MARKET FAILURES

 When the market mechanism fails to allocate resources efficiently it leads to

market failures and the outcome is not pareto efficient.
 Pareto efficiency is a state of allocation of resources in which it is impossible to
make any one individual better off without making at least one individual worse
off. It is a natural phenomenon in society.
 Market failure occurs when market forces fail to produce the products that
consumers demand in the right quantities at the lowest possible cost
Economic Efficiency
 The using of resources in such a way as to maximize the production of goods and
services
 A system can be called economically efficient if:
Pareto Efficient
More output cannot be obtained without increasing the amount of input
Production proceeds at the lowest average cost
 The most economically efficient system is the one which provides more goods
and services for society without using more resources
 Market failure arises when markets are inefficient
 Four types of efficiencies have to be achieved by perfect markets1. Social
Efficiency
 When external costs and benefits are accounted for in society
 Social Marginal Cost= Social Marginal Benefit2. Allocative Efficiency
 When resources are allocated in a way that maximizes consumer satisfaction
 FOP and AS can be increased to reach the unattainable point on the PPF
 It is also referred to as Pareto Efficient Allocation: resources cannot be readjusted
to make a consumer better off without making another one worse off
 Situations like these are termed as opportunity cost3. Technical Efficiency
 Production of goods and services using the minimum amount of resources4.
Productive Efficiency
 Production of goods and services at the lowest input cost
Features/Causes of Market Failure
 If left to market forces, some products may be under-produced, some over-
produced and some may not be produced at all. Prices may be high due to lack of
competitive pressure and difficulties in lowering the price.
 A lack of investment and reduction in expenditure on R&D can also slowdown
the improvement in the products1. Failure to Conduct a Cost-Benefit Analysis
 Firms may ignore the social costs and focus only on the private benefits
 This could negatively affect the third parties
 E.g. Bhopal Incident
 Solution: effective CBA2. Information Failure/Gap
 For consumers to buy the products with highest satisfaction and lowest price, they
must be fully informed about the nature of the products on offer, the benefits they
can receive from them and their prices
 Workers need to know what jobs are on offer, the location, the qualifications
required and the remuneration they would receive. They should also be aware
about the best fitting job for them.
 Producers need to know what products are in demand, where to purchase raw
material and the most cost-effective methods of production
 There may be a lack of information or inaccurate information
 There could also be asymmetrical information in which consumers and suppliers
do not have equal access to information
 Knowledge is imperfect because:
consumers do not have adequate technical knowledge
advertising may be misleading
producers and unaware of all the opportunities
producers cannot accurately measure productivity
decisions are often based on past experiences rather than future knowledge
Solution: provision of symmetrical information to producers, consumers and
workers3. Inappropriate Consumption of Merit and Demerit Goods
 Merit goods are products that are more beneficial to the consumers than they
themselves realize and that have benefits for those who are not involved directly
in their consumption
 The failure of consumers to acknowledge the true value to themselves and to
others means that these products will be under-consumed and hence under-
produced, if left to market forces
 Solution: the government could increase awareness about their benefits and
therefore increase demand or supply merit goods for free
 Demerit goods are more harmful to consumers than they realize and they involve
external costs
 Demerit goods are over-consumed and therefore over-produced
 Solution: the government could raise their price through taxes or provide
information about their harmful effects to reduce demand. They may also ban
them.4. Inadequate Provision of Public Goods
 The degree of market failure is greater in the case of public goods than
merit/demerit foods
 If left to market forces, no public goods would be made
 Private sector firms would have no incentive to make products they cannot charge
for. It is not possible to exclude non-payers from enjoying benefits such as
defense.
 If public goods are provided for some people, free riders will also benefit
 Solution: merit system5. Abuse of Market Power
 Failure may arise due to producers having more market power than the consumers
 If one firm dominates a market, it may not be allocatively, productively or
dynamically efficient
 It will lack competitive pressure to respond to consumer demands and consumers
will have no choice but to buy from it, even if the price is too high, quality too
low and their needs are not fully met
 However, more than one firms could also get together and collude to reduce
competition e.g. price fixing
 Solution: the government could remove restrictions on the entry of new firms into
a market and making uncompetitive practices such as price fixing illegal. They
may also stop some firms from merging.6. Immobility of Resources:
 To achieve allocation efficiency, it is necessary for resources to move from
producing products that are decreasing in demand towards those which are
experiencing an increase in demand
 This requires both occupationally and geographically mobile resources
 Solution: the government could promote occupational mobility of labor through
education and training. They could also provide investment grants to make it
easier for firms to change the use of land and buildings.
 Solution: Geographical mobility of labor can be encouraged by making it easier
for them to rent and buy housing in areas where demand for labor is high. This
may be achieved by constructing houses in areas or providing financial help for
workers who move to these locations. Short Termism
 In perfect competition, firms prefer to enjoy high profits and therefore may be
uninterested in investing long-term
 There is a risk that market forces may not result in sufficient resources being
devoted to capital goods
 Private sector firms may be interested in making quick profits and may not plan
for times ahead. This may result in lack of investment.
 Solution: a government may have to stimulate private sector investment through
expansionary policies and undertake some investment itself.8. Unfairness and
Inequity
 Income distribution can become very uneven if it is solely determined by market
forces
 Private sector firms will only produce those products that people are willing and
able to purchase
 This may mean that they will not produce products for the poor
 Uneven distribution may be socially divisive and result in less productivity of
some workers, social unrest, some people not being able to earn incomes
  If people are poor, they will be less healthy, less educated and less productive
 Solution: The government may provide financial assistance to the poor and
provide some essential products to them free of cost- financed through taxes of
the rich
 Solution: Taxation and benefits may also be used to reduce income and wealth
inequality9. Government Failure/Inefficient Government
 Government intervention may worsen the situation
 The government may lack information and overestimate private benefits since it is
difficult to conduct an efficient CBA- especially regarding public goods
 Governments can take time to make decisions and those decisions can be
influenced by political factors
 Intervention may also reduce incentives and therefore reduce efficiency
Measures to Correct Market Failure
 State Provision
 Extension of Property Rights
 Taxation
 Subsidies
 Regulations
 Prohibitions
 Positive Discrimination (Merit System)
 Redistribution of Income
 Wage and Price Controls
 However, governments may use market failure as an excuse to intervene in
markets and result in inefficient allocation of resources (aka government failure)