Welfare Economics.doc

Welfare Economics Topic 7. Market failure and the theory of second best Key reading: Chapter 5 Johansson This lecture will Provide an overview of market failure [read for detail] Explain in detail the use of total surplus to measure allocative efficiency and allocative inefficiency arising from market failure. And Introduce you to the application of game theory to strategic decision making in 2 areas relevant to market failure: pricing by imperfectly competitive firms, and free-riding for public goods. Introduction First fundamental theorem of welfare economics. What is the role of Government in a competitive economy that satisfies the conditions for Pareto optimality? → legal framework for private transactions → income distribution? The meaning of ‘market failure’ Market failure: deviations from perfectly competitive markets, such that the conditions for Pareto optimality are not satisfied by a reliance on private markets (‘decentralised decision making’) Where market failures exist, outcomes from private transactions may not be allocatively efficient. Implication: non-market mechanisms may be required.  Sources of market failure: overview Imperfectly competitive markets → monopoly, monopolistic competition, oligopoly → monopsony Economies of scale External effects → +ive externalities in consumption → -ive externalities in consumption → +ive externalities in production → -ive externalities in production Pure public goods → non-rivalry + non-excludability Impure public goods → common property resources Imperfect information → adverse selection → moral hazard → principal-agent problems Note: problems with ‘Merit good’ arguments. 4. The theory of second best Given market failure precludes a ‘first best’ outcome from private markets, do we achieve the ‘second best’ by following the ‘first best’ rules wherever possible? No: if one or more of the conditions for Pareto optimality are violated in one sector of an economy, there is no guarantee that meeting the cond