The Concept of Market Failure - Research Paper Example

The Concept of Market Failure Abstract: The government intervention in free markets has been remained a moot issue for most of the economists all around the world. The wave of privatization in public sector and government reinvention has multiplied the importance of the issue of government intervention in markets. In order to decide the degree according to which these decisions should be undertaken the economic theorists take the support of the concept of market failure. Market failure is an important concept which ekes the process of understanding the economic theories by the learners, practice of these theories by the officials and legal analysis. Some economic theorist have disputed the authentication of the concept and claimed that the concept is fatally flawed. The paper is aimed at undertaking a brief evaluation of the concept of market failure and the circumstances which lead to the market failure. The later part of the paper will discuss the measures by the governments to correct these failures. The notion of the market failure is defined as the economic activities of the people undertaken in order to maximize their own profit rather than taking in view the profit of the whole society. In such cases it is important for the governments to intervene in the market and implement several roles and regulations to turn the monopolist behavior in the right direction in order to safe the combine interest of the society. Only in the particular situation of the market failure the Government intervention is justified or in the other situation the Government intervention makes things worse. The concept of Market Failure can be used to cover all the circumstances in which the unregulated market in (terms of direct price and quantity fails to achieve allocative efficiency. In other words the distortion which prevents the visible hand from the efficient allocation of resources is described as Market Failure. The most obvious case in which market profitability is deficient is when some benefits or costs incurred as a result of the project do not have market prices. This may occur because some of the benefits are of a public good or externality nature which, because of non-excludability and or non-rival ness, cannot be priced. Thus for example, it is often argued that the expenditures on immunization or on education provide external benefits to those not actually being immunized or educated, and that, therefore, the profits from providing these services on competitive markets might understate the net social benefits of their provision. (Buchanan & Kafoglis, 403-14) The notion is an important contribution to the economic study of the market since it provides with the broader perspective by keeping in view the overall benefit of the society rather than just serving the purpose of an individual. In the absence of this type of regulation from the Government side the wastage of the public fund will be inevitable. The most important factor of the market failure is the externality. An externality can be defined as the economic activity of an individual for his own benefit with out taking care of that the benefit of the others are harmed by the activity. The externalities are of two types: Positive externality & Negative externality. When a person not involved in the production or consumption of a good receives a benefit for which he does not pay, he is said to be the recipient of a "positive externality." An example of this is immunization. Individuals not involved in the sale or purchase of immunization shots benefit from such shots without paying for them. They benefit because the more people that become immunized, the less likely it is that the individuals not involved with the purchase or sale of the immunizations will be exposed to the dreaded disease, since fewer people will contract the disease. A beautiful home with a well-manicured lawn and garden is another example. In this case, passers-by who have not paid for the privilege of viewing the beautiful home and grounds still gain from the pleasure of being able to enjoy the view. They, too, receive a benefit without paying. A lighthouse provides another example. Ship owners who have not helped to pay for the construction of a lighthouse still benefit from it when they pass by at night. The second type of externality is a "negative externality." This exists when a person who has nothing to do with the sale or purchase of a good has a cost imposed on him for which he is not compensated. A leading example of a negative externality is pollution being emitted from, a steel mill. In this case, people who neither buy nor sell steel may experience the harmful effects of the pollution but are not compensated for the negative effects they experience. (Simpson) The production of too few goods or too little information is thought to be a market failure when the overall cost of production is less than the benefits to those who consume them. Too much pollution is a market failure when the costs of reduced emissions to the firm are less than the benefits to the population at large. The firm does not pollute less, even though the decrease would appear to produce gains from trade. These failures are also classically called externalities in those cases in which the pricing system supposedly fails to account for all the costs and benefits from trade. But with externalities, as in market failure analyses, gains from trade fail to be realized whenever there is a trade that would be worthwhile only if transactions costs were zero. All the externalities do not result in shape of market failure. One need to consider (a) whether they have public-good characteristics and (b) whether taking the actions needed to manage the externality would result in positive net benefits. (Pannell) Possible Sources of Market Failure: There are many possible sources of market distortion: Imperfect Competition: In case of perfect competition the producing firm sets the price equal to the marginal cost resulting in shape of marginal benefit to the consumer. In the imperfect competition the producing firm equates marginal cost to marginal revenue hence reducing the price of the last unit below the marginal revenue. As the consumers maximizes their marginal benefit by equating it to marginal cost of a unit the reduction in the price will lead to an increase in the marginal benefit of the consumer as compare to the marginal price. The situation will lead to the reduced production by the industry as the increase in output will lead to increased consumer benefit rather than production cost or the opportunity cost of resources. The production of too few goods or too little information is thought to be a market failure when the overall cost of production is less than the benefits to those who consume them. Common property resources such as groundwater aquifers, lakes, oceans, some grazing land, etc. are accessible to anyone and belong to no one in particular. However, they can be exploited. The harvest becomes the property of the harvester and can be sold on the market for a positive price. Negative externalities occur in the case of common property resources because individuals harvesting the common property resource do not take into account the impact of their level of activity on the resource and other harvesters. Static (instantaneous) externality: each individual harvesting the resource imposes a cost on all other harvester by depleting the resource. As the resource becomes scarcer, the cost of harvesting increases for all. But this cost is not taken into account since it depends on the total amount harvested, which is not under the individual harvester’s control. Dynamic (inter-temporal) externality: in common property renewable resources, such as fish. The amount of fish next year depends on the amount of fish left over this year to reproduce. Small individual harvesters do not take into account this cost since it depends on the total sum of the harvests and not on their individual harvest. These externalities can be analyzed as in B with a MPC (calculated by adding up all the private MC of harvesting) understating the MSC. The Marginal Benefit curve in that case is often assumed constant as the harvest from a particular common property resource may be assumed to have no impact on the market price for the harvested good. The Nobel laureate economist Ronald Coase had a fundamental insight when he noted that the standard welfare- economic analysis of such situations, which emphasizes the gains to trade that do not occur, assumes that the transactions costs of achieving such gains to trade are zero. So market failure occurs and externalities exist when in reality one can not gain from further trade. (Zerbe, Mc Curdy) Ronald Coase argued that individuals could organize bargains so as to bring about an efficient outcome and eliminate externalities without government intervention. The government should restrict its role to facilitating bargaining among the affected groups or individuals and to enforcing any contracts that result. This result, often known as the "Coase Theorem," requires that 1. Property rights are well defined; 2. People act rationally 3. Transaction costs are minimal Only if all three of these apply will individual bargaining solve the problem of externalities. Intervention with externalities Direct controls: Output quotas prohibition Taxes on output ("make the polluter pay") Emission fees etc Subsidizing 'good' behavior: Grants to firms that use pollution efficient technology Tradable pollution permits (marketable permits) Government intervention may seek to correct for the distortions created by the above and to improve the efficiency in the way that markets operate E.g. Pollution taxes to correct for externalities Taxation of monopoly profits (the Windfall Tax) Regulation of oligopolies/cartel behavior Direct provision of public goods (defense, legal system etc) Policies to introduce competition into markets Price controls for the recently privatized utilities Micro-government intervention would also include Maximum prices Minimum prices (e.g. the National Minimum Wage) Producer subsidies Price stabilization / price support schemes (e.g. through the operation of Buffer Stocks) References James A. Buchanan and Milton K. Kafoglis, “A note on Public Goods Supply,” American Economic Review, 53 (June 1963), 403-14 Zerbe, Richard O. & Mc Curdy, H., The End of Market Failure, Regulation 10, Volume 23, No. 2, retrieved as on November 29, 2005 from http://216.109.125.130/search/cache?p=journal+article+Externalities+and+market+failure&toggle=1&ei=UTF-8&u=https://www.cato.org/pubs/regulation/regv23n2/zerbe.pdf&w=journal+article+externalities+market+failure&d=UjiSAY6CL3_B&icp=1&.intl=us Pannell, D.J. (2004). Thinking like an economist 5: Public goods and public benefits in NRM, Pannell Discussions No. 22, 18 October 2004, http://www.general.uwa.edu.au/u/dpannell/pd/pd0022.htm Simpson, Brian P., Why Externalities Are Not a Case of Market Failure March 2003 * This paper is based on a chapter of a forthcoming book titled Markets Don't Fail! http://216.109.125.130/search/cache?p=externalities+and+market+failure&toggle=1&ei=UTF-8&b=11&u=www.mises.org/asc/2003/asc9simpson.pdf&w=externalities+market+failure&d=WzwcRY6CL39r&icp=1&.intl=us Read More