4.8 • +11k Ratings
Save
Print
Edit
What happens when you have a factory polluting the air? Who bears the consequences of air pollution? Should the government step in? What is the government's role in this scenario? This is what market failures are all about, and this article will help you learn all about it.
Market failure can be defined as a situation where there is an inefficient distribution of goods and services in the free market. Typically, this means the socially optimal output is not reached. A distortion can arise between the interests of different actors in the free market. The mismatch of the interests happens when there is a violation of the basic principles a free market.
According to free-market assumptions, all individuals are rational actors motivated by self-interest, and they respond to incentives. For the free market to operate, there also needs to be a system of clearly defined property rights. Finally, we need prices to accurately reflect the true social cost of production--all of the economic costs, even if those costs fall on individuals who are not participating in this market. If any of these factors are missing, there will likely be a market failure of some sort.
A market failure occurs when an assumption about free markets is violated. If there is a common resource that no one has private ownership of, then the market for using or consuming the resource will involve a market failure. Similarly, if there is a positive or negative externality, then market prices do not accurately reflect the true social cost of consumption or production, and there is a market failure.
Whenever the activities in a free market occur in such a way that there is a disequilibrium in goods demanded and supplied, then we can say that there is a market failure. The market fails to reach the socially optimal equilibrium outcome. Another way to say this is that the allocation of resources is inefficient. Governments often step in to take corrective action when there is a market failure, and the type of intervention depends on the type of market failure.
Market failures can take many forms. They generally arise from one of several sources:
An externality is a cost or benefit associated with a particular economic transaction that is incurred or benefited by an agent not directly involved in the transaction. It is important to know that an externality can be positive or negative.
One example of a negative externality is pollution. There are many companies that produce certain goods, and during the production process, they pollute the air or water. The good is sold in the market to interested buyers at a price that accounts for only the company's costs of production. Any pollution caused in the production process is unaccounted for in the pricing of the goods. However, the pollution affects the whole community living in the region, and such an externality causes a market failure.
How do governments deal with externalities such as pollution? Well, the first thing to recognize is that pollution has both a benefit and a cost and therefore should not be completely zero at the socially optimal outcome. The benefit of the pollution is the ability to manufacture the goods without spending more money, and the cost of the pollution is the well-being of the people affected.
By ceasing the company's production process altogether, all of the consumers who were enjoying the good would lose the benefit of their enjoyment, which could be larger than the negative effects of the pollution. Instead, the efficient level of pollution is the level where the true marginal cost of the production process, including any externalities, equals the true marginal benefit to society of consuming the good. When the marginal cost and marginal benefit of an externality are equal, a socially optimal point is reached.
Figure 1 shows a fictional market for the pollution itself. The "demand for pollution" is the marginal social benefit of the next consumer who gets to enjoy the good. The "supply of pollution" is the marginal social cost of the next individual harmed by the pollution. The socially optimal outcome is where the marginal cost of pollution and marginal benefit equal each other. At that point the quantity of pollution should be Q* at a price of P*.
Figure 1. Dealing with externalities - StudySmarter
If the market clears in a way that the socially optimal pollution is produced, then the markets are efficient and hence there is no market failure. This is, however, not the case in many instances in the real world. In many instances, the costs of pollution are incurred by society because companies do not have the incentive to prevent pollution.
If left unregulated, pollution is produced beyond the socially optimal point. This is because preventing pollution is costly, and the company does not receive direct economic benefits. Pollution is an example of an external cost.
An external cost is any negative externality created by a firm's operations and imposed on other people without compensation.
Another assumption that is important to ensure that free markets are efficient is that all agents have perfect information. If buyers and sellers have accurate information about the good they are buying and its quality and characteristics, then prices accurately reflect production costs, and markets clear efficiently.
However, instead there may be information asymmetry. That means one side of the market--typically the sellers--have more accurate information than the other side of the market--typically the buyers. Since sellers only earn revenue when they make a sale, their incentive is to share only the information that will help them to sell the product. In the presence of information asymmetry, a market may never reach the socially optimal equilibrium price and quantity; hence market failure occurs.
When you buy a used car from your neighbor who wants to sell her car, your neighbor has much more detailed information about exactly how well that car has been operating and how well she has taken care of it. You and your neighbor have asymmetric, or different, information about the car. If you don't trust your neighbor to be honest with you about the shape the car is in, you probably won't want to buy it. This is an example of a market failure.
You can see a lack of information, or asymmetric information, present in many industries in the real world, including financial markets. To fix the problem of asymmetric information, governments usually require companies to share key information about their products or business operations. This is especially true in the stock market, where every publicly traded company is required by law to disclose its financial situation.
A free market is one in which no single entity has control over the market. This means that the forces of demand and supply are allowed to shift and determine the market price. The self-regulating aspect of competitive markets fails, however, if a single entity can control one side of the market, either the demand or supply.
Such power is possible in a monopoly market. A monopoly occurs when a single firm is the sole producer of the good. The monopoly firm can adjust production to maximize its own profits without considering the general welfare of the society. Having monopoly power is considered an artificial control of production. It hinders the market forces of demand and supply, which leads to market failure.
To understand how public goods cause a market failure, we first need to understand the concept of a public good. There are two characteristics of goods used to classify goods. They are:
Milk is sold in any number of grocery stores. This is because milk is excludable and rival. Each store can provide a gallon container of milk only to the people who are willing to purchase it, and once the gallon is consumed, it is no longer consumable by anyone else.
The construction of new roads is provided by the government. Roads can be very useful for getting to the grocery store! However, they can be used by the whole population, regardless of who paid the taxes that paid for the construction of the road. That's because they are nonexcludable. In addition, roads are nonrival because using the road still leaves it available for others to use after you.
Public goods are both nonexcludable and nonrival in consumption. These two properties create the free-rider problem. A public good is socially beneficial, and in the absence of intervention, the free market will underprovide any public good. This is called the free-rider problem. Private companies cannot operate efficiently to provide public goods due to a lack of incentives, since everyone can consume the good together once it has been produced. This is a market failure.
That's what leads to government interventions for the provision of public goods.
Market failure occurs when the market outcome is inefficient, and therefore, the government may step in to correct the market. Under certain assumptions, free markets are able to self-regulate through competition, in the absence of government intervention. When there is not enough competition in the market,
One broad approach the government uses is ensuring competition in the market. The government promotes competition by preventing anticompetitive market structures such as monopoly and oligopoly. Monopiles are only allowed when it is a natural monopoly. Even with natural monopolies, the government has oversight to ensure the production of goods is carried out efficiently. Therefore, the government promotes competition by preventing unnatural monopolies and ensuring natural monopolies are not manipulating the demand and supply process.
The government promotes competition by establishing legal frameworks and policies that prevent the formation of monopolies and other anticompetitive market structures. One policy used is the antitrust policy. The first antitrust act in America is the Sherman antitrust act. The Sherman antitrust act is the three major federal antitrust law. The act was passed in 1890. The Sherman antitrust prevents the artificial restraining of interstate trade and monopolizes interstate trade and commerce.
The other two antitrust acts are the Clayton antitrust act and the federal trade commission act. The department of justice has an antitrust division that oversees antitrust laws. The goals of the antitrust laws are to protect competition, ensure lower prices, and promote the development of new products.
The Clayton antitrust act was implemented to clarify the Sherman antitrust act since the Sherman act was not clear on specific practices. Clayton made it illegal to make price discrimination, anticompetitive practices, anticompetitive mergers and acquisition, and interlocking directorates.
The federal trade act was passed in 1914 and was intended to create a federal trade act (FTC) and make it illegal to use unfair methods of competition in interstate trade.
There are several different ways that a government can intervene in a market when there is a market failure. Regulation and price mechanisms typically do not bring about the socially optimal outcome, but taxes, subsidies, and government provision of public goods have the potential to correct market failures and create socially optimal outcomes. In addition, the U.S. government interventions often aim to simply bolster the competitive environment. Each of these types of government interventions into markets are discussed below.
One option the government has is outright regulation of an industry or behavior. The government can create standards that businesses must follow, or enact bans on certain goods. If the government simply made pollution illegal, then companies would have to find a way to manufacture their goods without causing pollution. The outcome would be zero pollution, but fewer goods and higher prices due to higher production costs.
The government may use price mechanisms like price ceilings or price floors to correct what it sees as a market failure. Rent control is an example of a price ceiling.
The government can levy a tax to correct a market failure. For example, in the case of pollution, the government can tax the goods whose manufacture causes pollution. This can lead to the socially optimal level of pollution being attained. In the absence of the tax, market forces do not account for pollution since it is a negative externality not incurred by the company. Therefore, the government can enforce a pollution tax that the consumer incurs, and this can bring about the socially optimal quantity.
In the case of a positive externality, the government could impose a subsidy to correct a market failure. The government subsidizes a lot of farming operations to ensure that they can weather temporary downturns and continue to provide food for people to eat. A subsidy works just like a tax to bring the market to the socially optimal outcome.
Some goods that are associated with market failures are also essential to people. These include electricity, water and sanitation, transport, and other public amenities. Private firms do not have enough incentives to provide public goods because they are nonexcludable and nonrival. The government steps in to cover the cost of such goods and services by producing them itself, since there are essential.
The U.S. government tries to take a minimalist approach to market interventions by promoting competition in hopes that the market forces will then provide self regulation. The best way to promote competition is break up any monopolies and oligopolies. The government's mechanism is through enforcement of anti-trust laws.
Some common example markets failure include pollution, education, healthcare, water supply, cigarette smoking, alcohol consumption, defense, and policing. Most of the market failures are associated with negative impacts, but some market failures have positive benefits. Education is an example of a positive externality. Although the government spends tax revenue on public education, the improvement in human capital benefits the whole society.
Market failure can be defined as a situation where there is an inefficient distribution of goods and services in the free market.
When activities in the free market occur in such a way that there is a disequilibrium in goods demanded and supplied, then we can say that there is a markets failure, and the allocation of resources occurs in an inefficient way.
Common interventions can include (1) regulations and standards, (2) taxes and subsidies, (3) promoting competition through enforcing antitrust laws, and (4) providing public goods.
Market failure types include externalities, lack of information, concentrated market control, and the public good.
Yes it can, if the government chooses the wrong policy to address a market failure, or levies a tax that is not the optimal size, then the outcome might still be market failure. Sometimes government intervention is not even warranted and actually causes a market failure in an otherwise efficient market.
60%
of the users don't pass the Market Failure and the Role of Government quiz! Will you pass the quiz?
Start Quiz
Be perfectly prepared on time with an individual plan.
Test your knowledge with gamified quizzes.
Create and find flashcards in record time.
Create beautiful notes faster than ever before.
Have all your study materials in one place.
Upload unlimited documents and save them online.
Identify your study strength and weaknesses.
Set individual study goals and earn points reaching them.
Stop procrastinating with our study reminders.
Earn points, unlock badges and level up while studying.
Create flashcards in notes completely automatically.
Create the most beautiful study materials using our templates.
Sign up to highlight and take notes. It’s 100% free.
