS must juggle three priorities when offering a public service:
coverage, cost and choice. They almost always have to sacrifice at least one of
the three. As austerity bites, this equation is going to lead to very tricky decisions.
Health is an area
where the trilemma
clearly applies.
Britains National
Health Service offers
universal coverage
but as a result has to
limit patient choice
in order to control
the costs.

The American health system historically gave a high priority to patient choice at
the price of ballooning costs and the exclusion of the uninsured from the system.
Having increased coverage, the Obama reforms will have to restrict choice if
they are to control costs.

L'tat c'est moi!


Improving the utility of one individual must not diminish

the utility of another individual.


The individuals incapacity to cooperate market failure
Public economy actors:
Man organized in communities (or any other organizations)

State through:
Power of coercion monopoly on:
Law making;
National defense;
Management of military reserves during war.

Accountability limited power through nations will (Constitution, laws);


Motivation public interest.

How much does the state matter?


Public expenditures (% GDP)

States functions
Allocative function Government intervention in the allocative

function of the market to correct its negative effects;


Distribution function ensuring equity, social justice on the

distribution of income and wealth;


Stability function mitigate market failures in the national economy

as inflation, unemployment, stagnating economic growth, balance of


payments imbalances;
Regulatory function maintenance of individual behavior within

limits imposed by society and contract discipline (through a functioning


legal system).

Allocative function
Property right
Belongs to an individual (private property) the right to exclude other
individuals from the benefits provided by a certain good;
Belongs to more individuals (common property) the right of a group
of individuals to benefit without boundaries from the object of that
property (see tragedy of the commons and free rider);
The use of common property right:
Umg = Price
It does not involve scarce resources
Otherwise:
Excessive use (like in the case of excess hunting and fishing);
Premature exhaustion of natural resources;
Congestion (in the case of positional goods goods having an insufficient supply
and their production cannot be easily increase).

Distribution function (1)


Income distribution between the members of society

social cohesion
Income distribution
Existent (can be in accordance with societys standards on equity)
Preferable (desirable) established through state intervention in order

to correct the existent income distribution

Why the State and not another actor?


Free rider behavior
Competition can leave out certain interest groups

The State redistributes its revenues and wealth through:


Progressive taxes to finance monetary benefits;
Subsidies for the provision of public goods and services.

Distribution function (2)


Public goods and services:
Fully financed through taxes;
Provided at subsidized prices.
Alternatives for the provision of goods:
Direct provision;
By providing additional income for those acquiring the
goods on the market.
individuals may not choose the most appropriate level of public

good, such as education and health;


State would prefer to have direct control over quality and price of
these goods and services because of their importance for the
general welfare merit goods.

Regulatory function (1)


Regulating the producers and consumers decisions so to

reduce:
Tendencies towards monopoly;
Negative externalities.

Why the State and not another actor?


There are large costs (for the individual consumers) of obtaining and
interpreting information about product safety;
The individuals may not be able to protect themselves because they
do not have the resources at their disposal to establish minimum
standards and quality control.

Regularization limits the discretionary behavior and freedom

of individuals by imposing rules.

Regulatory function (2)


Regulations are based on legal norms aimed at:
Protecting the consumer against fraud,
Preventing damage to consumer health,
Control the design of goods so as to ensure their safe operation,
Ensure harmless conditions of employment,
Control the commercial systems, biological research etc.

The State also regulates:


Money supply;
Prices of utilities and nationalized industries;
Many of the allocative decisions in the economy (through price and
income policies).

Regulatory function (3)


Criticisms:
Restriction of personal freedoms, namely of choice on the efficient
market
Implementing regulations entails costs (e.g. operational costs of the
regulatory bodies)
Tendency to increase uncertainty in business
Delays in carrying out investments.
Stigler (1971) The theory of economic regulation the

demand and supply of regulation


Peltzman - reaction to regulation can prove to be contrary to
the wanted effect (Peltzam effect) a strict regulation of
safety belt use can encourage the driver to be less careful

Regulatory function (4)


Deregulation
A stage which logically follows a state of excessive
regulation
When the regulation cost exceeds its social benefits
Regulation
for countries in transition to market economy
is absolutely necessary to first introduce coherent
economic regulation

Self-regulation
Automatic regulation of systems (cybernetic system)
Principle anticipated by Smith "invisible hand"

Stability function (1)


When does it intervene?
In case of macroeconomic imbalances (inflation, unemployment,

economic downturn, deficits of the trade balance and balance of


payments etc.)

To reach the macroeconomic targets:

Economic growth
Job security reducing unemployment;
Price stability inflation control;
External balance balance of payments.

How?
Through monetary and fiscal policy instruments used to restore

balance
By coordinating the economic decisions of different groups of
economic actors from the private sector

Stability function (2)


Economic growth
global process referring to an upward evolution of certain aggregate
economic measures, over a period of time, on a national or
international level, and producing favorable effects both economically
and socially.
an element of continuity beyond the particular macroeconomic policies
implemented by one government or another.
takes place long term, governments are often faced with cyclicity,
requiring reformulation of the objectives of economic growth:
Establishing a social, economic and institutional environment favorable to

economic growth
Ensuring balance for an economic growth path (Keynes)
Targeting economic recovery (growth of real national income vs. Growth of
potential national income) limit economic cycle oscillation for ensuring
sustainable and balanced economic growth

Stability function (3)


Jobs security
Utopia heavily promoted during the communist command
economic system
Associated with the right to work
Open access to the labor market
institutional and economic environment to stimulate the

development of economic initiative

Confusion!
States responsibility to ensuring the general conditions for every
individual to work (with the appropriate exceptions)
States duty to secure jobs for all those who want to work
oversizing the public sector developing the PS in accordance with
different criteria, not economic efficiency

Stability function (4)


Reformulating the

objective:

Much more productive


Full use of production factors (L

included) means:
Their efficient use (optimum use)

Securing jobs

Reduce
unemployment

by every economic agent


NOT using all factors of production
available at a time
unemployment rate 0
(an unemployment rate lower than the
natural rate can cause short circuits
on the labor market)
A difference must be made in

terms of types of unemployment

Stability function (5)


Types of unemployment:
Cyclical unemployment seasonal unemployment
Is formed during economic cycle recession (crisis depression)
Or directly flows from economic activity downsizing in certain seasons of

the year
measures for employment growth are those supporting economic recovery
Structural unemployment determined by the restructuring of

economic activities, property forms etc., which is influenced by the


technical and economic progress, or important social and political
phenomena.
Frictional unemployment determined by L switching jobs (in
transition from one job to another).
macroeconomic policies (! OLF)

Stability function (6)


Price stability
Associated with the anti-inflationary policies
The dilemma of macroeconomic policies reducing unemployment

or reducing inflation
The achievement of a high degree of price stability; this will be
apparent from a rate of inflation which is close to that of, at most,
the three best performing Member States in terms of price stability
(one of the convergence criteria)
Where is Romania standing?
Inflation/deflation/disinflation?
What is the supervising body?
Through what tools?

Also contributes to regulating competition tendency to

artificially increase prices for monopoly and oligopoly

Stability function (7)


External balance
Ensuring balance for:
Trade balance
Balance of payments

Monetary policy
Policies for economic recovery
Lead to solving many other macroeconomic imbalances
Preferred due to social pressures pertaining to recession

How do we define the public sector in economic terms?


1. Types of activity
Defining government intervention == public expenditures
Defining public intervention
Market vs. Non-market
Public vs. Private

Private market
sector

Enterprises
Form of production of market economy

Public nonmarket sector

Government
Public administration

Public market
sector

State-owned companies
Provide goods and services

Private nonmarket sector

Non-profit associations
Participates in production through labor

How do we define the public sector in economic terms?


2. Results of activities

Productive

Non-productive

The activity of state-owned

Public administration activity

companies
The existence of a
commodity
Marketable goods and
services

Non-existence of a

commodity
The existence of
expenditures item financed
from taxes
Non-marketable goods and
services

How do we define the public sector in economic terms?


3. Time
Short term

State budget
Public revenues and
expenditures = Correlating
the budget with the public
sector size
Shows the balance/
imbalance
Budget surplus (can show a

false profitability, inflationary


situations)
Budget deficit (common
situation)

Long term
The public sector itself
Marginal social benefit (MSB) =
marginal revenue of the public
sector
Marginal social costul (MSC) =
cost of administering the public
sector
MSB = MSC optimum size of

the public sector


MSB > MSC public sector is
efficient, in terms of profitability
MSB < MSC oversizing the
public sector, low public
service efficiency

How do we define the public sector in economic terms?


4. In practice market economy models

Laissez-faire model

Welfare state

Social aid
Lower income

Social-democrat model

Providing collective services


Active policy aiming at employment
High tax rates

Hybrid model (Japanese)

Low involvement of the state (both socially and economically)


Consumer has the main role
Economic problems are solved through individual decisions (not
decisions of the collective authorities)

Based on private enterprises


Promotes cohesion and solidarity

Soviet model rigid and authoritative planning

How do we define the public sector in economic terms?


5. In terms of other criteria
Negative versus positive economic policy
Negative promotes competition, anti-monopoly, neutrality in the

national economic space


Positive direct state involvement, supporting imports and exports,
measures favoring the economic

Nationalization versus privatization


Common objectives :
Improving resource allocation;
Improving pricing and investment policies;

Distinct objectives:
Nationalization strengthening the public sector and national strategies,

control of natural resources;


Privatization improve efficiency and reduce costs, reduce the needs of
budget financing/ public borrowing.

Reforming the public sector (1)


What is it? Politic activity
Why do we need it?
Improving efficiency in public resource allocation;
Greater justice in income distribution.
What does it depend upon?
Technology;
Economic and political circumstances.
What are the reform reasons?
Institutional reform;
Reducing expenditures, costs savings
Who influences the reform?
Decentralization institutional change (political and administrative);
Privatization institutional change (economic);
Private sector deregulation (to intensify competition).

Reforming the public sector(2)


Results in the public sector
Expansion/
reduction of
public sector

Decentralization

Privatization

Deregulation

Exemples
Decentralization

Expansion of public services


Reducing expenditures through a

better allocation
Privatization
Expansion after changing the stateowned company into a joint stock
company (still state-owned)
Reducing PS by transferring social
assistance to the private sector
Deregulation
Expansion due to cost coverage
(American financial system)
Reducing PS through careful
deregulation

Reforming the public sector (3)


Micro-focused

Macro-focused

Focused on single programs;

Focused on the general

Technical and administrative

dimension of PS;
Political nature.

nature.

Both strategies aim at:


Either improving results through:
Introducing new programs;
Technologies;
Institutions.
Or cost savings.

Reforming the public sector (4)


Privatization can cover:
Sales of public property;
Long-term lease of public
infrastructure, private
enterprises;
Use of decision-making
processes like contracting and
bidding (procurement);
Replacement authority as a
mechanism of coordination with
market mechanisms;
Insertion of market incentives in
the reward system for the public
officials.

Decentralization strategy

replaced:

Planning
Rigid budgets
Control
System of
rules
Supervising

Evaluation
Performance
budgets
Management
by objectives
Framework
legislation
Discretion

Do these contribute to productivity and efficiency increase?

Answer
Efficiency
Can be stimulated by a local

administrative (decentralized)
system, but moving resources
(down) does not necessarily
improve efficiency (e.g. police and
justice)
Reduction policies are neutral in
relation to efficiency or inefficiency
in the PS

Productivity

Aimed at through

privatization
Need for increased competition

on the supply side


Expanding opportunities for
selection on the demand side

Will these released resources be used for public sector


development?!

The current trend (1)


Focus on return, marketing
Managerial state = a new concept of public service

provision, part of the initiatives reported as key reforms


Australia and New Zeeland
New model takes into account the market values, so the

PS:
Becomes a set of internal markets;
Intensive use of tender process (procurement) for providing public

goods and services;


Allocation of vast resources to implement such a management model.

The current trend (2)


Return suggests profit and efficiency
Applying specific private sector mechanisms:
Decisions models;
Marketing mix;
Activity Based Costing (ABC);
Corporate Social Responsibility (CSR);
Operations management;
HR management;
Public policy management;
Performance management;
ITC management;
Structural analysis of sectors of activity

Structural analysis of sectors of activity


Potential
competitors

Suppliers

Existent
competitors
in the field

Substitute
products

Buyers

Porters Five Forces Model


Threat of
new
entrants

Bargaining power
of suppliers

Competitive
rivalry within
the industry

Threat of
substitute
products

Bargaining power
of buyers

Idea
The five forces are the grounds for STRATEGY

development
reflect the complexity of competition in a sector
A greater intensity of competition is registered under perfect competition

(free market entrance, existing players have no bargaining power with


suppliers and customers, and the rivalry is unlimited due to the presence of
a large number of identical products)
Influence the profitability of a sector
Lower return if there is a better and cheaper substitute
Or if there is market rivalry
Do not consider factors that may influence short-term return - have

TACTICAL significance

Fluctuations in the economic situation;


Shortages of raw materials;
Strikes;
Demand fluctuations, etc.

1. Threat of new entrants


Barriers to entry in a particular industry
Economies of scale
Product differentiation
Financial needs
Costs of changing partner
Access to distribution channels
Cost disadvantages independent of scale economies (know-how)
Existing reactions from the existing players
Price to prevent entry
Characteristics of the barriers to entry (e.g. exclusive rights

to technology)

2. Intensity of rivalry between existent


actors
Exit barriers

Depends on structural factors:

Low

High

Entrance barriers

number of actors or actors of


equal size
Slow sector development
pace
High storage or fixed costs
Lack of differentiation or
partner switching costs
High strategic stakes
High barriers to exit

Low

The presence of a large

High

Low
stable
earnings

Low,
risky
earnings

Large,
stable
earnings

Large,
risky
earnings

3. Pressure from the substitute products


Perform a function identical to that of the product in question
Presents a dangerous cost-performance rate for the

products in a particular sector


Attitude towards substitute products takes the form of

collective action (Buy American)

4. Bargaining power of buyers


It is a focused group or buy a large quantity of the

concerned products
Products are standard or undifferentiated
The switching cost is reduced
The buyer has complete information
In case of upstream integration

5. Bargaining power of suppliers


A more focused and smaller group than the one is selling

their products to
There are no substitute products
Sector is not an important client for the group of suppliers

The providers product is an important input for the work

done by the buyer


There are switching costs

Let us remember
Public policy objectives impose:
The need for a market mix;
Technically possible (PPF); What and how is produced?
What individuals prefer (utility). Whom for?
Public intervention. How are these decisions taken?

The aims is to ensure a Pareto efficient economy (the ideal

situation)
Namely a competitive economy
With an efficient resource allocation

What if the market fails?

Failure dissatisfaction
You always want what you do not have!
The idea of an alternative way to organize the economy
(more advantageous for one who thinks of it)
Maybe you are right!
Markets (almost always) produce too much of something
(pollution) and too little something (research);
a change that improves the situation of the rich without
affecting the poor is also Pareto efficient

The market intervention can happen both when markets


fail, and when the markets are efficient

Intervention the beginning


Property right
tragedy of the commons
Property guarantee leads to:
Improvement (rent vs. property);
Increased saving and investment capacity.

Contracts guarantee
The problem of the overdue loans

Government intervenes to protect the citizens and


their rights

The intervention generated by market failure


Six situations in which the markets are not Pareto efficient:

1. Failure of competition
2. Public goods
3. Externalities
4. Incomplete markets
5. Failure of information
6. Unemployment, inflation and imbalance

! Failure = the best possible result was NOT reached


= inability of individuals to cooperate

1. Failure of competition
Pareto efficiency means perfect competition (ideal

situation)
Number of companies is large enough to keep the
market price unchanged
Otherwise:
Monopoly
Oligopoly

Reasons to limit competition


Competitive advantage of large companies
When the production cost decreases with the production growth
(economies of scale)
Natural monopoly
A company produces cheaper together with other companies (utilities
water, electricity etc.)
Large transport costs
Granting patents / licenses - they stimulate innovation, but

restrict competition

2. Public goods
They are either not provided or are insufficiently

provided;
For a private company that good would be inefficient

and non-marketable;
Pure public goods (defense, police protection, energy

plants etc.):
They do not involve additional costs when they are consumed

by another individual (non-rival);


Is difficult or impossible to restrict the individuals access to the
benefits brought by that good (non-excludable).

3. Externalities
The actions of an individual / a firm raises costs for another

individual / company negative externalities


Examples:
Pollution
Use of cars traffic jam more time spent while driving higher risk

(accidents)
Individuals do not cover the total cost of negative externalities they

generate they will get involved in more and more activities of


this kind
People do not enjoy the full benefit of the positive externalities

tempted to get involved less and less in such activities

4. Incomplete markets
Not only pure public goods and services are those that

private markets fail to provide


A complete market - providing all goods and services for
which the delivery cost is lower than the cost that individuals
are willing to pay
An incomplete market - which fails to provide these goods
and services
Examples:
Failure of the insurance market covering all types of risk
Failure of real estate market first house loan
Failure of students loans market

Why do markets become incomplete?


1. They concentrate on product innovation and not market

innovation
2. Market innovation

Involves large transaction costs (information, decision, negotiation,


cost of closing a deal)
There is no protection through patents and licenses

3. Face asymmetric information and enforcement costs


The two sides have different levels of information about risk (e.g. covering

the risk of a dropping demand)


unguaranteed student loans

== adverse selection (a participant in a transaction has


more information about the game than the other party) role in health
insurance market study

5. Failure of information
Information = public good (supplying information to an

individual does not reduce the information quantity of the


others
Example: weather information
Regulating information disclosure
Supported as is considered vital - for example, labelling products
Combated, being unnecessary, irrelevant and costly

6. Unemployment, inflation and imbalance


The most common symptoms of market failure
Indicators of market failure but also of macroeconomic

imbalances
Influence the structure of fiscal policy
Heavily regulated on a regional level

Intervention on efficient markets


Income distribution
Competitive markets Equal distribution

Government intervenes for income redistribution (social services)


Merit goods
Perfect information does not always lead to good decisions
Smoking, seat belt

this type of intervention = paternalism (example: drug prohibition,


compulsory social security) libertarianism
Paternalism (smoking ban) externality (example: the cost of smoking
may be covered by a fee)

The consequences of failure


Changes made by state intervention are often unpredictable
Public policies aimed at ambiguous concepts such as

serving the public interest


Even the implementation of policies may be a failure (due to
complexity)
Government intervention is not free, is made through a
bureaucracy that is expensive to administer
Rent-seeking - lobbying to influence regulatory policies
(price distortion) which lowers social welfare (social costs)
(monopoly - transfer of wealth from buyer to producer)

Let us remember
Market fails

Markets (almost

always) produce too


much of something
(pollution) and too
little of something
(research);

P
S

PE
E

Market is efficient

Marginal benefit =

Marginal cost = Price

QE

Equilibrium (balance) on the labor market


What do we take into

account?
Supply of labor

Demand of labor
Quantity of the good (labor)

DL

Price of labor

wE

Significance of the

IV

SL
I
E

II

III

imbalances
I over-wage
II over-quantity
III under-wage
IV under-quantity

LE

Underuse of labor
Labor main factor of production
Underuse of labor unemployment:
Supplied labor quantity is higher than demanded labor quantity (II)
It must be considered for both the over-wage and the under-wage
areas
There will be losses due to the production that the unused workers
could cover
Okuns Law unemployment assumes sacrificing a part of

the potential national income


Based on the statistical data for the American economy, Okun draws

the conclusion that for an increase of 1 per cent over NAIRU (Non
Accelerating Inflation Rate of Unemployment) in the unemployment rate there
will be a reduction in the GNP growth rate of 2 per cent in terms of
the potential national income

Overuse of labor
Can lead to overproduction of goods
Associated to an economic boom

USA 2006-2007 unemployment rate < 5%


Oversizing the wages

The costs of labor (L) increase

Inflationary pressures occur


Solution = perfect competition (equality of wages)

?!

Change in wages
Type of job
Education (undergrad studies, high school etc.)
Age
Experience at work (employee loyalty, encourage employment

stability and enterprise attachment) does not substitute the


workers competence

Gender and race (discriminations)


Market type (the case of the unionized labor markets)

Imperfections of the labor market

Competition on the labor market


Monopsony on the labor market
A single dominant buyer
The small companies will follow the wage policy of the large
companies
Particular case : coordinated oligopsony (agreement between the
companies on wage levels)

Effects:

Lower wage levels


Lower employment levels (in comparison to the perfect

competition)

Monopsony
Monopsony with low wage

Monopsony with differentiated wages

There is no negotiation on

hiring is done in groups

wages, or differentiations in
these negotiations
The hiring conditions are
pre-established (wage
included)

Labor:

wage negotiations take

Accepts the monopsonys

terms,
Leaves the area to search for
work (uncommon, due to
rigidity)

place in groups or even


individually

Wages are set differently, so


that the wage costs do not
exceed the planned level

Monopoly on the labor market


The union sets a wage salary (Wi)
The employment level will be QC,

W
S
Ec

Wi

Er

WE
A

Qc

B
E

QEQr

pertaining to the labor demand


Real supply is larger Qr
The area WiEcQcO represents
supplementary income of the
employees (Union members)
The area ABQrQc (limited by WE)
represents losses for the workers
who could still be hired if the labor
market would be competitive
Pareto inefficiency

The monopoly monopsony confrontation


Described by the negotiation power of the two sides
Creates powerful actors
Unions
Employers associations
Trigger
Large transaction costs on the labor market
Free rider behavior
Illegal hiring
Hiring immigrants

State interventions on the labor market


Setting a minimum wage
Discourages the use of illegal labor since taxes and contributions are
calculated as percentages relative to the entrance wage
Diminishes the unduly monopsony profits received through wage
differentiation
Avoids a low employment level (artificially)

Establishing the minimum wage on the level of the wage of that

market balance, otherwise imbalances occur


The meaning of the minimum wage a policy tool to correct the

income distribution and to combat poverty


Alternative raise taxes on high wage earners (also affects
companies through the contributions quota)

Regulating the labor market


Limiting the excesses of the two main poles of the

labor market:
union - monopoly
employers monopsony

Involves two categories of actions:


Trade unions and employers regulation in order to prevent excesses

and discrimination;
Direct involvement in the negotiations between unions and employers
as a mediator to ensure convergence to the labor markets optimum.

Regulations on employers
Consider void the employment contracts subject to not belonging

to the union (yellow-dog contracts);


Declare as core labor rights: the right to self-organization of labor
and the right to collective bargaining;
Prohibit employers to interfere in trade union activities and create
obstacles to trade union organization;
Prohibit employers discrimination against union membership
pertaining to hiring, firing and promotions;
Consider illegal to discriminate against any worker who has claims
against employers, or testify against him;
Require employers to properly negotiate with the unions, without
resorting to pressure or threats;
Prohibit or limits wage discrimination based on gender, race,
religious beliefs etc.

Regulations on unions
Address three main areas:
Union organization
Unfair union practices
Right to strike

Union organization
Aims at exclusive objectives specific to the labor

market:
higher wages,
better working conditions,
shorter working hours,
paid annual leave etc.

Political neutrality

Have the autonomy to negotiate (organized as Unions)


May have degrees of recognition:
Closed shop,
Union shop,
Open shop.

Unfair union practices


Pressure on employees to become union members
Judicial jams
Secondary boycotts (confrontation between unions)
Sympathy strikes
Discriminatory or excessive contributions
Refusal to negotiate with employers

The right to strike


Free way of expressing the attitude of workers

about the working conditions


The aim should refer to the labor market
Otherwise, are prohibited:
Political strikes
Religious strikes
solidarity or social groups strikes.

Are also prohibited :


Strikes that can block the entire national economy and
may endanger public health,
or national security.

Let us remember
Economy system organized on markets:
Labor market
Market of goods and services
Monetary market
An efficient market = a competitive market

Perfect competition

Imperfect competition
Non-optimal income distribution
State intervention

The Pareto inefficiency of monopoly


Monopoly
Best known case of imperfect competition
Lack of competition on one goods market
The supplier has discretionary powers on setting

the operating conditions of a goods market


Monopolistic competition
Who is competing against monopoly?

Who is competing against monopoly?


With the companies that produce substitutable goods in

relation to the good self-produced.


With any other company the limited nature of short-term

income.
Considering short-term consumer income constant, it results that any

increase in consumption of a good will lead to a reduction in


consumption of another good, regardless of the relationship of
substitutability or complementarity.

Advantages of monopoly will attract other supplier/

manufacturers.

Monopolys strategies

Legend (1)
Monopoly faces the market demand demand curve

around the gates of the company will be identical with those


of market demand.
The optimal level of monopoly output (Q*) is set in relation to
the intersection of marginal revenue with marginal cost curve
(Vm < VM)
The price corresponding to this level of supply is P*, but
market demand is at a higher marginal income PC > P*
Monopoly can set the supply at its discretion (the only
supplier)
Usually the monopolistic firm restricts the supply to get a
higher sales price (the more the supply curve will be to the
left, the higher the price will get)

Legend (2)
The monopoly obtains superprofit (S), as the difference

between the profit pertaining to the intersection between the


demand curve and the supply curve (PC) and optimizing
price (P*)
Pareto optimum? No.
Obtaining superprofit is in the detriment of consumers, meaning that

the Q* solution is not Pareto optimum


The prices are higher than the level pertaining to profit maximization
(P*)

Are there favorable conditions for monopoly? When it does

not worsen the welfare of others


The case of the technological monopoly improving technological

performance can be found in welfare improvements (R & D)

The Pareto inefficiency of oligopoly


Kinked (broken)
demand curve

Legend (1)
Initial situation (Q0, P0).
Temptation price control.
The oligopolistic firm has the following alternatives:
If it wants to increase the price, the demand will suddenly turn elastic because

its product that became more expensive will be substituted by powerful


products of other firms from the oligopoly that have kept the price unchanged
losses for the supplier.
If it intends to reduce the price, the demand will turn inelastic, because at least
one other firm from the oligopoly will do the same, and the sales surplus will
be split between firms that reduce price losses for the supplier.

Legend (2)
The marginal income Vm in the case of the imperfect

competition is below average income (of the market


demand) the marginal revenue curve of the oligopolistic
firm will be discontinuous
Point N marginal revenue curve break (slope changes in

the firm's demand curve)

The second part of the marginal revenue curve is negative

(which measures the change in total revenue of the


company to lower prices, unlike the first part which describes
the change in revenue from an increase in price)

Solution negotiation
Cooperation between
firms in the oligopoly
avoids the kinked curve
and the firm gains
because the income
earned due to price
increase is larger than
the income lost due to
sales quantity drop

Methods of coordination in the oligopoly


Trust firms are horizontally integrated through joint assets

monopoly
Cartel firms keep their autonomy (e.g. OPEC)
Coordination may be based on agreements negotiated by

the participants
These agreements provide for:
commodity prices,
local markets,
Supply quotas assigned to each participant.

How does coordination take place?


Sending signals through the lead price promotional

strategy
Conditions favorable to tacit coordination :
Less fierce competition,
Demand expansion,
Lower danger of new competitors emergence.

Otherwise - coordination arrangements

Coordination difficulties in the oligopoly


Non-transparent pricing strategies pricing information

exchanges take place only when cooperation is desired


Wholesale - If a company raises the price of some of its

supply contracts for next year is unlikely that a competitor


can benefit from an increase in sales since it works with its
traditional clients
Real complex and non-fungible goods
Antitrust law

Coordination horizontal/vertical
Horizontal structures define the same level of

economic activity (producers, sellers).


Vertical structures are considered:
Integration on technological flows (upstream-downstream),
producer-seller,
In line with the supplies of raw materials or parts.

How do we establish the influence of the oligopolistic


horizontal coordination on free competition?
market definition monitoring through specialized bodies

(setting the price increase threshold)


sales concentration (degree of market concentration)
determine the share in total sales H-H index
barriers to entry (see Porter's Forces)
other market characteristics
Predator behavior (price dumping)
degree of complexity pertaining to the supplied goods quality

Suppliers history on that market.

efficiency and cost savings following a merger.

The case of coordination through vertical integration


Merger between two independent firms that had made

transactions, on being the others supplier


Where do problems occur?
long-term contracts make the entrance of a new seller or buyer

impossible
franchise, sales, leasing, licensing, sales, exclusive, contractual
requirements, territorial restrictions
resale price maintenance price strategy used by the manufacturer to
control the final consumer price
informational limitations
conditional sales contracts conditions the delivery of a good by the
purchase of another good

The difficulty establishing the boundaries of the intervention


Regulation of competition
Involves complex mechanisms
It is costly

It is unnecessary when the barriers created by state

regulations produce Pareto efficiency losses


(beyond the benefits of regulation)?
Not necessarily the case of merit goods
But yes, looking for the solution of self-regulation:
professional associations
agreements on compliance with quality goods and services
fair rules of doing business.