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Market Failure

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14 views12 pages

Market Failure

Uploaded by

tyliqueantoine
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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SUBJECT: ECONOMICS

TOPIC: MARKET FAILURE


OBJECTIVES

Students should be able to;

• Define market failure


• State and explain the causes of market failure
• Explain the consequences of market failure
MARKET FAILURE
Is the inability of the market to allocate resources efficiently to best satisfy society’s
wants. Markets fail for a number of reasons.
The causes of market failure lie in four areas:
• The provision of public goods; there is a market for public goods, yet no private
firms are willing to supply these goods. This is a case of ‘missing market’.
• The provision of merit goods; the socially desirable quantity of these goods is
neither produced nor consumed. Since there is under-production and under-
consumption, this causes the market to fail.
• Externalities – positive and negative; externalities are spillover effects of
production and consumption. When externalities are created, it means the market is
not operating as efficiently as it should.
• Monopoly; when there is a monopoly operating, prices are higher and output is
lower than if a number of firms were operating in that industry.
CAUSES OF MARKET FAILURE
Public goods: one cause of market failure lies in the provision of public
goods. Public goods are goods that are collectively consumed by society.
Characteristics of public goods
• Non-excludability; means that a consumer cannot be excluded from
consuming the good, even if they did not pay for it. There is an absence of
ownership rights attached to the purchase of these goods.
• People who do not pay for a good or service but enjoy its benefits are
known as free riders.
• Non-exhaustibility; means that consumption of a public good by one
individual does not reduce the amount available for other individuals to
consume. A public good can be consumed simultaneously by numerous
individuals. E.g. of public goods are streetlights, traffic lights, defence
(police force).
• For resources to be efficiently allocated, the price of the good must be
equal to the marginal cost (P = MC). This means that the value society
places on the last unit of the good produced – price – must be equal to
the value of the additional resources used to produce that good – its
marginal cost.

• When there is market failure as a result of the provision of public goods,


there is an economic role for government to play. The government
intervenes and supplies public goods and this financed out of taxation.
When the government supplies the public good, this market failure is
eliminated.
MERIT GOODS
Are goods for which the social benefits to the community of the consumption of the
good far outweigh the private benefits to the consumer. E.g. education and health care.
When there is a healthy and educated workforce, all of society benefits. Productivity
increases, crime falls and output increases. The consumption of merit goods results in
benefits falling on the entire society. If the choice was left to the consumer, an
individual might not consume adequate amounts of merit goods. Society under-
consumes merit goods (that is, it consumes less than the socially optimum quantity).
Firms also under-produce merit goods (they produce less than the socially optimum
quantity). The market fails, as the quantity of the good that is produced and consumed
is not sufficient to maximize society’s welfare.

When there is market failure in the provision and consumption of merit goods, the
government might intervene. The government then provides these merit goods free of
charge or at a subsidized price. This encourages more consumption of the merit goods
and the market failure is reduced.
EXTERNALITIES
• Are spillover effects of production or consumption that fall on a third party. When
externalities are created, the market also fails. The producer and the consumer are the two
parties to a transaction. In the course of producing a good or consuming a good, a third party
might be affected. The third party is external to the transaction. This third party might be
affected negatively or positively. When the third party is affected negatively, this is an
external cost or negative externality. When the third party is accepted positively, this is an
external benefit or positive externality. When externalities result from production
activities these are called production externalities. When externalities result from
consumption activities these are called consumption externalities.
• With externalities, the third party has nothing to do with the transaction, but is nonetheless
affected. The market has therefore failed to satisfy society’s ants efficiently. The buyer and the
seller might be satisfied. However, the market is not efficient, as there is a spillover on the
third party. N.B. positive externalities are still a form of market failure as, in the operation of
the market, too little of the good is being produced. If more of the good is produced, then
more of the good and more of the positive externalities will both be enjoyed. More obviously,
when there is negative externality, a cost falls on a third party and he is in no way
compensated for this cost. Too much of the good is being produced. Therefore, with negative
and positive externalities, the market fails.
• It is assumed that the government will do what it can to promote the welfare of citizens. The
government will try to intervene and reduce the market failure. The government might tax
firms that produce negative externalities so that the firm reduces production. It might even
place a direct control, limiting the quantity produced by the offending firm. When
production is reduced, the negative externality (pollution) will also be reduced. The
government might even use the revenue collected from the tax to clean up the pollution of
the firm, or to provide public goods and merit goods. The government can encourage firms
that are producing positive externalities to produce more; it can do so by giving the firms
subsidies or grants.
MONOPOLIES

• Markets also fail when there are monopolies. A firm is allocatively efficient when the
price of the product is equal to marginal cost (P = MC).
• Marginal cost is the value of the last unit produced, based on producer costs. Or is
the additional cost from the production of an extra unit of output.

• Price is the value that society places on the last unit produced. The value that the
producer places on the last unit produced (marginal cost) ought to be the same as
the value society places on this unit (price). When this true, then there will be
allocative efficiency and no market failure. However, the monopolist sells at a price
that is greater than marginal cost (P>MC). Too little of the good is produced and is
sold at too high a price. In the monopoly market, there is therefore market failure.
Ways government reduce market failure in a monopoly market
• Passing laws discouraging or limiting the formation of monopolies.
• Encouraging firms to enter industries where there are monopolies.
• Taking over industries where monopolies cannot be avoided – eg. Water and electricity
– and thereby regulating prices (water and electricity rates).
Summary of the causes of market failure
Causes Result

Public goods Missing market at zero price

Merit goods Underproduction (too little)

Negative externalities Overproduction (too much)

Positive externalities Underproduction

Monopoly Underproduction, as P>MC


CONSEQUENCES OF MARKET FAILURE
• Retrenchment; occurs when workers lose their jobs due to the declining activity of a firm. If a firm
that is producing a negative externality is forced to reduce output or close down, it will use less factor
inputs – land, labour, capital and entrepreneurship. If monopolies reduce economic activity due to
government restrictions, retrenchment will occur.
• Unemployment; as workers are retrenched or laid off, they might be unable to find jobs; perhaps
there are none available, or maybe their skills do not match the skills needed for the available jobs.
They become unemployed. The unemployed refers to those persons who are actively seeking jobs but
are unable to find a job. If the market fails to provide merit goods such as education, workers will be
unable to develop new skills. The poor will receive no education or training for jobs. Lack of health
care can result in more days lost by workers due to sickness. Absent workers lead to a fall in
productivity. Employers, where they can, will substitute capital for labour, and unemployment
therefore grows.
• Economic depression: occurs when there is falling output in the economy and rising
unemployment.
• A rise in the levels of poverty: when people are out of jobs and health and education services are
produced in insufficient quantities and at very high prices, this leads to an increase in poverty. The
poor have no jobs. They cannot afford education and training to make them employable. Also, they
cannot afford expensive healthcare and so might be sick and unable to work.
• A decline in provisions for social welfare: when there is market failure, government has to
intervene. The government has to use its resources to provide public goods and merit goods. Firms
producing positive externalities must be given grants to increase output. There are, therefore, fewer
resources available for government to provide for the welfare of citizens.
QUESTIONS FOR STUDENTS

• Give two causes of market failure


• Give two consequences of market failure

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