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What is Market Failure?

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What is Market Failure? Market failure is the inability of an unregulated market to achieve allocated efficiency in certain circumstances. There are various reasons why allocated efficiency may not be achieved and these include factors such as public goods, immobility of factors with time lags in response, imperfect information, inequality, market power and externalities. There is a clear economic case for government intervention in markets where some form of market failure is taking place. Government can justify this by saying that intervention is in the public interest. There are two types of efficiency that we will briefly consider. These are allocated efficiency, which occurs when resources are distributed in such a way that no consumers could be made better off without other consumers becoming worse off, and productive efficiency, which is achieved when production is carried out at its lowest cost. Public Goods Certain goods and services would not be provided without the intervention of the government. We cannot perhaps imagine this country without a legal system, defence forces, schools, roads and health services but all of these goods and services are provided largely by the government although there are elements now of the private sector in each category. ...read more.


The government normally chooses to tax those products that generate negative consumption externalities. Such examples include cigarettes and alcohol. Externalities An externality is said to exist when the production or consumption of a good directly affects businesses or consumers not involved in the buying or selling of it and when those spill over effects are not reflected in market prices. The spill over effects are known as external costs or benefits. Externalities can cause market failure if the price mechanism does not take into account the full social costs and social benefits of production and consumption. The study of externalities by economists has become extensive in recent years - not least because of the concerns about the link between the economy and the environment. Externalities create a divergence between the private and social costs of production. Social cost includes all the costs of production of the output of a particular good or service. We include the external costs arising, for example, from pollution of the atmosphere. SOCIAL COST = PRIVATE COST + EXTERNALITY An example of this is when a chemical factory emits wastage as a by-product into nearby rivers and into the atmosphere. ...read more.


One solution may be to extend property rights to define who owns property, what use it can be put to, the rights other people have over it and how it may be transferred. Individuals may be able to prevent other people imposing costs on them. Not only the above mentioned but taxes and subsidies and subsidies can play an important role as well. Assume a chemical firm in the course of production pollutes the atmosphere. In the diagram below the firm produces Q1 where P = MC, but takes no account of the external costs imposed on society. If the government imposes a tax on production equal to the marginal pollution cost the firm will internalise the externality. The firm will now maximize profits at Q2, which is the socially optimum output where MSB = MSC. If the government want to fully correct the market failure then the amount of the tax needs to be equivalent to the external costs. This would then shift the supply curve to be identical to the marginal social cost curve and correct the market failure. In practice this is very difficult as it can be a problem quantifying the value of the external costs. 04/05/07 Page 1 of 6 ...read more.

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