Market Failure

1.0 Introduction

Market failure refers to a situation whereby a freely-functioning market fails to allocate resources efficiently or optimally resulting in undesirable outcomes. Main examples of market failures include market power, externalities, unequal distribution of economic prosperity and inadequate public goods.

Market power occurs when economic actors are able to exert considerable influence on market prices or the quantity of goods sold causing concentration of power and imperfect competition. Externalities are the uncompensated impact caused when the market disregard external costs of an economic activity on the well-being of a bystander. Externalities diverge social costs of benefit from the private optimum, leading to market failure as well. Unequal distribution of economic prosperity occurs as people are rewarded according to their ability in generating high income by producing things others are willing to pay off. Markets fail as significant differences in income and wealth leads to a wide gap in living standards between different groups in the economy. Market also fails when there are inadequate public goods which are not provided by the market mainly because of the free rider issue[1].

Hence public policies are required to correct market failure and increase the efficiency and productivity of the market. This ensures that the market is able to achieve the highest total social welfare, thus allowing a greater distribution of income and wealth and higher standard of living.

2.0 Public Policies

Public policies are basically described as attempts taken by the government as an approach towards public issues and are commonly incorporated in legislations, regulations, decisions and actions (Venus 2010). Examples of public policies that can be taken to remedy market failure are legislations and regulations, implementation of taxes, subsidies and price controls.

2.1 Legislations and Regulations

Legislation is a law which has been enacted by a governing body whereas regulation is a rule or restriction promulgated to control activities of businesses and consumers. There are two forms of regulations, namely industry regulation which prevents firms from gaining and exploiting excessive market control; and social regulation which protects consumers from social costs like externalities, socially undesirable goods and asymmetric information. Examples include price regulations or orders prohibiting collusive practices and monopolistic behaviours which help reduce concentration of market power. Legislations regarding the protection of the environment can also be enforced to reduce externalities like pollution.

Legislations and regulation are also an example of command-and-control policies which are specifically targeted at reducing externalities. Command-and-control policies correct externalities by regulating behaviours directly, making them either required or forbidden. This is usually carried out by respective environmental agencies or commissions of a country, for instance the Environmental Protection Agency in United States which restrict levels of pollution and emissions emitted by factories and industries.

2.2 Taxes

Taxes are a financial charge or levy imposed upon an individual or entity. Taxes can be used to regulate the market, redistribute income and reduce externalities through the manipulation of the demand and supply curves in the market. Even so, the tax imposed must be equal to the external cost or benefit to achieve the optimal quantity of output.

A form of tax is environment levy which is imposed on firms to make them pay for the negative externalities they created. Taxes can also be imposed on undesirable goods to increase their price and reduce the quantity demanded or even used to compel people to pay for public goods to overcome the free rider issue. Similarly, taxes imposed in accordance with income earned helps reduce the market failure of income differentials. At the same time, taxes also helps increase government’s revenue which can be spent on alternatives such as direct provision of public goods and services to compensate for the lack of collective goods.

Tax is also part of market-based policies, developed specifically to reduce externalities. Market-based policies internalize externalities by providing incentives so that private decision makers will solve the externalities themselves. An example corrective taxes used to persuade private firms to take account of social costs that arise from negative externalities.

Effect of tax on the market can be seen in Diag. 1. Tax imposed on a product would increase its price, effecting both consumers and producers. As production cost increases, the supply curve will shift to the left from S to S1 as producers would decrease the product’s supply. Since the price of the good is now more expensive, the quantity demanded by consumers would also decrease as seen in the change from Q2 to Q1. However, should the demand of the good be inelastic, taxes would fail to create any significant reduction in the demand of the good as shown in the diagram. For example, cigarettes.

2.3 Subsidies

Subsidies, also known as negative tax, are financial assistance provided to businesses or economic sectors. Subsidies are used to assist small and potential firms by reducing their production cost so that they are able to compete against larger firms. They can also come in forms of loans or research and development grants to assist firms in their research to produce products of better quality. This reduces the barriers to entry and simultaneously increases competition among firms in the market besides effectively solving under consumption of resources, a positive externality. Furthermore, subsidies can increase socially desirable goods and assist in the redistribution of income. Even so, the subsidy imposed must be equal to the external cost or benefit to achieve the optimal quantity of output.

Effect of subsidies on the market can be seen in Diag. 2. Subsidies imposed on a product would reduce its price, effecting both the consumer and producer. Production cost decrease as producers receive assistance and the supply curve will shift to the right from S to S1 as producers would increase supply. Since the price of the good has now reduced, the quantity demanded by consumers would also decrease as seen in the change from Q to Q1.

2.4 Price Controls

Price control is a form of public policy where the government uses its law-making power to regulate prices of goods or services. The government may attempt to fix and enforce exact prices of a particular good or service sold or set a ceiling price or floor price (Johnson 2005). Government will then be able to assist consumers and producers with the impact it has on consumer demand and production of the good or service.

Price ceiling is the legal maximum price which a good can be sold at but not any lower than that. An example would be rent control to help poor consumers which cannot afford housing. Price ceiling only takes effect when it is imposed below the equilibrium price as shown in Graph A as producers are forced to meet the maximum price set. However, this may result in shortages (Graph A) as the lower price will increase demand for the product.

Price floor is the legal minimum price that can be charged but transactions at higher prices are prohibited. An example is the minimum wage laws which increases workers’ standard of living. Price floor only takes effect when it is imposed above the equilibrium price as shown in Graph B as suppliers have to raise their prices to meet the government’s minimum price. However, a surplus may occur (Graph B) as the higher price will decrease consumers’ demand.

3.0 Conclusion

As a conclusion, it can be seen that markets require public policies and government intervention in order to function effectively and achieve the objectives of producers, especially small and potential firms; and consumers. Market failure can be redressed through enforcement of legislations and regulations, taxes and subsidies and price control which are able to increase competitiveness, redistribute income and reduce externalities and socially undesirable goods. Although the implementation of these policies are useful in reducing negative impacts on the economy and basically have positive implications, there are also drawbacks. For instance, legislations and regulations are difficult and expensive to enforce whereas subsidies requires a government to first have sufficient financial means which prevents all countries from carrying them out efficiently. Price control also results in surplus and shortages of products they are imposed on in the long run which will also lead to inefficient allocation of resources. Hence, governments should always analyze the economy carefully and critically and carry out policies accordingly to prevent any further deteriorating of the economy.

4.0 References

Books:

• Mankiw, N. G. 2008, Essentials of Economics, 5th Edn, South West Cengage Learning, United States
• Webster, N. 2005, Economics, 2nd Edn, Greg Eather, Adelaide

Websites:

• Johnson, P. M. 2005, Price Controls: A Glossary of Political Economy Terms, retrieved 16 March 2010,
• The Smartacus Corportion 2009, Government Intervention: Price Ceiling, retrieved 17 March 2010,
• The Smartacus Corportion 2009, Government Intervention: Price Floor, retrieved 17 March 2010,
• Venus, D. 2010, What is Public Policy, retrieved 16 March 2010,
• Watkins, T. n.d., Impact of an Excise Tax on Subsidy on Price, retrieved 17 March 2010,