2.10 – Market Failure
Before we dive into what market failure, let’s familiarise with some terms related to market failure:
Public goods: goods that can be used by the general public, from which they will benefit. Their consumption can’t be measured, and thus cannot be charged a price for (this is why a market economy doesn’t produce them). Examples are street lights and roads.
Merit goods: goods which create a positive effect on the community. Examples are schools, hospitals, food. The opposite is called demerit goods.
External costs (negative externalities) are the negative impacts on the society (third-parties) due to production or consumption of goods and services. Example: the pollution from a factory.
External benefits (positive externalities) are the positive impacts on the society due to production or consumption of goods and services. Example: better roads for the society due to the opening of a new business.
Private costs are the costs to the producer and consumer due to production and consumption respectively. Example: the cost of production.
Private benefits are the benefits to the producer or consumer due to production and consumption respectively. Example: the better immunity received by a consumer when he receives a vaccine.
Social Costs = External costs + Private Costs
Social Benefits = External benefits + Private benefits
Market failure occurs when the price mechanism fails to allocate resources effectively. This is the most disadvantageous aspect to the market economy. Causes of market failure are:
- When social costs exceed social benefits. (Especially where negative externalities (external costs) are high)
- Over-provision of demerit goods (alcohol, tobacco).
- Under-provision of merit goods (schools, hospitals, public transport).
- Lack of public goods (roads, bus terminals, street lights).
- Immobility of resources. When resources are not used to the maximum.
- Information failure: When information between consumers, producers and the government are not efficiently and correctly communicated. Example: a cosmetics firm advertises its products as healthy when it is in fact not. The consumers who believe the firm and use its products might suffer skin damage.
- Abuse of monopoly* powers: Monopolistic businesses may use their powers to charge consumers a high price and only produce products they wish to, since they know consumers have no choice but to buy from them.
*Monopoly: a single supplier who supplies the entire market with a particular product, without any competition. Example: Microsoft is very close to being a total monopoly, with hardly any competitors.
2.11 – Mixed Economic System
In a mixed economic system, both the market and government intervention co-exist. Examples include almost all countries in the world (India, UK, Brazil etc.). This is because it overrides all the disadvantages of both the market and planned (govt. only) economies. It identifies the importance of the price mechanism in operating an efficient resource allocation and also the role of the government in correcting (any) market failures
- both the public and the private sector exists
- planning and final decisions are made by the govt. while the market system can determine allocation of resources owned by it, along with the public organizations.
- the govt. can provide public goods, necessities and merit goods. The private businesses can provide most-demanded goods (luxury goods, superior goods). Thus, everyone is provided for
- the govt. will keep externalities, monopolies, harmful goods etc. in control
- the govt. can provide jobs in the public sector (so there is better job security)
- the govt. can also provide financial help to collapsing private organizations, so jobs are kept secure.
- taxes will be imposed, which will raise prices and also reduce work incentive
- laws and regulations can increase production costs and reduce production in the economy
- public sector organizations will still be inefficient and will produce low quality goods and services.
The specific ways in which the government, in a mixed economic system, can correct market failures of the market:
- legislation and regulation – the government can make laws that regulate market activity, for example, prohibit smoking in public (which would cause a negative externality). One important kind of legislation the govt. can undertake is price controls – setting a minimum price or maximum price on goods.
Minimum price or price floor is set to control a decreasing tendency of price. The minimum wage laws in many countries is an example of minimum price. The government sets the minimum wage above the existing market equilibrium wage, to ensure that all workers get a basic minimum wage to sustain them. But even as low-income workers now get better wages, the higher wage will cause the demand for labour to contract, as shown in the diagram to the left. There will also be higher supply of labour (workers who want work) because of higher wages. A reduced demand and increased supply will cause excess supply of labour i.e., unemployment.
Maximum price or price ceiling is set to control an increasing tendency of price. It is usually set on rent (this is called rent control), to ensure that low-income tenants can afford to rent homes. But as a result of the lower rent, landlord will stop renting more homes, causing supply to contract, as shown in the diagram to the left. At the same time, lower rent will increase the demand for homes. A reduced supply of homes and higher demand for them will cause a shortage of supply in relation to demand.
- direct provision of merit and public goods – since there is little incentive for the price mechanism to supply these goods, government usually provide them. For example, free education, free healthcare, public parks. One way the govt. can do this is by nationalising certain products it considers essential to be provided by a governing authority, rather than the market. For example, in India, the government the government operates the only railway network because only it can provide cheap services to its millions of poor, daily passengers.
- taxation on products – imposing a tax on products (indirect taxes) with negative externalities can discourage its production and consumption. For example, a tax on tobacco will make it expensive to produce and consume. In the diagram below, a tax has been added on a product, causing its supply to shift from S to S1. The price rises from P to P1 because of the additional tax amount, and the quantity traded in the market falls from Q to Q1.
- subsidies – a subsidy is a grant (financial aid) on products that have a positive externality. Subsidising, for example, cooking gas for the poor, will increase the living standard of the population. In the diagram below, a subsidy has been imposed on a good, causing its supply to shift from S to S1. It results in a fall in price from P to P1 and subsequently, an increase in the quantity traded in the market from Q to Q1.
*Note: movements along a demand or supply curve of a good only happens as a result of a direct change in price of the good; changes caused by any other factor, tax and subsidy included, is represented by a shift in the curves.
- tradeable permits – firms will have to buy permits from the government to do something, for example, pollute at a certain level, and these can be traded among firms. Since permits require money, firms will be encouraged to polluting less
- extension of property rights – one of the main reasons for pollution in public spaces is that it is public – it does not harm a private individual – the resource is the government who cannot charge compensations easily. So the government can extend property right (right to own property) of public places to private individuals. This will effectively privatise resources, create a market for these spaces and then individuals can be fined for polluting
- international cooperation among governments – governments work together on issues that affect the future of the environment.
Notes submitted by Lintha
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