Identify the four major sources of market failure.
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. To ease them from this difficult state, an economist and sociologist called Vilfredo Pareto, postulated a benchmark criterion to help, namely the Pareto criterion. Later in the paper I will use Pareto optimality interchangeably.
A) The Pareto Criterion
When people are making decision with the aim of making the whole community better off in general, they first have to know how to tell when this is achieved. As a rule of thumb, the community becomes better off if one individual becomes better off and none worse off. If this is the case, the Pareto optimality is not yet reached as for any given state (e.g. a distribution of a given quantity of goods) is Pareto optimal, and thus efficient, if and only if there is no feasible alternative state achievable (e.g. no feasible alternative distribution of those goods) in which at least one person is better off and no one is worse off. This can be illustrated by Figure 3.1. It shows the contract curve which joins the two origins (OAOB). A contract curve shows all efficient allocations of goods between consumers A and B in the Edgeworth Box Diagram showing the possible allocations of clothing and food between A and B. The points of efficient allocations of goods between the two consumers are in fact where the indifferent curves of the two consumers are tangent to each other. Any points that are not on the contract curve (such as H and I) are not Pareto optimum since the two consumers can always move to a point on the contract curve where at least one of the consumers is better off without making the other worse off.
Figure 3.1
B) Conditions for Pareto Optimality
In order to achieve the Pareto optimality, the very first prerequisite is a competitive market. We will see how this is the case later but for the time being, we just take it for granted. Besides, there are several other conditions that need to be fulfilled.
a) Efficiency in Exchange
We have seen from the previous assignments that equilibrium is achieved when the consumers' indifference curves are tangent, therefore falling on the contract curve (please refer back to Figure 3.1). This is where both A and ...
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Figure 3.1
B) Conditions for Pareto Optimality
In order to achieve the Pareto optimality, the very first prerequisite is a competitive market. We will see how this is the case later but for the time being, we just take it for granted. Besides, there are several other conditions that need to be fulfilled.
a) Efficiency in Exchange
We have seen from the previous assignments that equilibrium is achieved when the consumers' indifference curves are tangent, therefore falling on the contract curve (please refer back to Figure 3.1). This is where both A and B's marginal rates of substitution between the goods are the same and this brings us to the first condition for Pareto optimality. As in Figure 3.1, Pareto optimality happens at D, E and G where
MRSACF = MRSBCF
This is so because if they have different MRS, they can trade with each other to obtain higher satisfaction in general.
In a competitive market, as in Figure 3.2 where both consumers are on his/her highest indifference curve tangent to the budget line and the price ratio of C and F. The previous condition in a competitive market is written as
MRSACF = PC/PF = MRSBCF
where optimality happens at point A. In both cases, neither consumers A nor B can obtain more of C or F without the other partner losing any with further exchange.
Figure 3.2
b) Efficiency in Factor Use
The two conditions above are analogous to factor use in production process. When deciding the usage of different inputs, maximum efficiency is said to have been achieved when the maximum level of output can be produced with a set of inputs. The major concern here is the possibility of moving a firm to a higher isoquant without lowering the isoquant of another firm. If there is no alternative as such, the Pareto optimum is achieved by equating the marginal rates of technical substitution of the two inputs (labour and capital) when producing C and F.
MRTSCLK = MRTSFLK
This condition will lead to either E, G or H on the production contract curve as in Figure 3.3. In this case, D is not Pareto optimality since there is always a point between E and G where the productivity of either C or F can be increased without hurting the productivity of the other good.
Figure 3.3
Same case as in the exchange situation, when the production process is within a competitive market, profits can be maximised with input level such that MRTS equals price ratio of inputs.
MRTSCLK = w/r = MRTSFLK
c) Efficiency in Production
When talking about efficiency in output, we cannot leave alone customer demand. The most ideal situation is which the consumers are on the highest indifference curves tangent to the budget line and the producers are on the production possibility curve. Since the slope of the production possibility curve represents the marginal rate of transformation (substituting the production of F for C), to achieve equilibrium between producers and consumers, the Pareto optimality says that
MRSACF = MRSBCF = MRTCF
This is graphically presented in Figure 3.4 where MRSCF carries the same slope as MRTCF.
Figure 3.4
Again, thing looks a bit different in competitive market where MRS (consumers) and MRT (producers) equal price ratio of both goods. Producers choose to produce such that price equals marginal cost which is also the MRT, therefore, under competitive market,
MRSACF = MRSBCF = PC/PF = MCC/MCF = MRTCF
Understanding the conditions for achieving 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. The other holds true for positive externality when not all of the benefits are considered. Prices would tend to be too high resulting in too few of them being consumed and produced.
Figure 3.6
Externalities also cause private marginal benefits or marginal costs to differ from social ones. Negative externalities in production (e.g., pollution) result in some trades occurring for which MBSOCIAL < MCSOCIAL, because private marginal costs do not reflect the external costs: MCPRIVATE < MCSOCIAL (as shown in Figure 3.6). If the cost of externality is taken into consideration, the equilibrium should occur at point A. However, since most people just ignore social cost, the equilibrium becomes point B where more quantity of a product is being produced and consumed at a lower price. The efficiency rule is not followed.
Positive externalities in production or consumption prevent some trades from occurring for which MBSOCIAL ??MCSOCIAL, as people fail to capture all the benefits of their activities and, thus, receive insufficient incentive to produce (MBPRIVATE < MBSOCIAL). As in Figure 3.7, equilibrium when social benefits are considered happens at point A with Q2P2. When these are being neglected, equilibrium is at point B. Obviously there is room for a higher level of production with a higher price.
Figure 3.7
C) Public Goods
Another market failure is the under-provision of public goods. Public goods have two defining characteristics. First, once a public good is provided for a group of people, there is no additional cost associated with it being enjoyed by an additional individual or group of individuals. This characteristic is known as non-rivalry. The second defining characteristic of public goods is that once they are provided for one person, it is difficult, if not impossible, to prevent their enjoyment by other people. This means that a person or firm will not be able to make a profit because s/he cannot effectively control who gets the product. In a free market, this product will not be produced at all in the first place. Rationally self-interested people would not continue to pay for something they can get without having to pay for it. This is called a "free rider" problem. Therefore, no profit-seeking firm would produce it and normally government will take charge in providing these kinds of goods. This results in a free market under providing these kinds of goods, if producing them at all.
If a good is non-excludable, a private provider of a good cannot capture the benefits arising from that good's consumption because he cannot receive revenue. Thus, the good is not produced, and trades do not occur (the good is not consumed) even though MBSOCIAL ? MCSOCIAL, because revenues (= MBPRIVATE), being zero, are less than the marginal benefits to society (0 = MBPRIVATE < MBSOCIAL). If a good is non-rival, the consumption of one consumer will not affect the consumption of the other consumers in the market, the marginal cost of providing the good to one more consumer is zero, yet a private firm must charge a positive price. Thus, some efficient trades do not occur because the price to consumers (= MCPRIVATE), being positive, is higher than the marginal social costs incurred (MCPRIVATE > MCSOCIAL = 0). Thus, the positive price inhibits efficient consumption of the non-rival good. Also, because the benefits from a public good enjoyed by any individual are almost always less than the cost of producing the public good (e.g. infrastructure), the market does not provide them. This obligation then falls to the hand of the government. However, it will be over-generalising the picture if we conclude that all goods provided by the government are public goods. A public good has to fulfill at least one of the characteristics described above and a pure public good should fulfill both.
"Externalities" and "public goods" are really different ways of describing the same problem. A positive externality is a public good; a negative externality is a "negative" public good and refraining from producing it is a positive public good.
D) Asymmetric Information
Another market failure stems from the market's inadequate provision of information. In most cases, especially in a competitive market where perfect information can be obtained readily, most people find enough information to make good buying decisions because price gives an accurate signal as to the quality of the product. However, there can be exception under which the market will not provide the information consumers need to make good choices. Some sellers of goods and services (used car dealers or banks) know better about the products than the buyers and may not voluntarily disclose important information about what they are selling. Normally this situation is referred to as market for lemons. In this case, price is no longer a reliable source to accurately evaluate the quality of the product. Because of the lack of available information, consumers are likely to over-consume or under-consume the good because they are not aware of its true costs and/or benefits. For example, in the used car industry where buyers have limited information, they will just presume a 50-50 chance of getting a value-for-money car. So they will pay an averaged out price (of the price for a good quality car and that for a low quality one). 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. REFERENCES
. JOHNSON, A., (1995), Microeconomic Theory and Applications, London: SOAS, University of London (Course Material)
2. ESTRIN, S., LAIDER, D., (1995), Introduction to Microeconomics, 4th Edition, New Jersey: Prentice-Hall, Inc.
3. PINDYCK, R.S., RUBINFELD, D.L., (2001) Microeconomics, 5th Edition, New Jersey: Prentice-Hall, Inc.
EP101 Microeconomic Theory and Applications Assignment 3 1
Connie Loi Kim Ieng
IND01535
