Market Failure and Government Intervention - Essay Example

Market failure and Government intervention Introduction A market is a place that facilitates exchange and transaction of goods produced and services provided. It always seeks efficient resource allocation across alternative or various users. In a market Adam Smith’s ‘Invisible hand’ rationalize individuals or entrepreneurs acting to maximize self-interest. The main role of a market is efficiency that is appropriately defined in terms of Pareto Efficiency (Aldridge, 2005). Efficiency in a market is where all agents maximize their personal interests. Market failure Market failure is a situation that describes a situation where the effects of demand and supply do not allocate their resources appropriately. This will therefore lead to a situation that defines market failure as a market place where the unauthorized price system leads to an extremely high or low allocation of resources for specific economic activities. Market failure is always inherent to the market and consequently causes the market equilibrium allocation to be inadequate. In relation to the theorem of welfare economics, there is a possibility that under absolute conditions the allocation of resources in the long-run competitive equilibrium is efficient. Unfortunately, most of the markets always fail in the allocation of various economic and environmental resources thus making the overall allocation of resources inadequate. Adam Smith’s invisible hand is always a major principle in allocation of resources. Various economists always refer these types of problems to approve the role for government intervention. A prominent economist once urged that existence of a free market always find it challenging to do away with the need of the government (Aldridge, 2005). Causes of market failure The free rider problems In a situation where the positive externalities extremely exceed private benefits, the good produced or services provide become non-profitable in the market context, there will be always some benefits associated with goods or services that are allocated free. For example, one puts security lights in his or her compound to light the compound and neighbors use the light too to light their compounds free. The problem is that the market system cannot easily supply goods or services provided that are jointly consumed (Besanko, 2011). Consequently, for a market to work appropriately a two party agreement is quite preferable. When non-paying parties cannot easily be excluded from the benefits of goods or services where the problem of the free rider arises. Good examples for such a situation include street lighting, roads, bridges, and drainage systems. Asymmetric information In most economic parameters, identification of the problems caused by a prominent firm or a collection of colluding firms is always a major cause of market failure. This situation is always common with contractors eyeing for construction projects and the possibility of them to enter in agreement of joint profits. There is always a general problem of information of one side information. This leads to the problem of asymmetrical information whereby some of the parties have more information than others do in an economic transaction (Aldridge, 2005). When a consumer diverts to a producer who is more informed, markets may not be able to achieve their goals in terms of efficient outcomes. For instance, consumers with enough information will always make rational decisions when they buy compact disc in entertainment outlets. This situation becomes different when they decide to purchase services from another builder. During these instances, purchasers must always rely on experience and advices from the builder in order to know what exactly they need with purchasers having rough knowledge of what they want to achieve (Cowen & Crampton, 2002). In cases where a party in a market structure gains dominance than others and takes advantage of this by pulling them out of market competition unfairly is always a major cause of market failure. Currently, a market analysis approach focuses on the agreement between the ‘principal’, who is the client and the ‘agent’ who is the contractor. This issue on the principal-agent relationship triggers the balance or equality of power between the less informed client and the agent who has enough knowledge. For example, it is always a routine that the doctor- ‘agent’ has extremely a lot of medical information than the patient- ‘principal’ (Krugman & Wells, 2005). Consequently, we are extremely reliant on doctors to act in our best interests. Externalities The conceptual parameters necessary to understand the externalities are already explained in the above statements. The major contrast was private costs and external costs, which is a distinction that helps to understand a broad set of environmental problems. An important tradition in welfare economics is represented in the related analysis. During that period, the idea was that economic efficiency was to describe a situation in which one was to be worse off for another person to be well. According to Pareto, in a sincerely effective competitive market all the exchanges done in economic transactions have to be agreed at fair and affordable prices. In a general equilibrium, all members of an economy face the real opportunity costs of their market driven actions. In various markets the price that a person pays for a good, service or resource is relatively higher or lower than the opportunity cost that the society pays for that good, service or resource. This means that, it is possible that decisions made by organizations or firms and consumers in a particular transaction will have to affect others who were not involved in the transaction. In other words, in a competitive market place, when a deal is between a buyer and a seller to exchange a good or a service at an agreed price, there might be possibilities of spill overs to third party; that is people who were not involved during that particular market activity. The spill over costs and benefits to the third parties are referred to as externalities (Besanko, 2011). Further clarification for the above situation might help to draw a clear point of view between the full economic costs and the cost of goods or services that are always considered basic. The major or basic cost takes into account all stages of production that involve extraction, manufacture, transportation, research, and development. In short, this means that the basic costs cover all the costs that are always added up to compensate for a market price. The full economic cost therefore includes all the basic costs plus the externalities. Full economic costs=basic costs + externalities An example of an externality is the pollution of a river that leads to a general loss of welfare in the community (Krugman & Wells, 2005). In case the community is unfortunately not compensated for then the cost is considered external to the production process. Any form of spill over that leads to environmental pollution is a negative externality because there are neighborhoods costs of the contaminated water and associated health issues. A paramount goal of the environmental economics is to do away with the gap between external costs and private costs. The main aim of this principle is to make sure that those responsible for causing pollution are made to pay the costs as per the laws of the economy. Lastly, there should be an acknowledgement that not all externalities are negative. Production of goods and provision of services can generate spill over benefits for third parties and in such a situation, the market failure is not that important. The government can decide to finance these goods and services to generate positive externalities that ensure companies are rewarded for production of goods and services. Imperfect markets Monopoly leads to an imbalance of power in the market. They always have behavior of restricting the quantity supplied and increasing the prices in the markets in order to make super normal profits. Oligopoly comprises of few dominant firms or suppliers that are top performers in the market. For example petroleum exporters. In this case, cartelization leads to the behavior in the case of monopoly. Restriction of output and extremely rising up prices greatly reduces the consumer welfare and leads to suboptimal outcome (Cowen & Crampton, 2002). References Aldridge, A. (2005). The market. Cambridge: Polity Besanko, D., Braeutigam, R. and Gibbs, M. (2011). Microeconomics. Hoboken, NJ: John Wiley. Cowen, T. and Crampton, E. (2002). Market failure or success. Cheltenham, UK: E. Elgar. Krugman, P., and Wells, R. (2005). Microeconomics. New York: Worth. Read More