1.

Notion of market failure

Market failure occurs when freely functioning market fails to deliver an efficient allocation of
resources. This also means that the market may not always allocate scarce resources efficiently in a
way that achieves the highest total social welfare.

The result of market failure results in:-

a. Productive inefficiency.
Businesses are not maximising output from given factor inputs. The lost of outputs from
inefficient production could have satisfied more wants and needs.
b. Allocative efficiency
Resources are misallocated that produces goods and services that are not wanted by
consumers. The resources could have been put to better use on the products valued by
consumers.

There are plenty of reasons why the normal operation of market forces may not lead to economic
efficiency.

a. Externalities [~]

b. Public goods

Public goods are services which must be provided collectively for two main reasons:

 Non-excludability - the goods cannot be confined to those who have paid for it
 Non-rivalry in consumption - the consumption of one individual does not reduce the
availability of goods to others

Examples of pure public goods include flood control systems, street lighting and national defence.
A flood control system, such as the Thames Barrier, cannot be confined to those who have paid
for the service. Also, the consumption of the service by one household will not reduce its
availability to others. If left to the free market mechanism, no public goods would be provided
and, as a result, there would be a clear market failure. No individual consumer would pay for a
product that could be consumed for free if another household decided to purchase it.

Types of public goods

Quasi-public goods: These are products that are essentially public in nature, but do not exhibit
fully the features of non-excludability and non-rivalry. The road network in the UK is currently
available to all, but could be made excludable via a system of electronic road pricing. There is
also non-rivalry in consumption, but only up to an extent. Once the road becomes congested there
is rivalry in consumption.

Environmental public goods: An example of an environmental public good is public open space,
which nobody would provide on their own, even though everybody benefits from it being
available. Street lighting is another example of a public good.

Public goods give rise to free-rider problem. When those who do not pay cannot be excluded, no
one has much incentive to pay. When a lot of people becomes free riders, too little of the goods
are produced. Given the nature of the free rider problem, public goods are often financed through
some form of enforcement, notably the compulsory nature of the management fees for residents
living in blocks of accommodation.
 c. Lack of competition

Monopoly leads to an inefficient mix of output. A monopoly will produce less than the socially
efficient output.

P1

MSB=MSC

MC1

Q1 Q2 MR AR(P) = MSB MC=MSC

Monopoly faces downward sloping demand curve, =>MR is below AR. Profit maximised at Q1,
where MR=MC. If there are no externalities, the socially efficient output will be at Q2 where
MSB=MSC

At MSB=MSC, the consumer surplus will be yellow triangle and at monopoly market, the
consumer surplus will be green triangle. Consumer surplus will is the difference between what the
consumers are willing to pay and what are actually paid (area under demand curve). The
inefficient the market goes, the smaller the consumer surplus will be.

Other problem from lack of competition

 Less incentive to maintaining efficiency and innovate
 Not pressured to constantly reduce the MC and improve quality of output

d. Asymmetrical information [~]

e. Immobility of Factors and time-lags in response

Factors may be slow to response to changes in demand or supply. Labour for example may be
immobile geographically or occupationally. This can lead to high prices of the goods and high
wages in short term and long term may be very long time.

There will be constant change in demand and supply, thus economy is also in the state of
disequilibrium and the long run never comes. This can cause problems of inability to achieve
social efficiency.

2. How government intervention may rectify the fail

There are many ways in which government intervention can take place – some examples are given
below

a. Government Legislation and Regulation

Parliament can pass laws that for example prohibit the sale of cigarettes to children, or ban
smoking in the workplace. The laws of competition policy act against examples of price-
 fixing cartels or other forms of anti-competitive behaviour by firms within markets.
Employment laws may offer some legal protection for workers by setting maximum working
hours or by providing a price-floor in the labour market through the setting of a minimum
wage.

The economy operates with a huge and growing amount of regulation. The government
appointed regulators who can impose price controls in most of the main utilities such as
telecommunications, electricity, gas and rail transport. Free market economists criticise the
scale of regulation in the economy arguing that it creates an unnecessary burden of costs for
businesses – with a huge amount of “red tape” damaging the competitiveness of businesses.

Regulation may be used to introduce fresh competition into a market – for example breaking
up the existing monopoly power of a service provider. A good example of this is the attempt
to introduce more competition for British Telecom. This is known as market liberalisation.

b. Direct State Provision of Goods and Services

Because of privatization, the state-owned sector of the economy is much smaller than it was
twenty years ago. The main state-owned businesses in the UK are the Royal Mail and
Network Rail.

State funding can also be used to provide merit goods and services and public goods directly
to the population e.g. the government pays private sector firms to carry out operations for
NHS patients to reduce waiting lists or it pays private businesses to operate prisons and
maintain our road network.

c. Fiscal Policy Intervention

Fiscal policy can be used to alter the level of demand for different products and also the
pattern f demand within the economy.

(i) Indirect taxes can be used to raise the price of de-merit goods and products with
negative externalities designed to increase the opportunity cost of consumption and
thereby reduce consumer demand towards a socially optimal level

(ii) Subsidies to consumers will lower the price of merit goods. They are designed to
boost consumption and output of products with positive externalities – remember that
a subsidy causes an increase in market supply and leads to a lower equilibrium price
(iii) Tax relief: The government may offer financial assistance such as tax credits for
business investment in research and development. Or a reduction in corporation tax
(a tax on company profits) designed to promote new capital investment and extra
employment

(iv) Changes to taxation and welfare payments can be used to influence the overall
distribution of income and wealth – for example higher direct tax rates on rich
households or an increase in the value of welfare benefits for the poor to make the tax
and benefit system more progressive

d. Lack of property rights

Markets are efficient at producing private goods, largely because producers and consumers
have the right of ownership of the resources exchanged in an economic transaction involving
a private good. However, markets are less efficient when property rights do not exist
 Many resources that are directly, or indirectly, used in an exchange have no specific or
identifiable owner, and are collectively available for everyone to use. Examples of common
property resources include; oceans, rivers and canals; beaches; the air; roads and pavements,
and even images, words and ideas. Because property rights cannot be established, the
effectiveness of markets in terms of the allocation, pricing and rationing of these resources is
substantially reduced.

Though complex to design and implement, government can grant property rights over scarce
resources in an attempt to protect them from opportunism, misuse, and over-use. According to
Ronald Coase, allocating property rights will encourage the appointed owners to protect the
resource by allowing the owners to sue those who exploit the resource. When applied to
resources that are under attack from pollution, extending property rights will enable the
owners to sue the polluters.
For example, the National Rivers Authority, now part of the Environment Agency, was
created with powers to act ‘as if’ it owned the UK’s rivers. This allowed it to police the rivers
and sues polluters and opportunists, such as poachers.
Property rights can be extended by creating laws to protect physical property; intellectual
property, such as copyrights to protect ideas, songs, music, books and film; patents, to protect
inventions; and trade marks to protect commercial images and logos.

3. Asymmetrical information

In the real world consumers and producers are not perfectly informed about all goods, prices and
technology. When one party has expert knowledge as compared to the other could be harmful when
the party with knowledge takes advantage over other party’s lack of knowledge. This situation is
referred as asymmetrical information and could lead to market failure in the following forms:-

(a) Adverse selection

A market process in which “bad” results occur when buyers and sellers have asymmetrical
information: the “bad” products of customers are more likely to be selected.
Example:
(i) Used car market
Akerlof (1970) analysed the “lemon” problem. With asymmetrical information:-
- Used car buyers have imperfect information about the cars.
- Low quality cars are cheaper than high quality used cars
- Low quality goods drive high quality goods out of the market which is referred as
the lemon problem.
- The market failed to produce mutually beneficial trade
(ii) Health Insurance
- People know better about their health than the insurance company
- Because unhealthy people are more likely to purchase insurance, the % of
unhealthy people in the insurance pool increases.
- Therefore the insurance premium increases and makes the healthy people with
low risk to drop out
(iii) Credit card
- Credit card company or bank doesn’t know who are the high and low quality
borrower
- Low quality borrowers are the ones who apply for more credit cards and the
default rate increases that give rise to increase in interest rate.
- This will reduce the high quality borrowers to apply lesser cards.
 However, with advance technology, asymmetrical information has declines as people are
being able to access all types of information. In terms of the used car, third party evaluation
can be sought before transacting. Medical screening is crucial in these days before getting the
insurance granted and banks are now linked up where the traceability of credit history is easy.

(b) Moral hazard

Moral hazard arises when one party to a contract passes the cost of his/her behaviour on to the
other party to the contract. Contracting parties cannot determine the future behaviour of the
person with whom they are contracting.

Individual may change behaviour because of insurance

- Parking an insured car in an unsafe area
- Leaving the doors open of an insured house
- Allowing risky loans by banks before a thorough screening, this moral hazard
happens in lending institution for risky financial decisions often transfer the
burden if fails to tax payers, depositors and other stakeholders. Henry Paulson
cited moral hazard as the reason for failure of Lehman Bros and Merrill Lynch,

(c) Ignorance & uncertainty

Firms are often ignorant of market opportunities, prices, costs, the productivity of workers
and the activity of rivals. On the other hand, consumers may not be aware of quality and
harmful side effect of goods that they purchase due to the lack of information.

4. Negative Externalities

Externalities are common in virtually every area of economic activity. They are defined as third
party (or spill-over) effects arising from the production and/or consumption of goods and services
for which no appropriate compensation is paid.

Externalities create a divergence between the private and social costs of production.

Social cost includes all the costs of production of the output of a particular good or service. We
include the third party (external) costs arising, for example, from pollution of the atmosphere.

SOCIAL COST = PRIVATE COST + EXTERNALITY

For example: - a chemical factory emits wastage as a by-product into nearby rivers and into the
atmosphere. This creates negative externalities which impose higher social costs on other firms and
consumers. E.g. clean up costs and health costs.

Another example of higher social costs comes from the problems caused by traffic congestion in
towns, cities and on major roads and motor ways.

It is important to note though that the manufacture, purchase and use of private cars can also generate
external benefits to society. This why cost-benefit analysis can be useful in measuring and putting
some monetary value on both the social costs and benefits of production.

MARKET FAILURE AND EXTERNALITIES

When negative production externalities exist, marginal social cost > private marginal cost. This is
shown in the diagram below where the marginal social cost of production exceeds the private costs
faced only by the producer/supplier of the product. In our example a supplier of fertiliser to the
agricultural industry creates some external costs to the environment arising from their production
process.

Why do externalities lead to market failure?

If we assume that the producer is interested in maximising profits - then they will only take into
account the private costs and private benefits arising from their supply of the product. We can see
from the diagram below that the profit-maximising level of output is at Q1. However the socially
efficient level of production would consider the external costs too. The social optimum output level
is lower at Q2.

This leads to the private optimum output being greater than the social optimum level of
production. The producer creating the externality does not take the effects of externalities into their
own calculations. We assume that producers are only concerned with their own self interest.

In the diagram above, the private optimum output is when where private marginal benefit = private
marginal cost, giving an output of Q1. For society as a whole though the social optimum is where
social marginal benefit = social marginal cost at output Q2.The failure to take into account the
negative externality effects is an example of market failure.

NEGATIVE CONSUMPTION EXTERNALITIES

Consumers can create externalities when they purchase and consume goods and services.

o Pollution from cars and motorbikes

o Litter on streets and in public places
o Noise pollution from using car stereos or ghetto-blasters
o Negative externalities created by smoking and alcohol abuse
o Externalities created through the mis-treatment of animals
o Vandalism of public property
o Negative externalities arising from crime

In these situations the marginal social benefit of consumption will be less than the marginal private
benefit of consumption. (i.e. SMB < PMB) This leads to the good or service being over-consumed
relative to the social optimum. Without government intervention the good or service will be under-
priced and the negative externalities will not be taken into account. Again there will be a deadweight
loss of economic welfare.

In the example shown in the chart above we illustrate the potentially negative effects of people
consuming cigarettes on other consumers. The disutility (dis-satisfaction) created leads to a reduction
in the overall social benefit of consumption. If the cigarette consumer only considers their own private
costs and benefits, then there will be over-consumption of the product. Ideally, the socially efficient
level of cigarette consumption will be lower (Q2). The issue is really which policies/strategies are
most appropriate in reducing the total level of cigarette consumption!