Three Main Reasons of a Market Failure - Essay Example

Market failure is a concept, which holds that there is inefficient allocation of goods and services by a free market. Market failure can better be explained as a situation in which an individual or single entity's actions towards fulfillment of its own interests lead to unsatisfactory outcomes for the society on the whole. In a macro-level analysis, a market failure can occur for three main reasons as discussed hereunder. First, an agent in a market can gain market power, allowing them to block other mutually beneficial gains from trade from occurring. In economics, market power is the ability of a firm to alter the market price of a good or service. A firm with market power can raise prices without losing all customers to competitors. This can lead to inefficiency due to imperfect competition, which can take many different forms, such as monopolies, monopsonies, cartels, or monopolistic competition, if the agent does not implement perfect price discrimination. OPEC (oil cartel in Middle East is an example of this). Second, the actions of an agent can have externalities, which are innate to the methods of production, or other conditions important to the market. An externality occurs when an economic activity causes external costs or external benefits to third party stakeholders who did not directly affect the economic transaction. In a competitive market, the existence of externalities would mean that either too much or too little of the good would be produced and consumed in terms of overall cost and benefit to society. External Costs & External Benefits Finally, some markets can fail due to the nature of certain goods, or the nature of their exchange. For instance, goods can display the attributes of public goods or common-pool resources, while markets may have significant transaction costs, agency problems, or informational asymmetry. In general, all of these situations can produce inefficiency, and a resulting market failure. However, on a more fundamental level, the underlying cause of market failure is often a problem of property rights as it is in the case of Oil Cartel in Middle East. As Lucas brings up the point that "One cause of market failure is the limited nature of property rights. [] Property rights define who owns property, to what uses it can be put, the rights other people have over it, and how it may be transferred. By extending these rights, individuals may be able to prevent other people imposing costs on them, or charge them for doing so." (2000: pp. 152-153) As a result, an agent can have imperfect control over the uses of its commodity, as the system of property rights that defines this control is not comprehensive. Typically, this includes two basic rights that have more generalized nature - excludability and transferability. Excludability caters to the an agent's ability to control who can use its commodity, how much, and for how long - and also the associated costs for doing so. Transferability states the right of an agent to transfer the rights of its commodity from one agent to another, primarily by selling or leasing a commodity, and associated costs associated for doing so. If a system of rights cannot fully guarantee these at low (or no) cost, then an inefficient distribution can be the consequence. There can be many examples of market failure. In this author's region, for instance, traffic congestion is an example, as driving can be considered to impose hidden costs on other drivers and the society, whereas the use of public transportation and/or other ways of avoiding driving to mitigate traffic congestion would be more beneficial to society as a whole. Other common global examples of market failure may include environmental issues such as pollution and exploitation of natural resources to an excessive extent. The Organization of Petroleum Exporting Countries (OPEC) is, currently, a cartel of 12 countries comprising Algeria, Angola, Ecuador, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates, and Venezuela. One of its principal goals is to determine the best means for safeguarding Organization's interests, individually and collectively. OPEC's power was further strengthened as various countries nationalized their oil holdings and created their own oil companies to control the oil. OPEC tries to influence prices by restricting production. It does this by allocating each member country a quota for production. All 12 members agree to keep prices high by producing at lower levels than they otherwise would. It also pursues ways and means of ensuring the interests of the producing nations and to the necessity of securing a steady income to the producing countries. Commodities trader Raymond Learsy, author of Over a Barrel: Breaking the Middle East Oil Cartel, further higlights the imperfection and inefficiency created by OPEC in global oil market. He holds that OPEC has trained consumers to believe that oil is a much more limited resource than it actually is. To back this argument, he points to past false alarms and apparent collaboration. He also believes that analysts are conspiring with OPEC and the oil companies to create a "fabricated drama of peak oil" in order to drive up oil prices and profits. OPEC's influence on the market has been widely criticized. Several members of OPEC alarmed the world and triggered high inflation across both the developing and developed world when they used oil embargoes. In context of this paper, it is imperative to analyze the perception of OPEC as market failure by its critics. This author believes (in the light of Understanding Business Behaviour by Michael Lucas and Vivek Suneja) this perception to be based on three reasons; One, and foremost, is the excludibility of property rights excercised by OPEC members. The OPEC cartel enjoys the power of restricting the usage of its oil and artificially escallating the costs associated to its usage. Two, this limitation enjoyed by OPEC creates an externality (external cost) for the society in the form of inflated prices. The consumers have to pay an additional involuntary amount for the exchange of oil commodity. This form of externality is sometimes refered to as pecuniary externality. Third, standard economic theory implies that any voluntary exchange is mutually beneficial to both parties involved in the trade. But OPEC has gained market power through this cartel that limits mutual benefits to the consumers and restricts buyers' negotiating powers. The imperfect price patters implemented by the cartel create an inefficieny and imbalance in overall control in the market. The same reason renders the existing competition to be imperfect and inefficient. However, a monopoly will always fail in a free market. And the monopoly being enjoyed by this cartel for the aforementioned reasons is very much expected to fail. One direct cause of its failure can be described as the researches and experiments already being carried out globally in search of alternate fuel resources. Moreover, as the competition in the industry grows insistent on exploring new oil reserves opportunities, the cartel may either fall apart or forced to follow a more efficient market pattern in terms of price, competition, production, and supply. This idea of monopoly failure is also highlighted by Lucas as he suggests that "Markets are not fallible: they can fail to organise economic activity in a socially desirable fashion. [] Markets may fail to generate socially efficient outcomes and or may fail to deliver equitable outcomes." (2000: 147) This is the theoretical explanation of the practical implications (discussed above) faced by OPEC. OPEC's control over oil prices has already been diminished somewhat due to the subsequent discovery and development of large oil reserves in the Gulf of Mexico and the North Sea, the opening up of Russia, and market modernization. This has contributed to stability in oil production and supply to some extent. There are a number of measures to control and monitor market behaviours and maneuver them to achieve social efficiency. These include Legal Regualtions, Regulatory Bodies, Price Controls, and Information Provision. Each of these measures carry their own merits and related disadvantages. The factors that mainly affect and determine the selection of right tool for market control are the costs associated and the anticipated efficiency of its outcome in given scenario. There is no absolute measure for market control, specially, in adverse scenarios. In case of OPEC, this is even harder to determine a control measure that can regualte the proceedings of associated industry and define its pattern. However, it is recommendable to formulate an International Regulatory body that can define the market efficiency and induce perfectly competitive pattern in oil industry globally. Such a body can exercise control over the market elements and work towards safeguarding the interests of each group involved. Although, such a body may have problems with the nature of its allocated powers, true exercise of its powers to achieve its purpose, commitment of OPEC and similar international bodies to follow its instructions and regulations, and the associated hight costs. However, it is highly desirable in current global economic setting to have a body to effectively control and monitor international trade circles and their activities in view of achieving golbal social efficiency. Bibliography Lucas, Michael and Vivek Suneja. (2000). Understanding Business Behaviour. Routledge. Learsy, Raymond J. "OPEC Follies - Breaking point". National Review. 04-12-2003. http://www.nationalreview.com/comment/learsy200312040900.asp. Retrieved on 31-12-2008. Read More