Microeconomics | Market Failure | 1

MARKET FAILURE
Market failure occurs when the free market fails to allocated resources in an optimum
and ecient manner! There are four main sources of market failure"
1# E$TER%ALI TI E&
E'ternalities occur when some of the costs or (ene)ts associated with production or
consumption of *oods and ser+ices spill o+er onto third parties!
,hen market failure is present- allocati+e ecienc. is achie+ed when MSB=MSC
Positive externalities Negative externalities
/ccur when societ. (ene)ts from the
consumption or production of a commodit.
or ser+ice
/ccur when costs are imposed on societ.
from the consumption or production of a
commodit. or ser+ice
Education- +accination etc! 0ollution- smokin* etc!
Merit goods Demerit goods
1oods that societ. +alues and 2ud*es that
e+er.one should ha+e whether the
indi+idual wants them or not!
1oods that societ. +alues and 2ud*es to (e
(ad for and indi+idual
Underconsumed due to imperfect
information 3 indi+iduals are unaware of
lon*4term (ene)ts and positi+e
e'ternalities
/+erconsumed due to imperfect
information 3 indi+iduals are unaware of
lon*4term detriments and ne*ati+e
e'ternalities
5onsumption of merit *oods is (elie+ed to
*enerate positi+e e'ternalities 6M&7
e'ceeds M07#
5onsumption of demerit *oods leads to a
fall in social welfare 6M07 e'ceeds M&7#
8ealthcare- education- pu(lic li(raries Alcohol- ci*arettes- dru*s- addiction to
*am(lin*
9# :ER/ 0R/;I &I /% /F 0U7LI 5 1//<&
A public good is a *ood=ser+ice which is
1! Non-rivalrous 3 its (ene)ts are not depleted (. an additional user
o M5 > ?- for allocati+e ecienc.- 0 > M5 > ?
o 0u(lic *oods ha+e to (e provided at no charge
9! Non-excludable 3 impossi(le 6or dicult# to e'clude people from its (ene)ts
o @Free riderA pro(lem arises no one will pa. for what he can *et free
o 0ri+ate )rms will not pro+ide pu(lic *oods 6una(le to char*e for
consumption#
o 0u(lic *oods- therefore- ha+e to (e provided b! the government
E'amples of pu(lic *oods include streetlamps and pu(lic li(raries
Note" a private good is one that is (oth rivalrous and excludable 3 automo(iles-
clothin*- food etc!
B# I M0ERFE5T 5/M0ETI TI /%
0refect competition does not alwa.s e'ist in real markets- and more often than not- free
market forces do not lead to optimum ecienc. in resource allocation!
/ne e'ample is the monopol." the monopolistAs output is not allocati+e ecient as it
produces at a point where 0 C M5- creatin* a <,L of (oth consumer and producer
surplus!
D# I %EEUI TF
The pro(lem of ineGuit. is distinct from that of ineGualit.! EGuit. refers to a distri(ution of
income that is considered fair 3 a normati+e issue! An eGuita(le distri(ution is thus not
the same as an eGual distri(ution!
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,hile to some e'tent- some de*ree of income ineGualit. is desira(le 3 as incenti+es to
work hard etc!- a +er. uneGual distri(ution of income has ne*ati+e repercussions
especiall. on the socioeconomic front!
The solutions to ineGuit. are (rieH. discussed under I<ealin* with IneGualit. and
IneGuit.J
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1/;ER%ME%T I%TER;E%TI/%
Problem "ntervention #valuation
$ero
provision of
public goods
Direct provision of pu(lic
*oods
Negative
externalities
Financial inter+ention" taxes
6eGual to the monetar. +alue of
the ME5# are imposed on
indi+iduals or a )rm- internaliKin*
E5s
%dvantages
Lea+es space for market forces to
interact
0ro+ision of re+enue for the
*o+ernment
Disadvantages
<icult. in +aluatin* E5
/+er+aluation means output is
(elow social optimum- as with
under+aluation means that output
is not sucientl. lowered 6ie-
societ.As welfare is not alwa.s
ma'imiKed#
ELecti+eness of ta' dependent on
0E<
Le*islation" la&s and
administrative rules are
passed to prohi(it or re*ulate
(eha+iour that imposes an E5-
e!*! pollution permits
Enforcement is dicult and
e'pensi+e
Education- campai*ns and
ad+ertisements sol+e the
pro(lem of imperfect information
(. allowin* the e'ternal costs to
(e made known to the consumer-
discoura*in* demand
7ene)ts must outwei*h the costs of
implementation!
A lot of time ma. (e needed for
eLects to (e felt
Positive
externalities
Financial inter+ention" subsidies
made to the producer or
consumer
%dvantages
5onsidered the most eLecti+e wa.
of sol+in* underconsumption as it is
easil. implemented
Disadvantages
Like ta'es- the +aluation of E7 is
dicult
8i*h *o+ernment e'penditure is
reGuired
/kunAs leak. (ucket" each dollar
transferred from a richer to a
poorer indi+idual- results in less
than a dollar increase in income for
the recipient! Leaks arise as a result
of administrati+e costs- chan*es in
work eLort- attitudes etc! arisin*
from the redistri(ution
Le*islation include re*ulation
seat(elt usa*e- compulsor.
education etc!
Enforcement reGuires constant
checkin* which ma. translate to
hi*h costs!
Non
provision of
merit goods
There is a need to produce merit *oods 6which are naturall.
underconsumed# at low prices or for free due to four reasons
1! Social 'ustice" the. should (e pro+ided accordin* to need and not
a(ilit. to pa.
9! (arge positive externalities- for e'ample in the pro+ision of free
health ser+ices helps to contain and com(at the spread of disease
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B! Dependants are su(2ect to their *uardians decision which are not
necessaril. the (est- therefore the pro+ision of ser+ices like free
education and dental treatment is needed to protect dependants
from uninformed or (ad decisions
D! "gnorance" The pro(lem of imperfect information makes consumers
unaware of the positi+e e'ternalities and (ene)ts that arise from
consumption
"mperfect
markets
Imposition of a lump4sum ta' on a monopolist 6shifts A5 upwards#- and
supernormal pro)ts are taken as ta'! 1o+ernments ma. also re*ulate
M5=A5 pricin* for monopolies!
1o+ernment ma. impose re*ulations to control a monopolies
1! For(iddin* the formation of monopolies 6e!*!- antitrust laws#
9! For(iddin* monopolistic (eha+iour 6like predator. pricin*#
B! Ensurin* standards of pro+ision!
D! Ensurin* competition e'ists 6e!*!- dere*ulation#
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%ATI/%ALI:ATI/% A%< 0RI;ATI:ATI/%
Nationali)ation refers to the pu(lic 6*o+ernmental# ownership of certain )rms to
pro+ide *oods or ser+ices sold in the market- that is- pu(lic corporations en*a*ed in
commercial acti+ities! 1o+ernments often take o+er natural monopolies to pre+ent
monopol. pricin* and e'amples include pu(lic utilities!
%dvantages Disadvantages
5onsumers protected from hi*h prices 5ross inecienc. ma. arise
Ensurin* social costs and (ene)ts are
taken into account when production
decisions are made
%o pro)t moti+e ma. lead to nationaliKed
enterprises (ein* allocati+el. inecient
Privati)ation refers to a chan*e in ownership of an acti+it. from the pu(lic to the
pri+ate sector!
&tate owned companies ha+in* lost mone. ma. pri+atiKe to *i+e new owners the
responsi(ilit. of restructurin* the enterprise!
F/RM& /F 0RI ;ATI :ATI /%
1! Denationali)ation" 0ri+atiKation of ownership 3 sales of assets or shares! The
*o+ernment ma. retain some shares in the enterprise- and acts as a re*ulator in
this case to ensure that pu(lic interest is protected!
9! *ranchising" 1i+es the pri+ate sector a ri*ht to operate a particular
ser+ice=acti+it. for a *i+en len*th of time! Ma. (e e'clusi+e or competiti+e
B! Privati)ation of production" 1o+ernment (u.s *oods and ser+ices instead of
producin* them
o Refuse collection ser+ices (ein* contracted to pri+ate )rms
D! Privati)ation of +nancing" 1o+ernment relies on consumer char*es rather than
ta' re+enue to su(sidiKe operations! 6e!*!- independent school fees#
M! Deregulation" Li(eraliKation of re*ulation to promote competition throu*h the
remo+al of (arriers to entr. 6creation of contesta(le markets#
o Telecommunications- )nancial industr.- airline 6U& @open skiesA polic.#
E;ALUATI /% /F 0RI ;ATI :ATI /%
*or %gainst
,evenue for the government 3 reduces
pu(lic4sector (orrowin* reGuirement!
Allows the *o+ernment to make ta' cuts
without reducin* spendin*! Re+enue mi*ht
come in from hi*her corporate ta' receipts
from the pri+atiKed companies
(ong term revenue loss 3 future pro)ts
from industries are lost (. the state
Natural monopolies are best left to
the public sector as duplication of
ser+ices is unnecessar. 3 wasteful and
inecient and not in the (est interests of
consumers
"ncreased competition due to
contesta(le markets and pro)t moti+es
which translates to
Bene+ts for consumers in the form of
lower prices- wider choices and (etter
Gualities as $4inecienc. is reduced 6see
Nationalization#
Competition ma! not increase replacin*
a pu(lic4sector monopol. with a pri+ate4
sector one does not increase competition
as )rms are still a(le to act like
monopolists
"ncreased e-cienc! and .exibilit! as
pri+ate companies are normall. more
successful in raisin* capital- lowerin* prices
and cuttin* out waste! Little *o+ernmental
interference allows the compan. to
respond to market forces- and make
commerciall. sensi(le decisions and
in+estments
Market forces ma! not ensure greater
e-cienc! 3 like (efore- remainin* as
pri+ate4sector monopolies are likel. to earn
supernormal pro)ts e+en if the. are
inecient! Lar*e )rm siKe also pre+ents
)rms from (ein* taken o+er
/ider share o&nership increases
accounta(ilit. to the pu(lic
Private-sector +rms ma! not act in
public interest as the. do not take into
account ne*ati+e e'ternalities 6like
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resultant unemplo.ment# and are unlikel.
to (ase their output and pricin* on social
2ustice and eGuit.
Cost-push in.ation is reduced! 0ri+ate
)rms are less willin* to accept inecient
workin* practices! ,a*e raises ha+e to (e
2usti)ed (. hi*her producti+it.!
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<EALI%1 ,IT8 I%EEUALITF A%< I%EEUITF
The tax s!stem can (e used to reduce ineGualities in income and wealth!
Progressive taxes" people earnin* hi*her incomes are ta'ed a hi*her
percenta*e of their income
o Reducin* income diLerentials
o Ma. create disincenti+es to work with e'cessi+e pro*ressi+it.
<irect ta' imposition on wealth 6e!*!- inheritance ta'es#
Monetar! provision" mone. raised throu*h the ta' s.stem is paid to low4income
*roups to increase F
<
Means-tested bene+ts are paid to those that )t certain criteria
Unemplo.ment (ene)ts
o Mi*ht create disincenti+es to work
o %ot alwa.s claimed (. those for whom the. are desi*ned
o E'pensi+e to administer
o Low take up rates" (ureaucrac. and social sti*ma
0niversal bene+ts are paid out to e+er.one in certain cate*ories re*ardless of
income=wealth
&tate pensions- child (ene)ts
o Ma. impl. pa.in* out mone. to those who do not need it
o More e'pensi+e
Direct provision of *oods and ser+ices are also )nanced throu*h the ta' s.stem! Free
pro+ision means that if ser+ices are used eGuall. (. all- lower income *roups *ain more
ad+anta*e- reducin* ineGualit.
8ealthcare and education
o &u(2ect to market failure- (ut 2usti)ed (. ineGuit.
1/;ER%ME%T FAILURE
1overnment failure arises when *o+ernment inter+ention in the market to impro+e
market failure worsens the situation" increases market distortions and reduces welfare
and economic ecienc. instead of otherwise!
REA&/%& F/R 1/;ER%ME%T FAI LURE
Problem of incentives" undesira(le incenti+es ma. create ineciencies
Ta'ation distorts incenti+es
o <isincenti+es to work harder with pro*ressi+e ta'
o <,L of a ta' ma. cause a disincenti+e to consume and produce
0oliticians moti+ated (. political power rather than economic imperati+es
o 0olicies desi*ned to retain power rather than ma'imiKe ecienc.
o 0olitical pressures dominates societal welfare
Ta'es that reduce e'ternalities ma. (e unpopular are a+oided
Inappropriate incenti+es of pu(lic enterprises
Problems of information arise as- 2ust as the markets lack information- more often
than not- *o+ernments do too! The *o+ernment ma. not know the full costs=(ene)ts of
policies e+en thou*h it wishes to work to the interests of the consumer
Imperfect information a(out the true +alue of a ne*ati+e e'ternalit.
o <icult to trace the source of a ne*ati+e e'ternalit.
o 0ro(lems of ta'ation 3 dicult to put a )*ure to E5 6see Government
Intervention#
Imperfect information a(out the le+el of consumer demand
o 0u(lic *oods pro+ided ma. not (e needed- or produced are wron*
Guantities
Problems of distribution arise as policies ma. aLect diLerent *roups of people
diLerentl.
Bureaucrac! and ine-cienc! arise when policies are wide reachin* and detailed-
more people and resources will (e in+ol+ed! InHe'i(ilit. due to (ureaucrac. leads to a
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lack of )ne4tunin* 6*o+ernments respond more slowl. to pro(lems when circumstances
chan*e#
2ime lags in plannin* and implementation of policies cause policies to (e ineLecti+e-
irrele+ant- or come too late to sol+e a mountin* pro(lem
*re3uent shifts in government polic! ma. cause economic ecienc. to suLer as
)rms )nd it dicult to plan without knowled*e of ta' rates- su(sidies- wa*e controls etc!
4icious circle of government intervention
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