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Identify the four major sources of market failure.

Extracts from this essay...

Introduction

I. INTRODUCTION Until now we all have seen how market acts as an invisible hand to maintain balance between suppliers and buyers when competition exists. We say that this type of market drives us to Pareto optimality where no one will be made better off without making the others worse off. This is a concept that will be discussed further in details. In general, where competition prevails, I believe that market works, that is, it takes us to Pareto optimality. However, when the pursuit of private interest does not lead to an efficient distribution of society's resources; situations where individual behaviour does not lead to Pareto efficiency, it is said that the market has "failed". Therefore, in this paper, I am going to identify the four major sources of market failure. To do so, I will start by explaining the conditions necessary for Pareto optimality and from which will bring to how each of the sources of market failure violates these requirements. One thing to note is that there are not only four sources of market failure. I will only focus on the four that were mentioned by Pindyck and Rubinfeld to keep it less complicated. As what I did in my previous assignments, I will derive my argument basing on several authors' publications, namely Estrin and Laidler, Pindyck and Rubinfeld, and the course materials. II. PARETO OPTIMALITY Many times, company owners or regional regulators find themselves caught in the middle when making decisions of whether the current situation is at best or if a decision can make the whole situation better off.

Middle

the Pareto optimality will help us identify the elements which prevent one from achieving it, what we generally call "the market failures". III. SOURCES OF MARKET FAILURE A) Market Power When firms have market power they tend to cut back production in order to drive up prices and increase profits (just as the case of monopolies discussed in the previous assignment). As we can see from Figure 3.5, demand is perfectly elastic at the point where MC equals to the market price in a competitive market, the equilibrium quantity is at QC at PC. However, if it is a monopoly or any situation where market power prevails, suppliers will produce at the point where MR equals MC. Figure 3.5 shows that this results in too few goods being produced in noncompetitive markets. It also means that income is concentrated in the hands of those who have market power at the expense of those who do not. Figure 3.5 B) Positive / Negative Externalities Free markets also fail to result in Pareto optimality when there are externalities, which occur whenever a person does not have to take all of the costs and benefits of an action into account in making a decision. When a person does not take all of the costs of an action into account, a negative externality will be resulted which will lead to under-pricing of the products and end up making and consuming too many of them.

Conclusion

The owners of the good quality cars will not sell at this low price and withdraw from the market, leaving the poor quality cars and all the buyers can get is then a higher price with a lower quality product. This does not fulfill the requirement of the Pareto optimality. The buyers could have bought the cars with lower prices were there perfect information. IV. CONCLUSION Normally we believe that market as a natural regulator results in Pareto optimality where no feasible alternative can be obtained to improve the status of one without degrading that of the others. However, there are also some exceptions where this optimality cannot be achieved. The prevalence of market power is one source. It results in less supply of a product at a higher price. This will not lead us to Pareto optimality. Free markets also fail to result in Pareto optimality when there are externalities, which results in variance between social benefit and private benefit, social cost and private cost. As in the case of public good, individuals can get benefits without paying the cost. The market will not produce it due to insufficient revenue resulted from the free-rider problem. Finally information asymmetry inhibits decision-making of the consumers due to the wrong signal provided by prices. They may judge wrongly the product they are buying because of the imperfect information obtained. Markets sometimes are not efficient alone and government plays an essential role in regulating and supplementing this inefficiency. The ideology of laissez-faire sometimes has to give way to reality. VI.

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