What causes market failure?
Market failure occurs when free markets are unable to allocate resources efficiently. Market failure causes economic and social welfare loss.
the following are identified as causes of market failure
1) Negative externalities- the negative effects of third parties that are not directly involved in an economic transaction. Negative externalities cause the social cost of production to exceed the private cost of production eg pollution.
2) Positive externalities- this is when the social benefit of consumption exceeds the private benefit such as the provision of education.
3) Imperfect information - leads to the over consumption of demerit goods and merit goods being under produced.
4) The private sector unable to supply important pure public and quasi-public goods
5) Market dominance known as monopolies - may lead to under production or higher prices would exist
6) Immobility of factors of production- this causes unemployment and thus leading to productive inefficiency.
7) Equity- Markets can cause distribution of income which leads to social exclusion.
Market failure also occurs when one of the three functions of price break down (see chapter on markets)
the functions of price include
1)Signalling;
2) Transmission of prices
3) Rationing function
the following are identified as causes of market failure
1) Negative externalities- the negative effects of third parties that are not directly involved in an economic transaction. Negative externalities cause the social cost of production to exceed the private cost of production eg pollution.
2) Positive externalities- this is when the social benefit of consumption exceeds the private benefit such as the provision of education.
3) Imperfect information - leads to the over consumption of demerit goods and merit goods being under produced.
4) The private sector unable to supply important pure public and quasi-public goods
5) Market dominance known as monopolies - may lead to under production or higher prices would exist
6) Immobility of factors of production- this causes unemployment and thus leading to productive inefficiency.
7) Equity- Markets can cause distribution of income which leads to social exclusion.
Market failure also occurs when one of the three functions of price break down (see chapter on markets)
the functions of price include
1)Signalling;
2) Transmission of prices
3) Rationing function
So why is market failure an issue?
Market failure results in productive inefficiency this is because businesses are not maximising output from given factor inputs. This is a problem because the lost output from the inefficient production could have been used to satisfy more needs and wants.
Key terms
Externalities
costs or benefits that spill over to third parties external to a market transaction Marginal private costs The cost to an individual or firm of an economic transaction Marginal external cost The spillover cost to third parties of an economic transaction |
Key termsMarginal social cost the full cost to society of an economic transaction, including private and external costs. Marginal private benefit the benefit to an individual or firm of an economic transaction Marginal external benefit the spillover benefit to third parties of an economic transaction Positive externality a positive spillover effect to third parties of a market transaction Marginal social benefit the full benefit to society of an economic transaction, including private and external benefits |
Reasons for government intervention
Positive externalities
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Government Intervention
The following are examples of government intervention; taxes, subsidies, laws and regulatory bodies. The government uses these to correct market failure.
Taxes and subsidies
Used to achieve to main purposes
a) to achieve greater social efficiency by altering the distribution of production and consumption.
b) redistribute income
when imperfections in markets exist such as those mentioned above, taxes and subsidies can be used to correct these imperfections.
The approach is to tax those goods and services that are being over produced, and subsidise those goods and service that are being underproduced.
Taxes and subsidies are one means of correcting market distortions. Externalities can be corrected by imposing tax rates equal to the size of the marginal external cost, and granting rates of subsidy equal to marginal external benefits. Taxes and subsidies can also be used to affect monopoly price, output and profit. Subsidies can be used to persuade a monopolist to increase output to the competitive level. Lump-sum taxes can be used to reduce monopoly profits without affecting price or output. Taxes and subsidies have the advantages of ‘internalising’ externalities and of providing incentives to reduce external costs. On the other hand, they may be impractical to use when different rates are required for each case, or when it is impossible to know the full effects of the activities that the taxes or subsidies are being used to correct. An extension of property rights may allow individuals to prevent others from imposing costs on them. This is not practical, however, when many people are affected to a small degree, or where several people are affected but differ in their attitudes towards what they want doing about the ‘problem’. Laws can be used to regulate activities that impose external costs, to regulate monopolies and oligopolies, and to provide consumer protection. Legal controls are often simpler and easier to operate than taxes, and are safer when the danger is potentially great. However, they tend to be rather a blunt weapon. Regulatory bodies can be set up to monitor and control activities that are against the public interest (e.g. anti-competitive behaviour of oligopolists). They can conduct investigations of specific cases, but these may be expensive and time consuming, and may not be acted on by the authorities. The government may provide information in cases where the private sector fails to provide an adequate level. It may also provide goods and services directly. These could be either public goods or other goods where the government feels that provision by the market is inadequate. The government could also influence production in publicly owned industries. Government intervention in the market may lead to shortages or surpluses; it may be based on poor information; it may be costly in terms of administration; it may stifle incentives; it may be disruptive if government policies change too frequently; it may not represent the majority of voters’ interests if the government is elected by a minority, or if voters did not fully understand the issues at election time, or if the policies were not in the government’s manifesto; it may remove certain liberties.
Taxes and subsidies
Used to achieve to main purposes
a) to achieve greater social efficiency by altering the distribution of production and consumption.
b) redistribute income
when imperfections in markets exist such as those mentioned above, taxes and subsidies can be used to correct these imperfections.
The approach is to tax those goods and services that are being over produced, and subsidise those goods and service that are being underproduced.