Market Failure

Market Economy

• Efficient system making use of the price mechanism
• Price changes signals surpluses and shortages
• Shortages can cause windfall profits
• Gluts incur losses
• Reallocation of resource takes place with firms entering profit-making markets and exit loss-making markets

Major Characteristics

1. Consumer Sovereignty

2. Decentralised decision making (pursuit of individual self-interest)

3. Economic efficiency is attained

• Productive efficiency achieved when goods are produces at lowest achievable cost (Any point on the PPC)
• Allocative efficiency achieved when no one can be made better off without someone being worse off (requires perfect competition and absence of externalities)
• Socially efficient allocation when Social Marginal Benefit = Social Marginal Cost, welfare maximised

Social Benefits and Costs

Social Marginal Benefit = Private Marginal Benefit + External Marginal Benefit

Social Marginal Cost = Private Marginal Cost + External Marginal Cost

External Benefits and Costs

External Benefits: Benefits from production/consumption experienced by people other than the producer/consumer

External Costs: Cost from production/consumption experienced by people other than the producer/consumer

Private Benefits and Cost

Private Marginal Cost

• Measures the cost to the producer from the last unit sold
• Represented by supply curve under perfectly competitive market

Private Marginal Benefit

• Measures the value the consumer places on the last unit of the good bought
• PMB = Px for rational consumer
• Represented by demand curve

Market Failure in Market Economy

Occurs when free markets, operating without any government intervention, fail to deliver a socially efficient allocation of resources to produce goods and services

Sources

1. Externalities (Either +ve or –ve)

• Costs/benefits from production/consumption experienced by society but not by the producers/consumers themselves, not accounted for by the Px mechanism
• Results in allocative inefficiency
• Partial market failure
• Illustrated using SMB/SMC graph
• Welfare loss in production = Area bounded by Q₀, SMC(PMC+EMC), SMB(=PMB=DD)
• Welfare loss in consumption = Area bounded by Q₀, SMB (PMB+EMB), SMC(=PMC=SS)

2. Underproduction of Merit Goods (Goods/services that have been deemed socially desirable and under-consumed through the political process, usually because of external benefits)

3. Overproduction of Demerit Goods (Goods/services that have been deemed socially undesirable and over-consumed through the political process, usually because of external costs)

4. Failure to provide Public Goods (Total Market Failure)

• Non-excludable, non-rivalry in consumption
• Free-rider problem
• Absence of price signal
• Market will not provide such a good

5. Imperfect competition

• Monopolists (not practically 100%): Single producer, Unique product, Barrier to entry, price setter
• Oligopolists: mutually interdependent, Collusion, High barrier to entry

6. Imperfect Information

• Asymmetric information (Either consumers/producers have better information than the other)
• Incomplete information (Ignorance of costs/benefits)
• Low frequency of consumption leading to lack of experience (Make wrong choice due to lack of experience)
• Complex products (Difficult for average consumer to knowledgeably evaluate)
• Conflict of interests (E.g. Health interest vs Profit interest in selling cigarettes)

7. Immobility of Factors of Production

• Labour (Occupational: Skills mismatch; Geographical: Barriers to movement)
• Capital: Capital goods usually only useful for purpose/location that it was built

Correction of Market Failure

Public provision

• Public goods
• May be extended to merit goods (e.g. education, vaccination)
• Question of Qty provided
• Issue of determination of public demand
• Concern about balance in provision of mix of merit and public goods

Market Solutions

1. Taxes

• Shifts PMC upwards, Tax should = EMC, Externality internalised
• Illustrated using SMB/SMC diagram (distance between PMC and SMC at Q_SE)
• Advantages:
• Permits the markets to operate;
• Ensures firms bear full social costs
• Magnitude can be adjusted in response to magnitude of problem
• Encourages firms to find alternatives to avoid the tax (e.g. for pollution)
• Disadvantages
• Unfeasible to use different tax rates (Too many factors to consider)
• Lack of knowledge (Measuring external costs and apportioning blame is extremely difficult)
• If taxes are lower than benefits from production, firms will continue producing (e.g. pollution tax lower than clean-up cost)

2. Marketable permits

• Cap and trade system, internalising externalities
• Market-based system that places economic value on reducing external costs
• Direct const penalty for producing externalities, Immediate economic incentive to reduce them
• Advantages
• Establishing market for externalities is effective means of controlling its production through market forces and internalising external cots (higher permit price, greater incentive to reduce externality production)
• Disadvantages
• Permits cheaper than reducing externality production would be ineffective
• Permits are not effective if externality discharged into common property, difficult to prevent those without permits from producing these externalities
• Enforcement is difficult, no way of knowing source of externality produced
• Difficulty in determining number of permits to auction off, difficult to withdraw/reduce number of permits

3. Subsidies

• Shifts PMC downwards, should = EMB, externality internalised
• Illustrated by SMB/SMC diagram (distance between SMB and PMB at Q_SE)
• Advantages
• Permits the markets to operate
• Ensures firms pass benefits to consumers
• Magnitude can be adjusted in response to magnitude of problem
• Disadvantages
• Breeds inefficiency, reduces incentive for firms to stay efficient by finding lowest cost of production
• Increase income inequality, difficulty in accurately estimating subsidy to impose due to difficulty to measure level of EMB
• Extent of co-payment for merit goods is debatable

4. Identifying Property Rights

• Define who owns property, its uses, the rights others have to it, and the transfer of such rights
• Advantages
• Encourage R&D (intellectual property rights)
• Internalise externalities
• Reduce need for government to estimate +ve/-ve externality (Property owner should have better knowledge of property than the government
• Disadvantages
• Government my bear the cost of monitoring infringement of property rights
• Costs of merit goods may increase due to patent rights, passed on to consumers
• Firms may monopolise as a result of possessing intellectual property rights
• Difficulty applying IP rights when externality arises from another country
• Process of extending rights may be extremely difficult, resulting in overproduction for a long time
• Difficult even for property owners to assess value of those rights

5. Regulation

• Production limits
• Age limits
• Regulate monopoly power through marginal/average pricing
• Exclusive bus lanes
• Bursary grants (to consumer rather than producer)
• Advantages
• Simple and easy to understand and administer
• May be possible to invoke emergency action
• Case-by-case approach may be used
• Provision of information to overcome market failure
• Disadvantages
• Blunt weapons (single time effect)
• Regulators bear high investigation costs
• Provision of information leads to higher production costs

6. Total Ban

• Absolutely zero output
• Advantages
• Easier to manage negative externalities using ban
• Protects community (especially in the case of harmful drugs)
• Disadvantages
• Cost of monitoring entry of banned products may be high
• May work against welfare of society (depends on relative size of welfare loss)

7. Nationalisation

• Public ownership
• Output controlled to take into account of social costs and benefits
• May result in lack of incentive, abuse of monopoly power, bureaucracy, political interference
• Privatisation is the opposite process

Government failure

Situations where allocative inefficiency worsened following government intervention

3 considerations to assess government’s success (Clifford Winston)

1. Does the government have any reason to intervene in a market?
2. Is the government policy at least reducing economic inefficiency or deadweight loss from market failure?
3. Is the government policy efficiently correcting the market failure and maximising welfare?

Possible causes

1. Pursuit of self-interest amongst politicians and civil servants (E.g. extra prestige in starting a spending campaign even though it is not beneficial)
2. Electoral pressures leading to inappropriate spending without full cost-benefit analysis (E.g. bring forward tax cuts or infrastructure projects to win at polls)
3. Tendency to look for short term solutions (does little to address structural problems)
4. Imperfect information (Government is unsure of what and how much to intervene)
5. Market distortion (correcting one problem may lead to another)
6. Cost of administration/enforcement (Cost may ultimately outweigh social benefits)
7. Regulatory capture (industries have large influence on government decisions on their sector)

Appendix

• Environmental Auditing
• Overview of government failure
• Public Choice Theory