Market Failure

MARKET FAILURE

Sources of Market Failure

Market failure is said to occur when free markets, operating without any government intervention. Fail to deliver a socially efficient allocation of resources to produce goods and services.

There are few reasons why Market Failure occurs:

1.    Externalities

2.    Failure to provide Public Goods

3.    Imperfect Competition

4.    Imperfect Information

5.    Immobility of factors of production

1. Externalities

            Externalities are costs or benefits from production or consumption experienced by society but not by the producers or consumer themselves, not accounted for by the price mechanism. Externalities effects can be either positive or negative.

Private and External Costs

·      Private costs are costs that are incurred by the one who undertakes an economic activity. Ex: those costs that you pay in order to obtain something.

·      External costs are costs incurred by third parties due to the economic activities of someone else. Ex: The passive smokers.

Private and External Benefits

·      Private benefits are those benefits that are incurred by the one undertaking an economic activity. Ex: the private benefit of getting better after visiting a doctor.

·      External benefits are those benefits that third parties enjoy from the economic activity of someone else. Ex: The fact that others didn’t get sick because you visited the doctor is an external benefit.

The sum of these costs and benefits are called social costs and benefits.

Negative Externalities

This happens when the price mechanism fails to bring about a socially efficient allocation of resources in this case. This is because the cost to society in terms of deterioration  of the environment is unpriced  by the price mechanism and therefore is not included in the private costs of production.

Positive Externalities

The analysis of positive externalities is similar to the analysis of negative externalities. Once again, the price mechanism fails to bring about a socially efficient of allocation of resources. This is because the benefit to society in terms of reducing the risk of others getting influenced is unpriced by the price mechanism and therefore is not included in the private benefit.

In conclusion, negative externalities lead market to produce a larger quantity than is socially desirable. Positive externalities lead markets to produce a smaller quantity than is socially desirable. In other words, externalities result in partial market failure.

Merit goods are goods or services that have been deemed socially desirable and under-consume through the political process, by the government.

Demerit goods are goods or services that have been deemed socially undesirable and over-consume through the political process –their undesirability is usually due to external costs imposed on society when consumed.

2. Failure to provide Public Goods

            Public goods not provided by the free market because of their two main characteristics:

·      Non-excludability where it is not possible to provide a good or service to one person without it thereby being available for others to enjoy.

·      Non-rivalry where the consumption of a good or service by one person will not prevent others from enjoying it.

Examples: Street lighting, lighthouse protection, police services, air defense systems, roads, terrestrial television, flood defense systems, public parks and beaches.

Because of their nature the private sector is unlikely to be willing and able to provide public goods. The government therefore provides them for collective consumption and finances them through general taxation.

Since it is not possible to exclude those who do not pay from consuming the good, no one has the incentive to pay what the good really is worth to them. A free-rider is anyone who receives the benefits from a good or service without having to pay for it. Hence, despite the fact that a pure public good yields valuable benefits to society, the free-rider problem means that the market will not provide such a good.

In conclusion, the non-excludability and non-rivalry characteristics of public goods result in complete market failure because the market fails to produce such goods.

3. Imperfect Competition

            A sole producer (monopolist) of a good or service which has no close substitutes may use market dominance to raise the price of a good by reducing its output. A few producers (oligopolist) may collude to raise price of a product by restricting output. This act of reducing output to raise the price of a good contributes to market failure since there are no allocative efficiency in production as in perfect competition.

4. Imperfect Information

            Imperfect information arises due to:

§  One side of the market (either buyers/sellers) having better information than the other, commonly known as Asymmetric Information.

§  Uninformed buyers and knowledgeable sellers (doctor and patient)

§  Uninformed sellers and knowledgeable buyers (Insurance and their clients)

§  Low frequency of consumption, a lack of experience

§  Complex products that are difficult for the typical consumer to evaluate knowledgeably

§  Conflict between consumer and producer interest (cigarettes)

How does imperfect information cause market failure?

§  In an efficient market, both buyers and sellers have good knowledge of the product in order to make rational decisions that equate marginal benefits to marginal costs.

§  When imperfect information exist, buyers and sellers are prevented from achieving the efficient outcome. The inefficient allocation of resources leads to welfare loss.

5. Immobility of factors of production (resources)

v Resources cannot respond to incentives to produce goods and services according to the consumers’ demands

v The greater the immobility of factors of production, the more difficult it is for markets to achieve allocative efficiency

Labour-Occupational Immobility: Missmatch of skill-> leads to a waste of resources and represents market failure because social welfare is not being maximized.

Labour-Geographical Immobility: Geographical immobility exists in large countries when there are barriers to people moving from one region to another in search of jobs

Capital Immobility: Certain capital goods are difficult to transfer from one use to another (a train once built is only useful as a train). For another capital goods, it is difficult to transfer it from a geographical location to another (Apetrochemical plant built in Tangerang, Indonesia cannot be easily uprooted and transferred to the US.

CORRECTING MARKET FAILURE

            Government Intervention

Government intervene markets in attempt to correct market failure. There is a high risk of market failure in a free market and that government action (Taxation and Subsidies)  can counter these risks, leading to a more socially efficient outcome.

            Taxes

·      A charge placed on the production of a good and service by the government

·      A tax will increase the cost of production to the producer

·      It is likely that the producer will produce less therefore the supply curve shifts to the left

·      The government might force the firm to pay a fee.

Subsidy

·      A benefit given by the government to groups or individuals usually in the form of a cash payment or tax reduction. The subsidy is usually given to remove some type of burden and is often considered to be in the interest of the public.

·      Used to help redistribute income

·      Used to help firms compete

·      Increases output – market failure is perceived as a lack of output

·      Long term effects on market – distorts price signals

·      EXAMPLES: state benefits, free school meals, working tax credits, agriculture, transport, regional development, housing, employment, education

The Basic Economic Problems

SCARCITY refers to the situation where the limited resources available are unabke to satisfy the unlimited human’s wants

 

Definitions to remember:

-       Needs= good or services that are required to survive. This would include the needs for food, clothing, shelther, health care.

-       Wants= goods or services that are not necessary for survival, but that we desire or wish for

-       Free goods= goods that don’t require any resources to produce and therefore have no opportunity costs

-       Economic goods= goods that require FOP to produce and therefore causes opportunity costs

-       Capital goods= goods that are used to produce other goods

-       Consumer goods= goods used/consumed by individuals

SCARCITY leads to making choices. In order to get what we want, we need to make choices we want to satisfy first. The choice we give up in order to get what we want first is the OPPORTUNITY COST or best alternative forgone.

THREE FUNDAMENTAL QUESTIONS

-       What to produce ?= the productions we would like to produce

-       How to produce ?= the method we are going to produce the goods, whether by labour-intensive method or capital-intensive method

-       Who to produce for ?= our aims, the people we expect to buy our productions

FACTORS OF PRODUCTION= resources available to produce goods and services

Consisting of… - LAND (all the natural physical resources), - LABOUR (the human input into production process), - CAPITAL (investment in capital goods that can be used to produce other than consumer goods and services), - ENTERPRISE (the willingness to take risks).

NORMATIVE STATEMENTS= express an opinion about what ought to be, they are SUBJECTIVE statements rather than objective statements, they carry value judgements

POSITIVE STATEMENTS= are OBJECTIVE statements that can be tested or rejected by referring to the available evidence. Positive economics deals with objective explanation and the resting and rejection of theories.

PRODUCTION POSSIBILITY CURVE (PPC)

è The PPC shows all the possible maximum attainable combinations of goods or services that can be produced in an economy, when all resources are used fully and efficiently, at a given state of technology.

Assumption:

-       Only 2 goods or services produced

-       Production observed over a specified period of time (yearly basis)

-       Quality and quantity of resources remain constant/fixed over the time period

-       Resources fully employed and efficiently used

-       No change in technology

-       Points inside the PPC are attainable but inefficient because resources are either underemployed or unemployed

-       All points along the PPC are attainable and efficient because all resources are fully employed

-       Points outside the PPC are unattainable because growth is limited by current amount of resources and state of technology (scarcity)

Other names for PPC:

-       Production frontier = draws boundary between what can and cannot be achieved

-       Product transformation curve = the economy moves along the curve from 1 point to another point then different combination of goods is being chosen

Planned economy

-       Which can also be called a certainly planned, command or collective economy

-       It is one in which the state makes the decisions about what to produce, how to produce it, and who receives it

-       No private enterprise, all productions are undertaken by states.

-       The state gives instructions, sometimes called directives, to state-owned enterprises

-       The state owns all or at least most of the economic resources

-       The state decides the remuneration paid to the workers and controls prices

-       No consumer sovereignty

However:

-       There is economic equality (as workers are paid the same wage rate)

-       The state provides for training and education, resulting in equal opportunity for everyone

-       The state provides welfare to the people (basic necessities. E.g= housing and transports)

A PLANNED ECONOMY= an economy where the govt. makes the crucial decisions, land and capigtal are state-owned and resources are allocated by directives.

Market economy

-       Also known as a free enterprise, is one in which consumers determined what is produced

-       They signal their preference through the price mechanism. If they want more of a product, they will be willing to pay more for it

-       In market economy, resources switch from products that are becoming less popular to those becoming more popular

-       Government intervention is minimum. Land and capital are privately owned. Private sectors firms decide how to produce the products consumers want to buy

-       In making their decision on which FOP to employ, firms will seek to achieve the least cost method of production.

-       Capital intensive= firms employ large amounts of capital relative to labour

-       Labour intensive= firms use a relatively high numbers of workers in comparison with the amount of capital used

In market economy:

-       Those who earn the highest income exercise the maximum influence on what to produce

-       Those workers whose skills are in highest demand and the most successful entrepreneur will be able to buy more products than those whose skills are in low demand and unsuccessful entrepreneur.

MARKET ECONOMY= an economy where consumers determine what is produced, resources are allocated by the price mechanism and land & capital are privately owned

Advantages of a Market Economy

-       A market economy should be very responsive to changes in consumers demand. In fact, consumers are said to be rulers

There is also choice in Market Economy, consumers can choose which firms to buy from, firms can decide what they want produce and workers can choose who to work for.

The profit motive and competition promote efficiency

-       Those firms which produce what consumers want at the lowest possible prices are rewarded with high profits

-       But firms which do not change their output quickly to reflect what is in demand and have high costs are likely to go out of business

High income provide an incentive for people to work hard and for entrepreneur to set up and expand firms.

è Competitions to improve oneself and become better emerges amongst people since everybody will try to do their best in order to control economic resources as much as possible.