What Is Meant By Market Failure And How Can Government Attempt To Correct It - Essay Example

?What is meant by market failure and how can government attempt to correct it? In economics, a market failure takes place when “the production or useof goods and services by the market is not efficient” (Miller, Vandome and Mc Brewster, 2010, pp. 5-6). In other words, market failure occurs when free market fail to provide optimum allotment of resources, either over-allocating, or under-allocating their resources, which results in economic inefficiency (Francis, n.d). In such a case, there exists another possible outcome where the market participants’ gains would compensate their losses. Market failure is a serious issue as in consequence it disrupts social and economic region of a particular region or even the whole country. Thus, it is a challenge for governments to interfere and ensure that there is no risk of market failure. There are several ways in which governments can correct the state of markets: by public section production, regulations and antitrust legislation, taxation and subsidies (Francis, n.d). This paper discusses different kinds of market failure and the ways in which government can attempt to correct them. There are several general categories of market failure: market power, externalities, public goods, and equity. Market power is the ability of a company to influence the market price of a good or service, raising prices above competitive levels (Francis, n.d, ICT regulation toolkit, n.d). A company with market power can raise prices without losing a significant portion of its business to other companies. The rise in the prices above competitive levels may affect negatively the market as it results in diminished customer demand, efficiency loses, and harm on the public interest. Furthermore, companies with significant market power may abuse their power, using their leading position to reduce competition. Some common forms of anticompetitive conduct involve abuse of dominance, cross-subsidization, and misuse of information (Market Power, n.d). There are several ways in which governments can deal with abuse of significant market power. To start with, all national regulatory authorities (NRA) have to make an assessment of the state of completion in specific markets and consider whether such competitive behavior harms another companies and customers (European Regulators Group, 2007). In such a case, the dominant company may be required to stop its abusive behavior or make specific changes to its policy so that it would not be damaging to competition anymore (Remedies for Abuse of Dominance, n.d). This remedy requires the authorities to monitor the company continuously to guarantee that the behavioral change is maintained. Another possible solution is fining the company or its employers with direct responsibility for anticompetitive behavior. The firm can also be ordered to pay compensation to its customers and competitors who have been harmed by their policies. The European Regulators Group (2007) proposes functional separation in markets where non-discrimination procedures were ineffective in dealing with problems of abusive market power. Functional separation may involve breaking the company into two different firms with separate market shares, or separating competitive and monopoly products and services of the company. This solution may also include such elements as separation of operational support systems, brands, employees, and information management systems among new, individual business units. When deciding on the degree of the separation proposed, the NRA’s have to take into account the cost and benefits of this solution and base their decision on completed market reviews (The European Regulators Group, 2007). Cross-subsidization occurs when companies with market power charge a high price for their non-competitive products services and use different proceeds to subsidize low prices for competitive goods. In such a case, governments can implement and enforce a price floor for the low-cost products in order to ensure that the revenue that is generated by the product recovers its total service long run incremental cost (TSLRIC). The governments can also implement the price regulation in order to separate the costs of the company’s competitive and non-competitive products. In the case of misuse of information, companies use sensitive information or business information, which they obtained from other companies through wholesale transactions, when competing again the same companies in business markets (Remedies for Abuse of Dominance, n.d). The government may prevent misuse of information by establish strict rules for the use and disclosure of information provided by wholesale customers of a company. The government can also set limits on the degree of sharing sensitive information between a carrier and its affiliates. Externalities occur when an economic activity affects people who are not engaged in it. Such outcome is not transmitted through prices and if positive, it is called an external benefit, while if negative, an external cost (World Trade Organization, 2004). In the case of negative externalities, governments can implement policies aimed at providing both producers and customers with prices that could allow them to internalize externalities. A common example of an externality is environmental damage caused by production. In such a case, a government can implement an environmental tax either on a good or service that causes environmental problems, or on a factor input used to supply that product. Some examples of environmental taxes involve the carbon tax, petrol duty, or the landfill tax (Externalities-Government Policy Options). However, environmental taxation is criticized by several economists, who find it difficult to put a monetary value on such externalities as the cost to natural habitat or to the life expectancy of the people affected. Furthermore, taxation involves the rise in prices, which has an adverse effect on consumer welfare, especially for low-income consumers. Finally, some producers affected by high taxes may shift production to a country with lower taxes, which can create such unemployment and discourage international competitiveness. Thus, governments are encouraged to use alternative ways to deal with externalities. As an example, externalities can be controlled with market incentive policies that charge companies directly for external costs they cause and reward them for external benefits to the society. Governments should also set a clearly defined and stable emissions target. Such solutions require regulatory organizations to monitor the companies continuously to ensure that they meet the national standards. Public goods are goods or services that provide benefits to the whole society. Nobody can be effectively excluded from using public goods whether or not they pay for it, and several individuals can use the same good without diminishing its value. Public goods are the source of concern to economists because of the possibility of market failure in the private market provision of these goods and services (Zilberman, 2002). Due to non-excludability of private goods, individuals cannot be excluded from consuming the goods, even if they do not pay for the benefits provided with public goods. As a result, the sales of public goods cannot bring sufficient revenues to induce private companies to produce the socially optimal level of public goods. In case of under-provision of public goods, governments can finance the provision of public goods with tax revenue. Some examples of non-excludable public goods that can be financed by government include National Defense and Social Welfare Programs (Zilberman, 2002). Both notions of equity, horizontal equity and vertical equity are inseparably related to government intervention in markets (Francis, n.d). Horizontal equity is the principle that individuals in the same financial circumstances should be treated in the same way, while vertical equity states that those with different resources must be treated differently. Under the principles of vertical equity, government can implement progressively rising tax rates in order to reduce relative poverty. However, the increase in tax rates for income households may lead to market failures as it often results in disincentives to take entrepreneurial risks, which can affect further prosperity of the market (Francis, n.d). In response to this problem, government can encourage entrepreneurial activities providing entrepreneurs with grants, loans and subsidies. It is also a good idea to introduce tax reliefs for small businesses, such as the UK Entrepreneurs Tax Relief, which allows business owners to pay only a 10% tax rate on business disposals up to a value of 10% (Entrepreneurs Tax Relief, n.d). Such solutions encourage setting up new businesses and, thus, contribute to the increase in national economic activity. Depending on the characteristics and scale of different kinds market failures, government can provide several solutions to correct them. In case of abuse of significant market power, national regulatory organizations can fine the company for anticompetitive behavior and implement functional separation in markets where non-discrimination procedures were ineffective. In order to prevent such problems as cross-subsidization and misuse of information, government can implement laws that establish price floors for the low-cost products and rules for the use of business information. When it comes to externalities, government can implement taxes on goods and services that cause negative externalities. However, such taxation may result in several negative outcomes both for producers and customers. Thus, it is a good idea to use alternative ways of dealing with externalities, such as direct charges for externalities, or, in case of environmental problems, setting a clearly defined emission target. Government can prevent under-provision of public goods financing such public goods as National Defense or Social Welfare Programs. Finally, when it comes to equity principles , when adjusting tax levels to the income of individuals, government should also provide subsidies and grants to encourage entrepreneurial activities. In all cases of government intervention in markets, it is necessary for all national regulatory authorities to make assessments of the state of completion in specific market and, thus, be aware of possible market failures. References Bruce, N. (2000). Public Finance and the American Economy. Boston, Addison-Wesley. Entrepreneurs Tax Relief (n.d), online. Available at : http://www.contractorfriend.co.uk/articles/tax/view/entrepreneurs-tax-relief . (Accessed 16 March 2011). European Regulators Group, 2007., Opinion on Functional Separation, (online). Available at: http://www.ictregulationtoolkit.org/en/Publication.3659.html . (Accessed 15 March 2011). Externalities-Government Policy Options (n.d), online. Available at: http://tutor2u.net/economics/revision-notes/a2-micro-externalities-policy-options.html . (Accessed 15 March 2011). Francis, R., n.d. Market Failures. Shortline Community College, (online). Available at: http://elmo.shore.ctc.edu/economics/market.htm . (Accessed 14 March 2011). ICT regulation toolkit, n.d. Market Power,(online). Available at: http://www.ictregulationtoolkit.org/en/Section.1711.html . (Accessed 14 March 2011). ICT regulation toolkit, n.d. Remedies for Abuse of Dominance, (online). Available at: http://www.ictregulationtoolkit.org/en/Section.1902.html . (Accessed 14 March 2011). Miller, F.P. Vandome, A.P. and Mc Brewster, J, 2010., Market Failure. Saarbrucken: VDM Publishing House Ltd. World Trade Organization 2004, World Trade Report. Section C: Market Structure, Externalities, and Policy Intervention, (online). Available at: http://www.wto.org/english/res_e/booksp_e/anrep_e/wtr04_2c_e.pdf . (Accessed 16 March 2011). Zilberman, David (2002). Economics of Resources and the Environment. Chapter 7: Public Goods, (online). Available at: http://are.berkeley.edu/courses/EEP101/spring05/Chapter07.pdf (Accessed 17 March 2011). Read More