Market Failures

Market Failures by

Erik F. Meinhardt

This section sets out to define and describe market failures, failures, how government intervention prevents them or minimizes their effects, and the arguments against government intervention.

Definitions and descriptions

I.

Mark Market et fail failur ure e occu occurs rs when when free free mark market ets s do not not brin bring g abou aboutt econo economi mic c efficiency, that is to say when a Pareto sub-optimal allocation of resources exists in a particular economy. Market failures remain one of the best reasons for gover governme nment nt interv intervent ention ion withi within n an econom economy y on moral moral and econom economic ic grounds, arguably, in the best interest of the public. The The follow following ing are are detail detailed ed descri descripti ptions ons of severa severall marke markett failur failures es in no particular order: A.

Public goods—Public goods are goods wherein the consumption of the them does does not not nec necessar ssariily pre prevent ent anot anothe herr per person son from from also also cons consum umin ing g it, it, nor nor does does that that cons consum umpt ptio ion n make make less less of the the good good avai availa labl ble e for for cons consum umpt ptio ion n by othe others rs.. Scho Schola lars rs comm common only ly pres presen entt breathable air as an example of a public good for virtually everyone has has acce access ss to cons consum ume e it and and its its cons consum umpt ptio ion n does does not not limi limitt the the amount available. Public goods pose a problem for the market because by their nature it cannot provide for them. The private sector will not make a profit from a good which everyone can enjoy whether or not they pay for it. The light lightho hous use e exam exampl ple e come comes s to mind mind:: no matt matter er who who pays pays for for the the construction of a lighthouse on a particular island, every passing ship will will bene benefi fitt from from the the prot protec ecti tion on it prov provid ides es and no way way exis exists ts for for excl exclud udin ing g thos those e who who did did not not pay pay. In addi additi tion on,, not not ever every y rati ration onal al consumer (including those who did originally pay) will keep paying for a publ public ic good good if they they can can stil stilll bene benefi fitt from from it with withou outt payi paying ng.. The The private sector knows the nature of public goods, and would never build the lighthouse in the first place. These things combined mean that the private sector cannot profit and it will thus under-provide the good. In the case of a lighthouse, if an island fishing industry relies on the protection from a lighthouse, this under-provision means that the fishing market will collapse. Hence, we have have a mark market et failur failure. e. The marke markett fails fails to provi provide de essent essential ial public public goods. Other examples of public goods are: defense and police forces, str street eet ligh lighti ting ng,, road roads s and and infr infras astr truc uctu turre, publ public ic park parks, s, et cete cetera ra.. Simi Simila larl rly, y, “mer “merit it good goods” s” incl includ ude e publ public ic heal health th serv servic ices es,, publ public ic

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educat education ion,, public public lib librar raries ies and museum museums, s, public public radio/ radio/tel televi evisio sion n et cetera. B.

Imperfect Imperfect competit competition ion—Imp —Imper erfe fect ct comp compet etit itio ion n occu occurs rs when when an agent in the market gains market power and the market can no longer meet the conditions necessary for perfect competition. This means the agent can alter the price of a good or service within the market without losing customers because it controls either all or a large portion of the market. The problem of imperfect competition plagues most markets and requir requires es governmen governmentt interventi intervention on to achieve achieve efficienc efficiency, y, proving proving that a pure market cannot be Pareto optimal. The monopoly, a prime example of imperfect competition, serves as an appropriate way to demonstrate market failure. In a monopoly, one firm remains the only seller of a certain product or service, the market prov proves es diffi difficu cult lt to ente enterr into into as a sell seller er,, ther there e are are no comp compar arab able le products for consumers, and the firm f irm in control can alter the price of its good or service as it wishes. This leads the firm to overprice its product and under under-pr -produ oduce ce it in order order to maximi maximize ze profi profits. ts. Since Since it has no compet competiti itive ve press pressur ures es upon it, the firm firm can do this this without without losing losing customers customers.. Society Society suffers as a result result of the monopoly causing higher unemployment (no need to hire more employees if a firm can underproduce) and higher prices. This leads to allocate inefficiency of the prod produc uctt and and a Paret areto o su sub-o b-opt ptim imum um equi equili libr briu ium; m; henc hence e we have have a market failure.

C.

Asymmetric information—Information asymmetry occurs when one party to a transaction has more or better information than the other party involved. There are two specific examples of the asymmetrical info inforrmati mation on prob proble lem, m, whic which h I will will expla xplain in us usin ing g the the auto automo mobi bile le insurance market as my model: Adverse selection selection—A 1. Adverse

risk risky y driv driver er woul would d get get a barg bargai ain n if he/s he/she he purchased automobile insurance; whereas a non-risky driver would actu actual ally ly lose lose mone money y. This This come comes s as a resul esultt of the the insu insura ranc nce e companies not knowing information about whether or not certain driv driver ers s are are risk risky y or not. not. The The insu insura ranc nce e comp compan any y must must rais raise e premiums for everyone in order to compensate for the amount it will dispense on behalf of the risky drivers. Some non-risky drivers will thus not buy the insurance, leading to a higher rate of risky driver drivers s buying buying ins insura urance nce in genera general, l, raisin raising g the premi premiums ums even even



2.

—An Moral Moral hazard hazard —An

easy easy examp example le to expla explain, in, this this probl problem em occurs occurs when those who have insurance take greater risks. An uninsured person would less likely drive riskily than an insured person. When some someon one e purch purchas ases es auto automo mobi bile le insu insura ranc nce, e, the the cost cost of his/ his/her her accident is externalized to the insurance company. Thus, it seems they have a higher likelihood to be more careless and risky when driving. The insurance company cannot monitor the driving of its clients and thus, has incomplete information. Again, the insurance company must raise premiums in order to compensate for those who will drive riskily as a result of having insurance. This prices out those who would not drive riskily if they had insurance and leads to inefficiency.

Government intervention

II.

Some scholars argue that government intervention is a good way to prevent market failures from occurring and to lessen their effects. They argue that the government does this in the best interest of the people. Many methods exist for a government to utilize when intervening in the economy. I describe some of them as follows: A.

Taxation and subsidies—The government frequently uses taxation (taking money away from agents) and subsidizing subsid izing (giving money to agents) in order to correct market failures. Taxation can discourage certain behaviors like monopolizing and overpricing. It is used to provide for public sector production of public goods and is also used to enforce the other government intervention methods. It collects money to provide for national defense, public infrastructure infrastructure and roads, public pub lic safety and health services and public pub lic schools, libraries and museums. Subsidies, on the other hand, encourage certain behaviors like producing a certain good. They can help reduce the cost of paying for merit goods like education, healthcare, and the arts, for example. Also, they can encourage production of certain crops and also reduce scientific research research costs for fo r public interest.

B.

Public sector production —The government employs this method to deal with the problem of public good go od market failures. Using taxation, the government collects money and then provides public goods—like national defense or law enforcement, for example—to the citizenry. The government can also nationalize industries to prevent monopoly and provide public goods. Public works such as the Hoover Dam can



C.

Antitrust legislation —The government passes these laws to limit the formation of monopolies and prevent imperfect competition. They make anti-competitive behavior like price fixing, geographic market allocation (cartels), and bid rigging illegal.

D.

Regulation—The government can require businesses to behave in certain ways. For example, by forcing car companies to make automobiles with seatbelts, the government is, in a way, providing a public good and also reducing insurance costs. Another example of this is requiring cigarette companies to put health warning labels on their products. This increases information and reduces insurance costs yet again.

III. III.

Cont Contra ra gove govern rnme ment nt inte interv rven enti tion on

Other Other scholar scholars s counte counterr that that gover governme nment nt interv intervent ention ion to preve prevent nt marke markett failur failures es might might not actual actually ly solve solve the probl problem ems s better better than than the mark market. et. I summarize some of their arguments as follows: A.

Govern Governmen mentt failur failure e—The —The main main argu argume ment nt agai agains nstt gove goverrnmen nmentt inte interv rven enti tion on is that that the the gove goverrnmen nmentt itse itself lf is very very inef ineffi fici cien entt at regulating the market. Political self-interest has politicians often pork barrel spending–using taxes and subsidies to favor their own districts rather than achieving efficiency. efficiency. Also, lobbyists of certain organizations can petition for harsher laws against their competitors which create mor more impe imperf rfec ectt comp compet etit itio ion. n. It is also also argu argued ed that that gove goverrnmen nmentt intervention in the form of taxes causes disincentives to productivity. Finally under this heading is the problem of imperfect information— Pigou argued that regulatory agencies are worse than individual actors in an economy at gathering information. The government cannot ever really know enough about people’s wants and needs based on how they vote.

B.

Private production of public goods —Some people think that public goods can actually be provided for without government intervention. The simplest example of this relies on charitable giving to provide for citizens’ education and healthcare.

C.

Natura Naturall mo monop nopoly oly —Som — Somet etim imes es gove goverrnmen nmentt inte interv rven enti tion on is not not needed needed,, as in the case of natura naturall monopo monopolie lies. s. This This falls falls under under the theory of contestable markets, but it basically says that competitive

Market Failures

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