Market Failure and Government Intervention - Literature review Example

Market Failure and Government Intervention Contents Introduction 3 Market Failure and Externalities 3 Role of Government 6 Conclusion 7 Bibliography 8 Introduction Mathur and Marcelin, (2015) defined market as a structure where buyers and sellers are engaged in the process of exchange of goods, information and services. It is a place where demand and supply of a commodity is created. When the supply of a good is equal to its demand then this leads to equilibrium. At this point, equilibrium quantity and equilibrium prices are determined which implies that the allocation of goods has reached its optimal point. Optimal point is a point where both the sellers and buyers are satisfied and resources are optimally allocated. This equilibrium price is often called market price. Market price reflects that the market is functioning efficiently and rational expectation of both the suppliers and the buyers are fulfilled. There are basically 6 categories in which a market structure can be divided. They are Perfect Competition, Monopolistic Competition, Monopoly, Oligopoly, Monopsony and Duopoly. Existence of imperfect competitive markets like Monopoly, Monopsony, Monopolistic Competition and Oligopoly can cause market failure. A monopoly exists when an organisation is the sole producer of a particular goods or services and they determine the prices in the market. In Oligopoly, a market is run by a small number of companies that enter into collusions. Monopsony is characterised by the existence of only one single seller. In Monopolistic Competition, firms produce differentiated goods. Its features are basically a combination of monopoly market and perfect combination (Berry, 2014). Market Failure and Externalities Market failure is a situation in which good and services are allocated inefficiently. Sometimes, market fails to offer commodities that are beneficial to the society and its fails to cease the production and utilization of harmful goods and services. Market fails when there is asymmetric information, principal-agents problem, non-competitive markets, public goods, merit and demerit goods and externalities. Externality is either cost or benefit that Externalities can be positive or negative (Hepburn, 2010). Positive Externalities also called external benefit occur when a positive effect of an activity falls upon a third party. Production and consumption of goods and services can both lead to the rise of this externality. It occurs when the firm making a production decision does not get complete benefit of that decision (Helm, 2010). The firm receives benefit which is less than the benefit that the society receives. In other words, it means that marginal social benefit is higher than the marginal private benefit, that is, when a consumer pays a lower price and consumes that level of quantity which is lower than the socially efficient output (Amemiya, Kitamura and Oshiro, 2014). This can be explained graphically. Figure: Positive Externality (Source: Pal, 2015) In this graph, suppose, individual are paying price P for a good and they are consuming Q level of that good. However, if the positive externality is taken into account, then the socially optimal output will rise to Q1. At Q, Marginal Social Cost is below Marginal Social Benefit. This implies that more of that commodity should be consumed. At point Q, both Social Marginal Cost and Private Benefit is point A but the Marginal Social Benefit is represented by point C. Hence, if only amount Q is consumed, then the society has to incur an opportunity cost which is shown by the shaded are A, C, B and this area is known as Welfare Loss (Bremmer, 2010). Negative Externality arises when a firm which makes a decision does not have to pay the complete cost of its decision. In this case, Private Marginal Cost (MPC) is lower than Marginal Social Cost (MSC) .Graphically it is shown below: Figure: Negative Externality (Source: Pal, 2015) In the above graph, it is shown that if free allocation takes place, then the firm will allocate Q amount of output. So, at point A, Marginal Social Cost curve is higher than the Private Marginal Cost. The point Q1, the socially efficient output, can be attained when the equilibrium is obtained at point B where, MSC=MSB (Amemiya, Kitamura and Oshiro, 2014). Another most important cause of market failure is failure of market to deliver public goods, merit and demerit goods. Market fails because of the unique features of the public goods, merit and demerit goods. Public goods are non-excludable, non-rivalrous in nature. Merit goods are those goods which are underprovided and under consumed (Mason, C. M., 2009). Whereas, demerit goods are those goods which are overprovided and over consumed. Also, Imperfect Competition like monopoly, monopolistic competition, monopsony can lead to inefficiency. In such markets, market equilibrium does not remain Pareto Optimal. Monopolist applies its market power to control the level of output so that he can keep it below the equilibrium quantity where Marginal Social Benefit equals Marginal Social Cost of the last unit bought with the aim of profit. Sometimes, nature of the transaction can also cause market failure. Imperfect information arises when one party has more information than the others which creates disparity of power during transaction (Weeden and Grusky, 2014). Role of Government When market fails, government intervene to correct the situation. Hence, government tries to implement different types of policies and regulations. It has four main roles to play: Regulatory role, Distributive role, allocative role and stabilisation role. The regulatory role of the government is to establish rules which make market to work efficiently. Introducing acts such as Employment Relations Act, Consumer Guarantees Act and Fair Trade Act. (Berry, 2014). Allocative role of the government is to resolve the problem of optimal resource allocation. Market failure leads to unfair income distribution. Distributive role of the government is to allocate sufficient income to the public. This is done through state housing, benefits and various educational courses. Under stabilisation role, the state intervenes with the motive of ensuring steady growth by implementing different fiscal and monetary policies. The public goods create free riding problem. Free riding problem occurs because goods are non-excludable. So after using such goods they do not pay thereby refusing to contribute to their cost. In such cases private producers do not have any incentive to manufacture because they cannot charge for these goods. Hence, government has to use the tool of taxation. They should be only responsible for the distribution of public goods. In order to check the existence of monopoly, they can prevent the entrance of some private companies through Industrial Policy. The growth of such enterprises can also be limited by MRTP Acts, Competition Acts, etc. even the policy of industrialisation can also be applied (Poynter, 2012). Coase (2012) suggested that to solve the problem of positive externality, the state applies the policy of subsidy. By subsidising, the marginal benefit of the goods can be increased when they are consumed. This will encourage consumers to buy more and more of such goods that give positive externality. Negative externalities include emission of harmful pollutants from the factories which pollute land, water and air. So another way of controlling this is to tax the polluters by imposing carbon taxes or taxes on plastic bags. Tax amount should equate the amount of negative externality that the firms are creating. Thus it gets added to the marginal costs of the producers which force them to reduce their output. Also by providing subsidies to households or companies can help reducing the impact of negative externalities. The problem of lack of information can be cured by different steps that include: Compulsory labelling on some products regarding their ingredients or health warnings in case of alcohol or cigarette packages that is implementation of statutory information and labelling (Berry, 2014). However, to mitigate the cost involved in market failure, sometimes government intervention can lead to even higher costs. Government policies like taxes, wage and price control, subsidies and regulations if not properly implemented can lead to inefficient allocation of resources. This situation is termed as government failure. Taxes can cause admin cost, that is, the tax amount may not be accurate and demand of the commodity may be very inelastic (Shleifer, 2005). Even subsiding can encourage firms to become more inefficient because they will now rely entirely upon government funding. Subsiding incurs more cost to the government. Again they may face lack of information regarding whom and how much to subsidise. The Competition Commission can block mergers in some cases to prevent the rise in monopoly power. However, Weeden and Grusky, (2014) argued that some mergers have advantages like they increase economies of scale. If government prevents such mergers that it can adversely affect the economy. Conclusion The classical economists advocated the concept of laissez faire in 18th century. According to Adam Smith, the metaphor “invisible hand” is used to emphasise that the market would automatically balance itself and would attain equilibrium on its own. However, it necessarily does not imply that the government should never interfere. Well planned government strategies have always being effective if intrinsic problems of democracy are resolved. An economy can grow if market functions properly. So mitigating market failure problem should be given special attention so that the needs of both the sellers and the customers can be met. Bibliography Amemiya, Y., Kitamura, H. and Oshiro, J., 2014. Market-Share Contracts with Vertical Externalities. Asian Journal of Law and Economics, 5(1-2), pp. 1-15. Berry, M., 2014. Neoliberalism and the City: Or the Failure of Market Fundamentalism. Housing, Theory and Society, 31(1), pp. 1-18. Bremmer, I., 2010. The End of the Free Market: Who Wins the War Between States and Corporations?. European View, 9(2), pp. 249-252. Coase, R. H., 2012. The firm, the Market, and the Law. Chicago: University of Chicago Press. Helm, D., 2010. Government Failure, Rent-Seeking and Capture: the Design of Climate Change Policy. Oxford Review of Economic Policy, 26(2), pp. 182-196. Hepburn, C., 2010. Environmental Policy, Government, and the Market. Oxford Review of Economic Policy, 26(2), pp. 117-136. Mason, C. M., 2009. Public Policy Support For The Informal Venture Capital Market In Europe A Critical Review. International Small Business Journal, 27(5), pp. 536-556. Mathur, I. and Marcelin, I., 2015. Institutional Failure or Market Failure?. Journal of Banking & Finance, 52(5), pp. 266-280. Pal, R., 2015. Cournot vs. Bertrand under Relative Performance Delegation: Implications of Positive and Negative Network Externalities. Mathematical Social Sciences, 75, pp. 94-101. Poynter, T. A., 2012. Multinational Enterprises and Government Intervention (RLE International Business) (Vol. 32). London : Routledge. Shleifer, A., 2005. Understanding Regulation. European Financial Management, 11(4), pp. 439-451. Weeden, K. A. and Grusky, D. B., 2014. Inequality and Market Failure. American Behavioral Scientist, 58(3), pp. 473-491. Read More