QUESTION 1
WHAT IS THE MARKET FAILURE?
In the absence of distortions, competitive equilibrium is efficient. We use the term market failure to cover all the circumstances in which market equilibrium is inefficient. Distortions then prevent the ‘invisible hand’ from allocating resources efficiently. We now list the possible sources of distortions that lead to market failure.
Market failure is an imperfection in market mechanism that prevent optimal outcomes. In other words,if invisible hand of market place produces a mix of output that’s different from one society most desires, then it has failed. It is a situation in which market equilibrium results in too few or too many resources being used in the productin of a good or service. This inefficiency may justify government intervention.
Besides, market failure is a situation in which market equilibrium results in too few or too many resources being used in the productin of a good or service. This inefficiency may justify government intervention. Market failure implies that the forces of supply and demand haven’t lead us to he best point on production possibility curve.
Causes of Market Failure:
Because market failure is the justification for government intervention, we need to know how and when market failures occur. There are four important cases of market failure. The four specific causes of market failure are externalities, public goods, incomplete information, market power, lack of competition and income inequality.
Externalities
Externality is a cost or benefit imposed on people other than the consumers and producers of a good or service. Externalities are also called spillover effects or neighbourhood effects. People other than consumers and producers who are affected by these side effects of market exchange are called third parties. Whenever externalities are present, the preferences expressed in the market place won’t be a complete measure of a good’s value to society. As a consequences, the market will fail to produce right mix of output. Specifically, the market will underproduce goods that yield external benefits and overproduce those which generate external costs.
Externalities are things like pollution, noise and congestion. One person’s actions have direct costs or benefits for other people but the individual does not take these into account. The problem arises because there is no market for things like noise. Hence markets and prices cannot ensure that the marginal benefit you got from making a noise equals the marginal cost of the noise to other people.
For example, you are trying to study and your roommate is listening to music at full blast on the stereo. The action of your roommate is imposing on unwanted external cost or negative externality on you and other third parties who are trying to study or sleep. When externalities are present, market failures gives incorrect price and quantity signals, and as a result, resources are misallocated. External costs cause market to overallocate resources, and external benefits cause market to underallocate resources.
Public goods
A second major source of inefficiency lies in the fact that private producers simply do not find it in their best interest to produce everything that members of society want. More specifically, there is a whole class of goods called public goods, or social goods, that will be underproduced or not produced at all in a completely unregulated market economy.
Public goods is a good or service with two properties which is the users collectively consume benefits and there is no way to bar people who do not pay(free riders) from consuming good or service.
It is a good that can be made available cheaply to many consumers, but once the good is provided to some consumers, it is very difficult to prevent others from consuming it. If public goods are available only in the marketplace, people wait for someone else to pay, and the result is underproduction or zero production of public goods. Hence, it will lead to market failure.[i]
For example, suppose a firm is considering whether to undertake research on a new technology for which it cannot obtain a patent or not. Once the invention is made public,other can duplicate it. As long as it is difficult to exclude other firms from selling the product, the research will not be unprofitable.
No exclusion
Most of goods and services produced in public sector are different from doughnuts-and not just because doughnuts look, taste and smell different from “star wars” missile shields. The same exclusiveness is not characteristics of national defense. If you buy a missile defense system to thwart enemy attacks, there’s no way you can exclude your neighbours from protection your system provided.
The free-rider dilemma
Free-rider is an individual who reaps direct benefis from someone else’s purchase (consumption) of a public good. For example, if you and me get benefit from nuclear defenses, I’d prefer that you buy it, there by giving me protection at no direct cost. Hence, I may profess no desire for a missile shield, secretly hoping to take a free ride on your market purchase. Unfortunately, you also have an incentive to conceal your desire for national defenses. As a consequence, neither one of us may step forward to demand a missile shield in market place. We’ll both end up defenseless.[ii]
Underproduction of public goods
Free riders asociated with public goods upset the customary practice of payingfor what you get. If I can get all the national defense, flood control and laws I want without paying them, I’m not about to complain. If public goods were marketed like private goods, everyone would wait for someone else to pay. The end result might be a total lack of public services. This is the kind of dilemma Robert Heilbroner had in mind when he spoke of the market’s “deaf ear”
‘ the market has a keen ear for private wants, but a deaf ear for public needs’
Incomplete information
If consumers do not have accurate information about market prices or product quality, the market system will not operate efficiently. Lack of information may give producers an incentive to supply too much of some products and too little of other products.
In other cases, some consumers may not buy a product even though they will benefit from doing so, while other customers buy product that leave them worse off. For example, consumers may buy pills that guarantee weight loss, only to find that the pills have no medical value.
There are also commodities for which markets are absent or limited. As with information, we can’t expect markets to allocate resources efficiently if the market do not exist.[iii] Lack of information may prevent some markets from developing. It may be impossible to purchase certain kind of insurance because suppliers of insurance lack adequate information about who is likely to be at risk.[iv]
Market power
Market power is the ability to alter the market price of a good or a service. The most severe form of market power is monopoly. Inefficiency arises when producer or supplier of factor input has market power. Suppose for example, that the producer of food has monopoly power. If therefore chooses the output quantity at which marginal revenue is equal to marginal cost, and sells less output at a price higher than in competitive market.
The lower output will mean lower marginal cost of food production. Meanwhile, the freed-up production units will be allocated to produce clothing, whose marginal cost will increase.
A similar argument would apply to market power in input market. For example, unions gave workers market power over the supply of their labor in production market. Low amount of labor would then be supplied to food industry at high wage and vice versa.
Lack of competition
Lack of competition or imperfect competition is two or more consumers and producers compete with each other to ensure market functioning properly. In Wealth of Nations, Adam Smith state: “ People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public or in some diversion to raise prices.[v] This quotation clearly states that in real world, businesses seek ways to replace consumer sovereignty with “ big business sovereignty”.
Only perfect competition makes firms equate marginal cost to price and thus to marginal consumer benefit. Under imperfect competition, producers set marginal cost equal to marginal revenue, which is below the price for which the last unit is sold. Since consumer equate price to marginal benefit, maginal benefit exceeds marginal cost in imperfectly competitive industries. Such industries produce too little. Higher output would add more to consumer benefit than to production costs or the opportunity cost of the resources used.
Income inequality
Market may also result in very unequal distribution of income, therefore raising a very controversional issue. Take an example; under impersonal price system, Tom Cruise earns a huge income for acting in movies, while homeless people roam the streets penniless.
To create a more equal distribution of income, government uses various programs to transfer money from people with high incomes to those with low incomes. Unemployment compensation and food stamps are examples of such programs. The federal minimum wage is another example of a government attempt to raise the earnings of low-income workers.
[i] Tucker, I. B. (2005). Economics for Today 4th edition. United States, America: Thomson Corporation.
[iii] Begg, D., Fischer, S., & Dornbusch, R. (2005). Economics 8th Edition. New York: Mc Graw-Hill Education.
[v] Smith, A. (1937). An Inquiry into the Nature and Causes of the Wealth of Nations. New York: Random House: The Modern Library.
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