Chapter 12: Market Failure

Market Failure

When a free market is not allocatively efficient, community surplus is not maximised and governments have to intervene to eliminate the market failure and move towards the optimal allocation of resources.

Types of Market Failure

1. Lack of Public Goods

2. Ways in which governments try to increase public goods

3. Under supply of merit goods

4. Over supply of demerit goods

5. The existence of externalities

Lack of public goods

Public goods are goods that would not be provided in a free market, as they are of benefit to society and thus should be made available to the general public. The lack of public goods is considered to be a form of market failure. Examples of public goods involve national defence and flood barriers. Public goods, which could be supplied by the free market, such as lighting and lighthouses, are known as 'Quasi-Public Goods'. Public goods are non-excludable and non-rivalrous, which makes them pointless for private enterprises to provide themselves. If a good does not have both of these characteristics, then it is not a public good.

Non Excludable Goods

Goods for which it is impossible to stop another person from consuming it once it has been provided. If a private individual has hired a security team to watch the road they live on, other residents in the neighbourhood will benefit from it.

Non Rivalrous Goods

Goods for which one person consuming it does not prevent another from consuming it as well. If a person installs a flood barrier to protect their house, they cannot stop others from benefiting from it as-well. The private benefit would be small relative to the cost, although the social benefit would be huge. Thus, there is no incentive for a private individual to erect a flood barrier.

Ways in which governments try to increase public goods

- Governments may try to provide the public good themselves, through the use of taxpayers' money to fund the provision, which spreads the cost over a large number of people who would not be prepared to pay individually.

- The government may subsidise private firms, covering all costs, to provide the good.

Under Supply of merit goods

Merit goods are goods that will be underprovided by the market, and, thus, they will be under-consumed. They are goods the government thinks provide positive benefits for both the people who use them and society as a whole, and therefore, they think that such goods should be consumed to a greater degree. All public goods are merit goods.

Governments will attempt to increase the supply and consumption of merit goods, depending on how important they think the goods is. With extremely important merit goods, such as education and health care, the government may provide them directly or subsidize them to the point where they are available at no direct cost to the consumer. If merit goods become less important in the eyes of the government, they will still be subsidized, but to a lesser extent.

Over supply of demerit goods

Demerit goods are goods which are considered to have a harmful effect to consumers. In a market failure-type situation, they are over-consumed. Government response to overconsumption depends on how harmful they perceive the good to be. Goods such as child porn or drugs will be outright criminalised, whereas goods such as alcohol and cigarette may be subject to mere indirect taxes.

The existence of externalities

An externality occurs when the production or consumption of a good or service has an effect upon a third party. If the effect is harmful, a negative externality is said to have occurred. If the effect is beneficial, a positive externality is said to have occurred. If no externalities exist, Marginal Social Cost (MSC) will be equal to Marginal Social Benefit (MSB). If they are not equal, then society's resources are being misallocated.

Negative externalities of production/external costs

When the production of a good or service creates external costs that are damaging to third parties. They usually relate to environmental damages during production. Additional costs are being created on top of the firm's private cost, causing marginal social cost to be greater than marginal private cost. The marginal social cost is equal to the marginal private cost plus the additional costs. As firms only take into account their private costs, the government, in order to rectify this, could: tax the firm to increase the firm's private cost and reduce production, legislate and ban the practices which are generating the negative externalities, the government could also put limits on the amount of emissions/damages to the environment the firm can incur. If they exceed this then legal penalties can be applied.

Positive Externalities of production/external benefits

When the production of a good or service creates positive external benefits for third parties.

Negative externalities of consumption

When de-merit goods are consumed, third parties suffer from the negative impacts, and a welfare loss is caused by the gap between marginal private benefit, which is higher than marginal social benefit. Consumers will consume where MSC = MSB, where private utility is maximised and will ignore the externalities they are creating with their overconsumption. The government could rectify this with a complete ban on the demerit goods, or they could impose indirect taxes on the goods, in order to reduce consumption, which would reduce the output of the demerit good and shift the MSC curve to MSC + Tax. The government could also create public awareness campaigns to inform the public about the dangers of the good, which would reduce consumption and shift MPB to the left, so that it becomes equal to MSB.

Positive Externalities of Consumption

There are goods which, when consumed, provide positive benefits to third parties and create positive externalities to society, such as healthcare, which prevents the spread of diseases. As MSB is greater than MSB, the government can rectify the externality by increasing consumption, usually in the form of subsidizing the good, or using positive advertising to encourage people to consume more of the good, or pass laws making consumption of the good mandatory.

Common Access Resources and Further Threats to Sustainability

Common access resources are typically natural resources which are accessible to the public and very difficult to exclude people from using them. It is in the interest of the individual to consume from these resources, as the resources generate positive externalities of consumption, however, their consumption can generate negative externalities, as it can deplete the stock of the resource, and so over consumption can generate a market failure situation. The consumption of common access resources is unsustainable, as it inhibits the ability of future generations to meet their needs.

Further Threats to Sustainability

The pursuit of economic growth results in environmental problems, such as the over-exploitation of land, soil erosion, land degradation and deforestation. For developing countries, the destruction of common access resources and weak regulations result in massive negative externalities and a significant threat to sustainability.

The use of Fossil Fuels as a threat to sustainability

The demand for fuels is negatively impacting sustainability. The production and transporting of goods and services requires fuel and the extraction of fuel generates external costs. The fact that producers and consumers of such fossil fuels are not able to account for the external costs to future generations means that fossil fuels are both over-produced and over-consumed and represent a significant market failure on a global level.

Cap and trade Systems as a Government response to threats to sustainability

A cap and trade system involves governments setting targets for emission reductions and encourage firms to meet the targets by creating economic incentives to reduce emissions.

Clean Technologies as a Government response to threats to sustainability

As the extraction and use of fossil fuels create negative externalities, focus has been put on technologies that utilise renewable sources of energy, such as: solar power, wind power, hydropower and biofuels.

Governments can assist the use of these technologies through subsidies and through tax credits to firms which use these technologies.

Imperfect Information

Firms and consumers may not have full information about the availability of products and range of prices. One of these cases is known as 'asymmetric information' wherein one party has access to more information than another, which prevents the market from reaching the allocatively efficient level of output. Governments may try to improve the flow of information and prevent producers from taking advantage of a lack of consumer information.

Imperfect Competition

When monopolists restrict output in order to push up prices and maximise profits, preventing them from operating at the socially efficient level of output.

Government Solutions to Imperfect Competition

The government may use legal measures to make markets more competitive, such as passing laws that do not permit mergers or takeovers that give an individual firm more than a certain percentage of the market.

They may set up regulatory bodies to investigate markets where it is felt that monopoly power is being used against public interest.