Economics of Market Failure

Economics of Market Failure

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Market failure has become an increasingly important topic for students. In simple terms, market failure occurs when markets do not bring about economic efficiency. There is a clear economic case for government intervention in markets where some form of market failure is taking place. Government can justify this by saying that intervention is in the public interest.

Government intervention occurs when markets are not working optimally i.e. there is a Pareto sub-optimal allocation of resources in a market/industry. In simple terms, the market may not always allocate scarce resources efficiently in a way that achieves the highest total social welfare.

There are plenty of reasons why the normal operation of market forces may not lead to economic efficiency.

Public Goods

Public Goods not provided by the free market because of their two main characteristics

· Non-excludabilitywhere it is not possible to provide a good or
service to one person without it thereby being available for others to
enjoy

· Non-rivalrywhere the consumption of a good or service by one person
will not prevent others from enjoying it

Examples: Streetlighting / Lighthouse Protection, Police services, Air defense systems, Roads / motorways, Terrestrial television, Flood defense systems, Public parks & beaches

Because of their nature the private sector is unlikely to be willing and able to provide public goods. The government therefore provides them for collective consumption and finances them through general taxation.

Merit Goods

Merit Goods are those goods and services that the government feels that
people left to themselves will under-consume and which therefore ought
to be subsidized or provided free at the point of use.

Both the public and private sector of the economy can provide merit
goods & services. Consumption of merit goods is thought to generate
positive externality effects where the social benefit from consumption
exceeds the private benefit.

Examples:Health services, Education, Work Training, Public Libraries,
Citizen's Advice, Innoculations

Monopoly

Few modern markets meet the stringent conditions required for a
perfectly competitive market. The existence of monopoly power is often
thought to create the potential for market failure and a need for
intervention to correct for some of the welfare consequences of
monopoly power.

The classical economic case against monopoly is that

· Price is higher and output is lower under monopoly than in a
competitive market

· This causes a net economic welfare loss of both consumer and
producer surplus

· Price> marginal cost - leading to allocative inefficiency and a
pareto sub-optimal equilibrium. See also the study page on economic
efficiency

· Rent seeking behaviour by the monopolist might add to the standard

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costs of monopoly. This includes high (possibly excessive) amounts of
spending on persuasive advertising and marketing.

· Libenstein's X-inefficiency may also result if the monopolist allows
cost efficiency to drop. An upward drift in costs because of a lack of
effective competition in the market-place can lead to consumers facing
higher prices and a reduction in their real standard of living

Externalities

Any exam question on market failure must make some reference to
externalities. What are the potential market failures arising from
externalities?

The social optimum output or level of consumption diverges from the
private optimum.

Main problem is the absence of clearly defined property rights for
those agents operating in the market. When property rights are not
clearly defined, market failure is likely because producers &
consumers may not be held to account.

Positive externalities can also justify intervention
if goods are under-consumed (social benefit> private benefit)
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