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Market Failure
Market - group of buyers and sellers linked by trade in a particular product or service
Prices in a market should reflect all the benefits and costs of production to society
When prices do not reflect this, there is market failure
Market failure occurs when a market, left on its own, fails to make decisions where resources are allocated efficiently
Aggregate costs are higher than aggregate benefits
Market Failure Defined
Markets fail for several reasons:
No market for those affected to communicate their costs
Market has insufficient information about gains/losses
A monopolist can influence price or output
Someone decides not to do something that creates benefits to others
Remedies for Market Failure
Society will seek a means of correcting the failure
Social, environment, or ethical issues not captured by transactions are called externalities
Liberal economists often advocate for internalizing externalities
Formal methods to remedy market failure:
Gov’t-set policy instruments (eg standards, bans, permits, or quotas)
Ability to seek compensation in courts
Gov’t provision of goods and services, such as health care, transportation, and education
Informal methods can also be effective:
Boycotts, protests, dissemination of information
Decision Making in the Public Sector
Public production in Canada is mainly in two classes:
Services which are not practical to require people to pay for: police/fire protection, national defence, maintenance of city streets
Services for which scale economies make it inefficient to have more than one provider, ie, natural gas, electricity
Single provider may charge excessive prices or be inefficient (monopolist)
Alternative is for gov’t to monitor/regulate performance
Benefit-cost analysis (BCA)
Project evaluation method often used in public sector
general framework for assessing the gains/losses of alternative projects when a broad societal view is needed
Also used in the private sector
Before conducting a BCA, it is important to identify:
Who will benefit from the project?
Who will pay for the project?
Identifying these two “points of view” clearly avoids confusion about what to include/what not to include
Generally, members of society are the users/beneficiaries of project services, and the gov’t is the sponsor
Challenge may be that there are several reasonable points of view
→ Each with a different set of users or sponsors to be included
This can lead to ambiguity/controversy over the results
Identifying and Measuring the Costs and Benefits of Public Projects
Generally classified into the initial capital costs and ongoing operating and administration costs
If the project generates savings, these are deducted from costs to produce a net cost to the sponsor
Some costs may be directly attributable to a project (direct costs), while others may be stimulated indirectly by the project (indirect costs)
Identifying and Measuring the Benefits of Public Projects
The benefits of a project to society include value of all goods/services that result from the project or program
Some of the effects from a project may be negative
These negative effects are referred to as social costs and are subtracted from benefits to obtain a net measure of social benefits
Some of the social benefits and social costs may be directly attributable to a project (direct benefits), while others may be stimulated indirectly by the project (indirect benefits)
Challenges arise because the benefits may not be reflected in the monetary flows of the project
ie real cash flows for road construction (costs, tax revenue)
vs intangible cost of traffic disruption during road construction
Intangible goods/services can be challenging to value
ie improved health and safety, value of noise abatement, value of the environment
Two methods used to value “intangible” benefits/costs:
Contingent valuation
hedonic price
Benefit-Cost Ratios
Same comparison methods that are used for private sector projects are appropriate for public sector projects
Benefit-cost ratios can be based on Pw or Aw
The conventional benefit-cost ratio (BCR) is given by:
BCR = Pw(users’ benefits)/Pw(sponsors’ costs)
A project is considered desirable if its BCR > 1
Modified benefit-cost ratio
In addition to BCR, a modified benefit-cost ratio (MBCR) is also commonly used
In MBCR, the sponsors’ operating and capital costs are separated to provide a measure of the net gain per dollar invested
The modified benefit-cost ratio (MBCR) is given by:
MBCR = [Pw(users’ benefits) - Pw(sponsors’ operating costs)] / [Pw(sponsors’ capital costs)]
Evaluating independent projects
Evaluate economic viability of projects with BCR/MBCR
For independent projects and mutually exclusive projects
For independent projects use following decision rule:
Accept all projects with a benefit-cost ratio greater than 1
Evaluating mutually exclusive projects
To use benefit-cost ratios to choose among mutually exclusive projects, perform incremental analysis
Suppose mutually exclusive projects, X and Y, with Pw of benefits BX and BY & Pw of costs CX and CY
We discard projects with a BCR < 1
If both projects have BCRs > 1, we rank the projects in ascending order by the present worth of costs
If CX >= CY, then form the ratio of the differences in benefits and costs:
BCR(X-Y) = (BX - BY) / (CX - CY)
If BCR(X-Y) > 1, X is preferred. Otherwise, Y is preferred
If CX = CY (in which case the ratio is undefined), we choose the project with the greater present worth of benefits
If BX = BY, we choose the project with the lower present worth of costs
Ambiguities in BCRs
It may not be clear whether certain positive effects are benefits to the public or reductions in cost to gov’t
Or, whether certain negative effects are dis-benefits to the public, or increases in costs to the gov’t
Differing results means that a comparison of BCRs may not carry the meaning intended
The MARR and the Public Sector
Private institutions concerned with generating wealth
Typical projects include health, safety, education programs, cultural development, and infrastructure
Hence, MARR for a public institution lower than private
In evaluating public sector projects, the MARR is used in the same way as in evaluating private sector projects, it captures the time value of money
