MARKET FAILURE

Public Finance

Ehtsham Ul Haq Raja

 FOCUS QUESTIONS
After completing this chapter, you should be able to know:

• What are the principle reasons why market fail to produce efficient
outcome?
• What is the role of government to make it possible for markets to work
for all?
• Why government intervene in market allocation of resources even when
it is Pareto efficient? What are merit goods? What is the role of
government in redistribution?
• What is the market failure approach to the role of government? What
are alternative perspectives in thinking about the role of government?
 MARKET FAILURE
• In the last chapter we observed that under ideal conditions the market economy
ensures Pareto efficiency. But there is often dissatisfaction with markets as people
think other ways.
• Nevertheless, some of the dissatisfaction is real.
• Markets often seem to produce too much of some things and too less of other things
(examples).
• Markets can lead to situation where people have too little income (examples).
• Economists have devoted enormous efforts in understanding the circumstances under
which markets yield efficient outcomes and vice versa.
PROPERTY RIGHTS AND CONTRACT ENFORCEMENT
• Despite efficient market mechanism there is need of government to define property rights
and enforcement of contracts (examples: public goods, loans).
 MARKET FAILURE
• MARKET FAILURES AND THE ROLE OF GOVERNMENT
• The first fundamental theorem of welfare economics asserts that the economy
is Pareto efficient only under certain circumstances or conditions.
• There are six important conditions under which markets are not Pareto
efficient. These are referred to as market failures and provides rationale for
government intervention.
The six conditions or situations are:
1. Failure of 2. public goods 3.
competition Externalities
4. Incomplete markets 5. Information failures
6. Unemployment, inflation and
disequilibrium.
 MARKET FAILURE
1. FAILURE IN
COMPETITION
• Pareto efficiency requires perfect competition. However, this is not the case
in all the products.
• There are some products which are provided by single firms (Monopoly) or
by some firms (oligopoly).
• Even there are many small firms and each is producing slightly different
good which leads to monopolistic competition.
• In all these situations competition deviates from ideal perfect competition.
• It is important to note that under these circumstances market economy
may seem to work in efficient way and may be producing according to
the requirement of consumers.
 MARKET FAILURE
• The first fundamental theorem of welfare economics requires more than
just some competition.
• Pareto efficiency requires different efficiencies (???) and these conditions
are satisfied only if households and firms believe that there is no effect on
price of the commodity.
• Reasons of limited competition
• Average cost of production declines when firm produces more will
larger firms
gain.
• There may be case of natural monopoly.
• Natural Monopoly:A natural monopoly is a distinct type of monopoly that may
arise when there are extremely high fixed costs of distribution and when large-scale
infrastructure is required to ensure supply.
 MARKET FAILURE
• Examples of infrastructure include grids for electricity supply, pipelines for
gas and water supply, and networks for rail and underground.
• It is easy to see why imperfect competition leads to economic inefficiency.
• Under perfect competition P = MC
• Under imperfect competition MR=MC
• Therefore under imperfect competition (under monopoly) the firm
produces lower output as compared to the level of output under perfect
competition.
• If there is natural monopoly with declining AC and with MC below the AC,
competition is not viable. Since if the firm charges price equal to MC it
would operate at loss. Even under natural monopoly the private firm would
charge more than the government.
Competitive equilibrium occurs
at Qc, whereas the imperfect competition
equilibrium occurs at Qi, a much
lower level of output.
 MARKET FAILURE
2. PUBLIC GOOD
• There are some goods which will not be provided by the private market and
even if supplied, will be supplied in insufficient quantity (Public Defense,
navigational aids). These are called public goods.
• Public goods have two critical properties:
1. No cost for additional individual to enjoy the benefits
(defense, lighthouse).
2. It is in general impossible to exclude any individual from the
enjoyment of pure public good.
• The fact that the private market will not supply or will supply too little
of public goods provides rationale for many government activities.
 MARKET FAILURE
3. EXTERNALITIES
• There are many cases where the actions of one individual or firm affect the
actions of other individuals or firms. Examples are air pollution, discharge
of chemicals in the water.
• The actions imposing cost on others are called negative externalities
• The actions providing benefits to others are called positive externalities.
• In cases if the externalities putting pressure on the resources (congestion on
the road, extensive fishing, and natural resources extraction) it will lead to
inefficient resource allocation.
• Under this situation the entry of the government is logical.