Why do markets fail - Essay Example

? WHY DO MARKETS FAIL? All across the world there are various instances of the failure of the market, and when we analyse the reasons behind the failure then we can find out that the reasons are more or less same.. No matter what is the market condition or consumer behavior or organization strategy the reasons are more or less the same, at least they have the common root behind their failure. According to Wilkinson (2005), “ market failure is the situation where the mechanisms associated with the market unable to allocate resources effectively. In this definition the efficiency word refers to both productive as well as elective parameters. According to his view, the main reasons behind market failure can be classified into the following headings: Monopolies, External factors, Public goods, transaction costs and imperfect information (Wilkinson, 2005, pp.473-474). There are several economists who prefer to call the market failure as market fail to achieve efficiency.. Some specific situation that is contributing to market failure are regulations of the government, costs associated with the transaction, the power of the competitive market (other country), imperfect information etc. Regulations: Restrictions such as price ceilings avoid the price mechanism for competently allocating resources. Market power: Some industries may feature economies of scale, so it is absolutely possible for an incompetent market conclusion to be reached if one organization or a few large institutions are able to leave out others to the disadvantage of potential market participant. Transaction costs: If the cost of any certain product in any trade is high in the first place, a market cannot function properly and it might result in the market failure. Imperfect information: If any one party in the market has material information that the other does not, or both the parties lack substance information that would affect whether or not the deal occurs, or for what price it may take place. Externalities: A trade (or the goods being traded) may inflict considerable costs on individuals not participating in the trade. Alternately, individuals not participating in the trade would realize significant benefits from it but the parties directly involved in the trade would not. Irrational actors: One party is not of sound mind when making the trade, factors are weighted inappropriately, long-term costs are ignored in favor of short-term benefits, etc.(Wilkinson, 2005, pp.474-478). According to Tatum (2013) market failure is a situation in which the demand for a particular product is not at par with the supply of the same product that manufacturers are now providing for sale.. There are several reasons behind the market failure, with some having to do with pricing and quality, while others are connected to the current general state of the economy. According to his viewpoint, the main reason behind this failure of the market is the externalities. These are simple factors that are outside the control of consumers or the companies producing the goods and services offered for sale. Examples of this include negative situations such as natural disasters that temporarily reduce production, or downturns in the economy that prompt consumers to greatly reduce their consumption of certain products. Positive events may also qualify as externalities, such as an economic recovery that increases consumer confidence and motivates increased purchases of non-essential and luxury products. In the former instance, companies may find that the demand for their products drops suddenly, leaving them with high inventories of finished goods that are not wanted at any price. The latter positive example may mean that, until producers can increase production to meet demand, they will not be able to adequately keep up with customer orders. Other causes of market failure have to do with an imbalance between the price of a product and its perceived level of quality. Price and quality may create a positive or a negative situation, because if consumers think that the price is reasonable in relation to the quality, demand will be high. Unless producers can keep up with that demand, there is a failure to meet market expectations. At the same time, if consumers see the quality of the products as not being worth the purchase price, demand will drop and the producer is left with a large volume of inventory.. Markets that are controlled by monopolies can also cause some products to fail. When a particular market is dominated by one or two companies, this can make it extremely difficult for smaller competitors to build client bases and sell enough products to keep their operations viable. Setting production schedules based on unrealistic projections for demand can also lead to market failure. Since so many different elements can affect the balance between demand and supply, many companies are constantly reviewing customer expectations and buying habits while also attempting to project how the economy will change in the months and years ahead. Doing so can aid in adjusting production accordingly and either prepare the company to meet increased demand or curtail production so that the business is not left with a glut of finished goods for which there is not a great deal of demand. (Tatum, 2013). Signs of Market Failure Every incident has a symptom associated with it. Market failure is no different. According to Vitez (2013), Signs of market failure include inequality, few raw materials that allow an economy to build and trade goods, and government intervention that chokes the trade and use of resources. This kind of failure may occur when one or more of these items are present. Inequality occurs when one group or class of citizens consistently has more income or resources than another. This is a market failure because every individual in the economy was unable to succeed. According to his viewpoint, most countries have fixed borders, which limit their abilities to gather resources. Market failure occurs when a nation’s borders are so small that few resources exist to produce goods internally.. Price controls and regulations are among the top two items that ultimately create market failure.(Vitez, 2013). Different authors define the term market failure differently and pointed out different reason associated with it. According to Munday (2000), at the time when free markets are not able to produce an optimum resource allocation then that particular market consider to be fail market. In his word, market failure comes into consideration when free markets not able to deliver economic efficiency. Munday, in his books pointed out 4 key reasons associated with the market failure. Those are externalities, public goods, difficulty of information failure, and absence of perfect competition.(Munday, 2000, p.29). Externalities: Generally the externality factor comes into play when when any third party gets affected by the action of the others. According to Muday (2000), when an individual or group not involved in a particular decision gets affected by the decision taken by the others then this is known as externally. According to his point of view, there are two different types of externalites, negative and positive externalities. Generally negative externality exists when the social cost associated with a particular activity is of greater value than that of the private cost. The private cost can be defined as the expenses incurred by those who are directly associated with the activity. An example of the private cost is an organization producing chemical products incurring different cost associated with raw material purchase and labor payment. The social cost can be defined as the expense or cost incurred by the entire society due to any particular activity. For example, the chemical factory located in an area causes air pollution, so the society has to bear the cost of making the area pollution free. The cost incurred for this action is a social cost. Likewise, the road develops near the company for fast delivery and proper communication also comes under the social cost. According to his point of view, all private cost comes under the social cost.(Muday, 2000, pp.30-31). In his opinion, the main problem associated with the negative externality is that, it leads to overproduction; as a result there are more expenses rather than earn which leads to loss of the organization. Externality Theory: Economics of Negative Production: Negative production externality can be defined as a situation when production of any firm reduces the well being that it generates fro the people who are not directly compensated by the firm directly. There are some terms associated with this, those are Private Marginal Cost (PMC), which can be defined as costs incurred by the producer to produce one extra unit, Marginal Damage (MD) can be defined as any cost which is associated with the production of any unit which producer do not pay and is recovered from others. Generally the social marginal cost when increased then any market tend to fall apart. Social marginal cost can be defined as the cost incurred by the summation of both private marginal cost and marginal damage. (Grubber, 2007, p. 4) SMC = PMC+ MD Grubber (2207), explain this scenario with the example of negative production externalities in the steel market. B C p1 A Q2 Q1 In this graphical representation, a negative production externality of $ 10 per unit of steel products (differences between two parallel lines is the marginal damage of $10) is the reason of the social marginal cost. Here the Social marginal cost is over and above the private marginal cost, the cost incurred by the organization. The social optimum quantity q2 is less than that of the market equilibrium quantity of q1. As a result there is an over production of q1-q2 which also resulted in the dead weight loss of the area in the graph marked by BCA. This kind of losses is responsible for the failure of the market as the organization used to recover the money from the customers and other who are not associated directly with the same.(Gruber, 2007 p. 6). Public Goods: according to Munday (2000), public goods have two distinct characteristics, these are non-excludability and non- rivalry. The non-excludability means that once an organization designed and develop a product for the benefit of one set of people then they cannot stop others to get benefited from the same. Non rivalry means more people get benefited from the development of one particular product or service and others who are enjoying the same benefit not deprived of the same despite of the usage increased. The problem associated with the public good according to Munday is that, it cannot be produced at all in the free market place. The incentives which are there to drive economic behavior in the free market place lead us to the logical scenario that the scare resources can be devoted to production of the public goods, but that does not happen. As a result there are market failure.(Munday, 2000, pp.35-36). Information Failure: Information failure is also a key point associated with the market failure. According to Munday, when there is wrong or incorrect information then the market. According to his point of view there are three different ways by which we can discuss the effect of wrong information and the way it affects market failure. These are information about merit and demerit of the goods, inappropriate trade practices due to misinformation, problems associated with the insurance market which cover the risk of the product. (Munday, 2000, p.38) Absence of Perfect Competition: Absence of perfect competition also is a key point associated with the market failure. Two deviations from the perfect competition situation are there according to Munday which trigger market failure. These are monopoly condition and the immobility of factors associated with the production (immobile resources).According to Munday, there are two different reasons behind the monopoly market, one is economies of scale and the other one is the profit motive. According to him. Monopoly is associated with the economic inefficiency and thus resulted in market failure. (Munday, 2000, p.43). Politically, market failure is a major problem for any government and in any country, stable government can effectively handle the market failure. According to some authors, market failures serve as a rationale for public intervention. However, the fact that self-interested market behavior does not always produce lucky social consequences, and it is not sufficient reason to draw this conclusion. It is necessary to assess public presentation under similar conditions, and hence to analyze self-interested political behavior in the institutional structures of the public sector. The approach emphasizes this institutional structure and thereby provides specific cautionary warnings about optimistic reliance on political institutions to improve upon market performance (Shepsle and Weingast, 1984). Conclusion Market failure is a situation that any market at any part of the globe have to face. Market failure is not only dependent on the external and government policy but also depends on the consumer behavior, company policies as well as status of competition in the market. External factors like Different factors like transaction cost, semi correct information. Regulations, market power, along with the externalities plays important role in market failure. The size or volume of market failure not always remain same. It depends upon the condition of the country’s economy. To control the market failure it is not always important that government has to intervene, because it is a proven fact the a government failure is much more costly than the market failure. Climate change, environmental harm caused due to market failure all can add up to the total volume of the market failure. Market failure in all the country is not a permanent situation, it is just a adverse situation both for the consumer as well as people who are directly associated with the market. Changes in the related factors associated with performance of the market and government intervention to the minimum extent will help to recover the adverse condition. References Gruber, J. (2007), Public Finance and Public Policy, Worth Publishers. Munday C.R. Stephen, (2000), Markets and Market Failure, Heinemann Shepsle , A. Kenneth, Weingast R Barry, (1984), Political Solutions to Market Problems, The American Political Science Review, Vol.78 , No.2, 417-434. Tatum Malcom (2013), What Are the Causes of Market Failure?, WiseGeek, retrieved on 14.11.2013 from http://www.wisegeek.org/what-are-the-causes-of-market-failure.htm Votes Osmand, (2013), What are the Signs of Market Failure, WiseGeek, retrieved on 14.11.2013 from http://www.wisegeek.com/what-are-the-signs-of-market-failure.htm Wilkinson Nick (2005), Managerial Economics: A Problem-solving Approach, Cambridge University Press . Read More