MARKET FAILURE

Definition         : Market failure exits whenever a free market, left to its own devices and totally free from any form of government intervention, fails to make the optimum use of scarce resources. In other words, it occurs when there is misallocation of resources.

Resources not allocated efficiently is when  resources are used to produce goods that nobody wants, or when  insufficient amounts of resources are used to produce what society is able and willing to pay

There are two classification of efficiency:

1.   Productive efficiency     : The producers have to make decision on how to produce goods in a low cost example like using less resources or using more efficient machinery

2.   Allocative efficiency       : Then producers only focused on consumer’s wants.

The allocation of resources said to be socially efficient when the marginal benefit to society equals to the marginal cost to society of producing or consuming the good


 Social Marginal Benefit (SMB) = Social Marginal Cost (SMC)

Social Benefits and Costs

1)   Social Marginal Benefit is the sum of Private marginal benefit (PMB) and External Marginal Benefit (EMB) . It can be said the benefits that we and the society received


2)   Social Marginal Costs is the sum of Private Marginal Cost (PMC) and External Marginal Costs (EMC).  It can be said the costs that we and the society received

External Benefits and Costs

1)   External Benefits are benefits from production/consumption experienced by people other than the producer/consumer themselves                                             


2)   External Costs are costs from production/consumption experienced by people other than the producer/consumer themselves                                            

Private Benefits and Costs

1)   Private Marginal Benefit (PMB) of a good measures the value that the consumer places on the last unit of the good bought

2)   Private Marginal Costs (PMC)of production measures the cost to the producer from the last unit sold.  Under the perfectly competitive market, PMC is represented by the supply curve and at any given quantity, PMC is represented by the height of the supply curve.

There are some reasons why market fails:

·     When there are externalities in the market

·     Failure to provide public goods

·     Imperfect competition

·     Imperfect information

·     Immobility of factors of production

·     Underproduction of merit goods and overproduction of demerit goods

·     Adverse selection or moral hazard

·     Where there are concerns about distribution of income and wealth

Externalities

Externalities are costs or benefits from production or consumption experienced by the one who does not directly involve in production or consumption itself

It occurs if a third party (someone not directly involved) is affected by the decisions and actions of others. There are two types of externalities; Positive and Negative externalities.

Example is when a factory produces a goods and the waste is thrown to the river near the residence, then the people near that residence who use the river will affected by the polluted water (negative externality)

v Negative Externalities

 This is illustrated in which shows that the social marginal cost (SMC) curve lies above the private marginal cost (PMC) curve.

v Positive Externalities

There is a divergence between Social Marginal Benefit (SMB) and Private Marginal Benefit (PMB), with SMB being greater than PMB, as illustrated in graph above

Failure to provide public goods

Certain goods are necessary for society but are not provided if supply would be left over to market forces. This is not because of externalities but due to the characteristics they posses. In this case we talk about Public Goods. Examples of Public Goods are national defence and the legal system (judges, courts, attorneys etc.)

v Public goods are:

Non excludable: this means that once the good has been provided for one consumer ,if it is impossible to stop all other consumers from benefiting from the good.

Non rivalry: As more people consume the product ,the benefit to those already consuming the product is not diminished.

Example of public goods, street lights and the police service

This public good case may leads to free rider problem which means some consumers attempt to gain ‘free ride’ on the back of other consumers’ purchases of the public goods

Example of questions

1.   Explain the link between ‘free rider’ problem and government provision of streetlights (5)

The free rider is the people who consume the goods or services without paying for it or not pay fully the cost. In this case, the streetlights itself can be classified as public goods. Everyone can enjoy the streetlights without paying for it. It is non-excludable and non-rivalry.

With providing public goods such as these streetlights, it can help to reduce or avoid free riders problem. When the government provides such goods, people don’t have to fight for this goods (there will be no rivalry). Everyone without exception can enjoy streetlights freely so that it will be fair also to the people who have lower income that cannot afford to spend some money that usually makes them become free riders.

v Private Goods are:

 Excludable: Consumers can be excluded from consumption by charging them a price. If they lack the ability to pay they will not enjoy the consumption of this good

Rivalry in consumption: Consumption of the good decreases the availability and quantity of the good. Take for example a bottle of Coca Cola. Once someone has started to drink from it there will be less Cola in the bottle and the quality of it has also gone down

Examples are movie ticket and luxurious hotel

v Quasi public goods are:

The combination of public goods and private goods, does not fully possessing the two required characteristics of public or private goods

Example are sandy seaside beach and fireworks as public attraction

Imperfect competition

It occurs when there is one producer who dominate the markets (monopolist) or a few producers (oligopolists).This act of reducing output to raise the price of a good contributes to market failure since there is no allocative efficiency in production as in perfect competition.

Imperfect information

Imperfect information arises when one side of the market – either buyers or sellers - having better information than the other. 

Example is Uninformed Sellers and Knowledgeable Buyers.  For example, in the market for life insurance, buyers know more about the risks they face than sellers do.

Immobility of factors of production

Immobility of factors of production also contributes to market failure as resources cannot respond to incentives to produce goods and services demanded by consumers.The greater the immobility of factors, the more difficult it is for markets to achieve socially efficient allocation of resources.

v Labour immobility

v Occupational immobility

v Geographical immobility

v Capital immobility

Underproduction of merit goods and overproduction of demerit goods

v Merit goods can be defined as products that generate positive externalities or greater benefits that the consumer may realize.

            Examples are health care and education

v Demerit goods can be defined as products that generate negative externalities or not beneficial to the consumer. The market, however, will produce these goods if there is a demand for them. Hence, there is a need for government control of such goods. Demerit Goods are goods whose social costs are greater than its private costs.

            Examples are cigarettes and alcohol

Government intervention to correct market failure

Government can help to correct market failure by giving some policies/regulations and also the use of taxation and subsidies

Examples :

#1 Parliament can pass laws that for example prohibit the sale of cigarettes to children/only to those above the age of 18 or ban smoking in the workplace/shopping malls. This policy may help to reduce the consumption of demerit goods

#2 Government impose more tax on demerit goods so that It can help the reduce in consumption and also the production of demerit goods

#3 By giving subsidies on merit goods ,the people may attract more to the merit goods and that can help the underproduction of merit goods