Lecture on Market

Failure by Mr BOOLAKY
MANISH
CAUSES OF MARKET FAILURE
1. NO PROVISION OF PUBLIC GOOD
A pure public good like roads and street lightings are non-
excludable ,non rivalrous and non rejectable. Given that such
obey the principle of non-exclusion,i.e,they can be consumed by
both those who pay and those who do not pay explains why such
goods are not provided by the private sector. The latter is not
interested in supplying a product which can be consumed by
free riders . Since the market fails to have a mechanism to
ensure the provision of such goods, everyone sits back wait for
someone who is foolish enough to provide such goods. For
example, the services of a street lightings may be enjoyed by all
pedestrians. Thus resources will not be diverted towards the
provision of public goods because no direct charge can be made
for such goods. Thus the market fails.
RECAPTULATION OF SOME ASPECT ON COSTS AND
BENEFITS
 SOCIAL COST-All cost to the society (social cost = private cost + external cost)
 PRIVATE COST- Cost borne by the owner-eg : cost of production,wages (PC=SC-EC)
 EXTERNAL COST-Cost affecting the third party,i.e those not directly involved in the project eg:
pollution traffic congestions (EC=SC-PC)

 SOCIAL BENEFIT-All Benefit to the society (social Benefit = private Benefit + external Benefit)
 PRIVATE BENEFIT -Benefit borne by the owner-eg : profit ,reputation, votes(PB=SB-EB)
 EXTERNABENEFIT-Benefit to the third party, i.e those not directly involved in the project eg: job
creation provision L of goods , infrastructural development (EB=SB-PB)
MARGINAL OF COSTS AND BENEFITS

MSC – MARGINAL SOCIAL COST- the additional cost to the society of producing an additional good or service
MPC – MARGINAL PRIVATE COST- the additional cost to the owner of producing an additional good or service
MEC – MARGINAL EXTERNAL COST-additional cost to the third party of producing an additional good or service

MSB – MARGINAL SOCIAL BENEFIT- the additional benefit to the society of producing an additional good or
service
MPB – MARGINAL PRIVATE BENEFIT- the additional benefit to the owner of producing an additional good or
service
MEB– MARGINAL EXTERNAL BENEFIT-additional benefit to the third party of producing an additional good or
service

Efficiency is achieved where MSB=MSC

2.UNDERCONSUMPTION OF MERIT GOODS
Merit goods like education and healthcare are those goods which are widely considered as
desirable by a society. A merit good is an essential product that improves the welfare of the
population .It has positive effect on consumers and considered to have external benefits. For
example, education does not only benefit the learner but the society at large. When there are
better educated and trained persons, the entire society will gain. However, the problem is that
consumers lack information about the extent to which these goods are beneficial to them. It
generates benefits far in excess of what they realise they themselves perceive.Hence,there is an
under consumption because of the lack of information.

Efficiency is
E1 achieved
where
E
MSB=MSC
The efficiency point is at E1 where MSC=MSB i.e. at output Q1.
However due to lack of information, people consume at MSC=MPB
(E), i.e. at output at Q as they tend to under estimate the real
benefits of such goods and finally take into consideration only
private benefits and ignore the external benefits of consuming
such goods. Thus there is an under consumption of Q1-Q.
3.OVERCONSUMPTION OF DEMERIT GOODS

Demerit goods are those which are widely considered as undesirable by a society. A demerit good is
a harmful product that has adverse effect on the welfare of the population .It has negative effect
on consumers and considered to generate external costs. For example, smoking does not only harm
the SMOKER but the non smokers also at large. However, the problem is that consumers lack
information about the extent to which these goods are harmful to them. It generates costs far in
excess of what they realize they themselves perceive.Hence,there is an over consumption because
of the lack of information.

E1
E1

E
The efficiency point is at E1 where MSC=MSB i.e. at output Q1.
However due to lack of information, people consume at MPC=MSB
(E), i.e. at output at Q as they tend to under estimate the real
harmfulness of such goods and finally take into consideration only
private costs and ignore the external costs of consuming such
goods. Thus there is an over consumption of Q1-Q.
4. ASYMMETRY OF INFORMATION
Asymmetry of information arises whenever buyers and sellers do not have the same information. The
existence of information failure or asymmetry of information leads to 2 types of problems commonly known
as:
1. Moral Hazard
2. Adverse Selection
Moral Hazard
This refers to a situation whereby a person does not have the appropriate information and seeks information
from others which he believes to be appropriate. For example, a person having a health problem and believes
in the prescription of the doctor which may not be necessarily right. This represents a waste of resources.
Adverse SELECTION
This arises whenever a person deliberately fails to disclose all information to other party.For example, a
person buying an insurance policy may not disclose all his health problems to the insurance company. This
will lead to a gain to the buyer and a loss to the seller.
5. FORMATION OF MONOPOLIES
The concentration of economic activities in few hands leads to a misuse of
resources and the exploitation of consumers. This is the case whenever
markets are dominated by monopolies. A monopoly refers to a situation
whereby there is a single firm producing a product having no close
substitutes. Monopoly usually leads to consumer exploitation with higher
prices and at times poorer quality with less variety. Also ,it also put
forward that monopolies do not produce at the minimum cost which is
productively inefficient. Also, it does not produce the right product at the
right price, thus it is allocative inefficient also.
6. GREATER INEQUALITIES IN THE REDISTRIBUTION OF INCOME

Over the last decades,economies are more and more market based
and there has been growing inequalities. Inequality in the
redistribution of income means that there is a large gap between the
incomes of individuals. The rich tend to become richer and the poor
poorer. An unequal distribution of income and wealth may result in
an unsatisfactory allocation of resources and can also lead to
alienation and encourage crime with negative consequences for the
rest of society
RECAPTULATION OF TYPES OF MAKET
FAILURE
1. NO PROVISON OF PUBLIC GOODS
2. UNDERCONSUMPTION OF MERIT GOODS
3. OVERCONSUMPTION OF DEMERIT GOODS
4. ASSYMETRY OF INFORMATION
5. FORMATION OF MONOPOLIES
6. GRETER INEQUALITY IN THE REDISTRIBUTION OF INCOME
GOVERNMENT INTERVENTION IN
DEALING WITH MARKET FAILURE
1. TAXES
Thus imposition of a
tax will shift supply
curve to the left
2.SUBSIDY
3.PRICE CONTROL
MAXIMUM PRICE
 A maximum price will be effective whenever it is imposed below the equilibrium as illustrated below
Minimum price
3.PERSUATION AND INFORMATION
4. REGULATIONS AND LEGISLATIONS
5.DIRECT PROVISION OF GOODS AND SERVICES
6. CONTROL OVER PATENTS AND LICENSES
7.NATIONALISATION
8. BEHAVIOURAL INSIGHTS AND NUDGE THEORY
 GOVERNEMENT FAILURE
IN CORRECTING MARKET
FAILURE
GOVERNMENT FAILURE
 Government intervention to resolve market failures, and to manage the
macroeconomy, can fail to achieve a socially efficient allocation of resources.
Government failure is commonly defined as a situation where government
intervention in the economy creates inefficiency and leads to a misallocation
of scarce resources.
 1.Distortion of the price mechanism
1.The effects of taxation
Intervention through taxation, through subsidisation, or via other interventions can
result in a distortion of markets and a weakening of the operation of the price
mechanism. Taxes and subsidies on goods and services can artificially raise or lower
prices and distort how markets work to allocate scarce resources.
Direct taxation can create a disincentive effect for households and firms. We have
seen that taxes on harmful demerit goods, where demand is inelastic, may simply
mean that more income is allocated to expenditure on harmful goods, and hence less
income is available for spending on beneficial goods.
Taxation can also distort behaviour by encouraging people to either avoid taxes
(which is the attempt to find legal loopholes in the tax system) or evade taxes (which
is illegal) through criminal activity such as smuggling and the use of black markets.
2.The effect of subsidies

Subsidies can be criticised as they can encourage the wasteful misuse or

over-use of scarce resources. For example, free healthcare can result in
doctors’ waiting rooms becoming become full with the malingerers and the
so-called ‘worried well’. This can result in a waste of public resources and
a denial of access to these services by those in genuine need.

Subsidies may also protect inefficient firms from open competition as well
as creating artificial barriers to entry for new firms – given that prices are
kept ‘artificially’ low. Subsidies, and other assistance, can lead to the
wider problem of moral hazard.
3. The effects of maximum price
Shortages, which may arise when government fixes price below the
market rate. Because public healthcare is provide free at the point of
consumption there will be long waiting lists for treatment
4. The effects of minimum price
Surpluses, which may arise when government fixes prices above the
natural market rate, as supply will exceed demand. For example,
guaranteeing farmers a high price encourages over-production and
wasteful surpluses. Setting a ‘minimum wage’ is likely to create an excess
of supply of labour in markets where the ‘market clearing equilibrium’ is
less than the minimum.
2.Costs of administration

Excessive bureaucracy is also a potential government failure. This is caused by

the public sector when it tries to solve the principal-agent problem. Government
must appoint bureaucrats to ensure that its objectives are pursued by the
managers of public sector organisations, such as the NHS.

Intervention through the imposition of taxes, or through legislation incurs various

administration costs. Taxes must be collected through government departments,
laws must be enforced through the legal system. Both of these incur considerable
costs.
3. The Law of Unintended Consequences
The law of unintended consequences is that actions of consumer and producers —
and especially of government—always have effects that are unanticipated or
"unintended." Particularly when people do not always act in the way that the
economics textbooks would predict.
The law of unintended consequences is often used to criticise the effects of
government legislation, taxation and regulation. People find ways to circumvent
laws; shadow markets develop to undermine an official policy; people act in
unexpected ways because of ignorance and / or error. Unintended consequences
can add hugely to the financial costs of some government programmes so that they
make them extremely expensive when set against their original goals and
objectives
4. Political self-interest
The pursuit of self-interest amongst politicians and civil servants can often lead to a
misallocation of resources.
For example decisions about where to build new roads, by-passes, schools and
hospitals may be decided with at least one eye to the political consequences.
The pressures of a looming election or the influence exerted by special interest
groups can foster an environment in which inappropriate spending and tax decisions
are made. - e.g. boosting welfare spending in the run up to an election, or bringing
forward major items of capital spending on infrastructural projects without the
projects being subjected to a full and proper cost-benefit analysis to determine the
likely social costs and benefits. Critics of current government policy towards tobacco
taxation and advertising, and the controversial issue of genetically modified foods
argue that government departments are too sensitive to political lobbying from the
major corporations.