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Causes And Effects Of Market Failure Economics Essay


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In relation of the market performance, many things are well done, but not everything is done well. First of all, we assumed that markets are competitive. In some markets, a buyer or sellers might be having a right to control market prices. This ability to influence prices is called market power. Market power can cause markets to be inefficient because it keeps the price and quantity away from the stability of supply and demand. Market failure happen when resources are inefficiently allocated due to imperfections in the market structure , in the world the decisions of buyers and sellers sometimes affect people who are not participants in the markets at all. Pollution is the classic example of a market outcome that affects peoples not in the market such side effects called externalities. Market power and externalities are examples of a general phenomenon called market failure. When market fail public policy can potentially remedy the problem and increase economic efficiency. In this case; governments will interference where some form of market failure is taking part. Allocate efficiency means good resource allocation, when we cannot make any consumer better off without making some other consumer worse off. Moreover, an allocation of resources that maximizes the sum of consumer and producer surplus is said to be efficient. The balance of supply and demand maximizes the sum of consumer and producer surplus. That is, the invisible hand of the marketplace leads buyers and sellers to allocate resources. Markets do not allocate resources efficiently in the presence of market failures such as market power or externalities. Policymakers are often concerned with the efficiency as well as the equity of economic outcomes. This approach looks at the given resources and tries to get the most output from them and it also means that firms sell at a fair price to consumers that reflect the real resource use.

Market failure is a situation in which a market left on its own fails to allocate resources efficientlywhen

freely-functioning markets, operating without government intervention . Therefore, economic effiency

welfare may not be maximized. This will leads to a loss of economic efficiency. When market fail,

government policy intervention can potentially remedy the problem and increase economic efficiency,

may also lead to an inefficient allocation of resources.

Causes of Market Failure

Public Goods

Public goods are properties or facilities that can be used up by many consumers instantaneously without

reducing the worth of consumption to any consumers. Therefore, public good is non-rival

and non-excludable. That is a consumer cannot be stopped from consuming the good whether or

not the individual pays for it. Realistically, non-rival means that the individual demand curves are

summed perpendicularly to get the aggregate demand curve for the public good if each of those

consumers has a demand curve for a public good (shown as the Figure 7.1).

Consider Good with Identical Aggregate Demand is a public good. (i.e., Moon Lake's Water Quality)

Figure 7.1

Mounting Aggregate Demand for Public Good

Aggregate demand is summed vertically of individual demand curves in the market for a public good.

The summed vertically of individual demand curves because all individuals can enjoy a similar public

good. Hence, for every marginal unit of Moon Lake's water quality:

aggregate demand = the total of consumer value for the unit

Non-Rival and Market Failure

Figure 7.3

Public Good: showed that the market price is not always in an efficiency condition because

the a public good is never "used up".

• P=MC cannot be the equilibrium price of water quality because the individuals would not spend for any

improvement in water quality. Individual would only spend for Q2, and because of Q2 < Q*, the effective

level of water quality would not be met. Thus, the social optimum solution would be to offer Q* and

charge each individual a unit price same to the individuals' marginal value at Q* or P1* and P2*.

The higher demand of consumer will spend a larger amount than the consumer with a lower willingness

to spend for the goods or services (refers to the shaded areas).

The reasons of inefficiency occurs in supplying public goods is that, unlike price, quantity is not an

effective market mechanism:

• For a given quantity, individuals will not automatically self-select their optimal price, but will instead

wish to pay the lowest price possible when they cannot be excluded from consuming the good.

Non-Excludability and Market Failure

The primary cause of market failure involving public goods is non-excludable. Non-excludability means

that the producer of a public good cannot prevent individuals from consuming it. Non-excludability is a

relative, not an absolute, characteristic of most public goods. A good is usually termed non-excludable if

the costs of excluding individuals from consuming the good are very high. Private markets always under

produce non-excludable public goods because individuals have the incentive to free ride, or to not pay

for the advantages they get from consuming the public good. With a free-rider problem, private firms

cannot earn sufficient revenues from selling the public good to induce them to produce the socially

optimal level of the public good.

Figure 7.4

Optimal Provision of a Non-excludable Public Good, The Free-Rider Problem, and

Market Failure

PubD1 = Demand of one individual for public good X.

D2 = Total Demand of two individuals for public good X.

D3 = Total Demand of three individuals for public good X.

D4 = Total Demand of four individuals for public good X.

MC = Marginal cost of providing the public good X.

The socially optimal level of public good X with four consumers is X4. (Note that the optimal level of the

public good with a very large number of individuals is X max.) Because of

non-excludability, markets may fail to provide X4.Under private markets, each individual may wait for

the others to purchase the public good so that he/she can "free-ride." In this case, the private market may

provide no public good, because no one is willing to purchase it. For example, if individual decides

to purchase (and the others free-ride), the private market will provide a level of the public good equal to

X1, where the marginal benefit of the purchasing individual equals to the marginal cost of producing the

public good. Notice that this is much less than the optimal level of provision of the public good, X4.

Cause of market failure

Market Failure is when a good is either over or under produced in a free market due to its externalities or other properties. This means that its ability to be used by more than one person at the same time, without any extra costs, makes it an unsuitable good to be produced by commercial suppliers. When demand is lowered, less will be produced, making the market fail. For an example, when a government subsidies for everyone to have enough of certain good or service, this is a market failure because demand still exists but supply is no longer limited for everyone who gets that product.

Externalities are usually in all field of economic activity. Externalities are defined as third party or spill-over, the effects of production and consumption activities not directly reflected in the market. Negative externalities causes market failure because the graphs have failed to measure true products within the society. Failed to allocate resources efficiently and has overproduced goods with negative spillover effects.

Negative externalities

For example, the consumption of gasoline produces a negative externality in that people who do not use it (own a car) share the costs of the air pollution for which it is responsible. Negative externalities are also property rights problems. Social cost is equal to private cost to the firm of producing the gasoline plus the external cost to those bystanders affected by the pollution. Therefore, social cost exceeds the private cost paid by producers.


Price Social Cost

Supply (private cost)

Demand (private value)

Q optimum Qmarket Quantity

Figure 1

Figure 1 shows, the supply curve does not reflect the true cost of producing gasoline, the market will produce more gasoline than is optimal.

Solving the negative externalities problem

Top of Form

Bottom of Form

Government develop a product price via using taxes onto the consumption of that particular good. Due to the increase of taxation, consumption will decrease because fewer people will be willing to buy at a higher price, since the tax on the product may be more expensive than before. Furthermore, when the tax is increasing, this will cause the businesses to compete with each other on their prices. On the other hand, there might be some underground business causes products are expensive. The government can particularly tax certain private parties to reduce the amount of marginal private cost in order for it to equal to the marginal social cost for a negative production externality. By taxing a party, they will have a higher cost when producing their goods. Taxation can also provide a source of payment for public goods. e.g. we wouldn't have roads without taxes to pay for them. When a good has a positive externality, the government will often create a subsidy to reduce the effects of a market failure. This means that the government will give money to the party that produces this positive externality, in order to encourage production. When subsidies are given, the producers have more money to produce their goods. This will increase production, bringing the marginal private benefits closer to marginal social benefits, decreasing the positive externality, and thus stopping market failure.

One of the reasons contributing to a market failure is the unequal separation of market power. Market power means how strong is the firm's influence on the market outcome, for example, the price of a good. Among all possible market condition, the one with most unequal market power would the monopoly market. A monopoly market means that the market has only one producer producing the goods, there is no other source of same or similar goods in the market. In this case, the particular producer would have absolute power to manipulate the price of the good in the market because consumers have no other choice but to buy the goods from that monopoly firm. The worst situation occurs when the goods sold in this particular market is basic necessary goods for the public, this is because the Price Elasticity of Demand (PED) for the good is so low, that the market would not be able to respond to the drastic change of price, if there is any.








S1 shift to S2





Figure 1

Figure 1 show that, the effects on the market outcomes when the demand curve is inelastic and supply curve is shifting to the left (from S1 to S2). The total expense increases from $40 to $45 after the firm raises the price from $5 to $9, even though the quantity traded decreases from 8 units to 6 units. If the market were a competitive market, such situation will not happen because as soon as the producer increases the price of good, consumers would switch their consumption onto similar goods produced by other producers in the market.

When there is a market failure, government is then needed to interfere and hence improve the market outcome. A good way to prevent monopolization of an industry is via taking legal actions, for example, in South Korea, a "Monopoly Regulation and Fair Trade Act" is introduced on 31/12/1980. The act was introduced to promote competition among firms and to protect the consumers in the country, hence providing the country a stable and balanced development o economics. Under this act, any company that attempts to combine with another company, regardless the process is done through merging, acquisition of stocks, business take-over, or any other method would be considered as breaking the law and legal actions would be taken by the government. This particular government policy would have a great effect on stopping markets to develop into oligopoly market or a monopoly market, however, in some cases the government actually gave a company the power to monopolize the business. In Malaysia, an electricity supplying company called Tenaga National Berhad (TNB) was appointed by the government to be the only official electricity supplier in the country, this was due to the high entry bounty and maintenance fees to run an electricity supplying company, companies other than TNB were unable to bear the high cost and hence the government appointed TNB as the only electricity supplier in the country and subsidy was provided to the company to reduce the cost. Of course in this case another law called price ceiling was applied to control the price of electricity bills in the country, and to prevent exploitation of the company on the residents in the country.

Government Policies

Price Control

Price control is government interference in markets in which lawful restrictions are located on the prices charged. The two primary forms of price control are price floor and price ceiling. Price ceiling is a legal maximum on the price at which a good be sold. Price floor is a legal minimum on the price at which a good can be sold. Price controls enforced on an otherwise proficient and competitive market create imbalances (shortage or surplus) which leadineffectiveness. However, enforcing price controls on a market that fails to reachproficient (due to public goods, externalities, or incomplete information) can actual riseefficiency. Price controls have widely used to decrease inflation in economy.

-Price Ceiling

Figure 8.1

Pricing and quantity effects of a binding price ceiling on Rental

From the figure 8.1, an equilibrium, Eo is occurs when supply curve intersects with demand curve in the free market. The initial price on rental is Po and quantity is Qo when the equilibrium is occurs. Rental control is a price ceiling on rent.

According to rental control in New York, when the government enforced maximum price is lower than market's equilibrium price, as shown by the binding price ceiling in figure 8.1. Graphically, the price of rental decrease from Po to P1. Sellers can no longer charge the price the market demands but are forced to meet the ceiling price set by the government.

A ceiling price can make sellers away from the market (decreases the supplied resources), while the lower price increases the consumer's demand. Hence, the quantity of supply reduces from Qo to Q1 while the quantity of demand increases from Qo to Q2. When DD>SS, the ceiling is a binding constraint on the price and causes a shortages. A number of consumers willing to experience a long line for the product when they need to purchase. Sometimes governments merge price ceilings with government rationing programs to ensure the market will allocate the supply of goods efficiently.

-Price Floors

Figure 8.2

Pricing and quantity effects of a price floor on Wage

Minimum Wage is approaching record lows in the United States. If no one earns any money except for one person, who earns all of the money, then the income distribution would be perfectly unequal. Governments make an effort to stop the poor from getting poorer, and the rich from getting richer in order to achieve an equilibrium in income distribution. Minimum wage laws have its greatest impact on the market for unskilled workers.

Minimum Wage is one of the price floors in market. Minimum wage laws establish the lowest price of wages that all employers must pay for labor. The quantity of supplied labor is higher than the quantity demanded in the traditional minimum wage model. According to the figure 8.2, Minimum wage, P2 is above equilibrium price, Po and quantity, Qo when supply curve intersect with demand curve. Labor supplied and labor demanded can be prevented from shifting toward equilibrium price and quantity. Hence, surplus is occurs between quantity of demand, Q1 and quantity of supply, Q2. Minimum wage levels become the price floor and wages cannot fall below the floor price.


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