Market Failure notes

Community surplus

When a market is in equilibrium, with no external influences and with no external effects, it is said to be in the state of Pareto optimality. Pareto optimality exists when it is impossible to make someone better off without making someone else worse off. It does not, however, mean that everyone is equal.

If a market is Pareto optimal, then it is said to be socially efficient. Social efficiency exists when community surplus is maximised. Community surplus is the welfare of the society and it is made up of a consumer surplus plus a producer surplus.

In this figure, we can see that the market is in equilibrium. At the equilibrium price and quantity the community surplus is maximised. Given the supply and demand situation, there is no other combination of price and quantity on the diagram that could give a greater community surplus. Thus the market is Pareto optimal/socially efficient, and there is and optimum allocation of recourses. No one could be made better off without making someone else worse off.

The supply curve is determined by the marginal costs of production and, since this is the marginal cost to the whole community, it is referred to as marginal social cost. The demand curve is determined by marginal utility (marginal benefit) and, since this is the marginal benefit to the whole community, it is known as marginal social benefit.

Market failure

In the “real world”, markets are not perfect. There are a number of things that prevent markets from being perfect and, therefore, from allocating resources in an optimal manner. If this is the case, then community surplus is not maximised and we say that this is a market failure. When markets fail, governments are often expected to intervene in order to attempt to eliminate the market failure and move towards the optimal allocation of resources.

Types of market failure

Imperfect competition

Monopolists, and other imperfect markets, restrict output in order to push up prices and maximise profits. ...

This is a preview of the whole essay

Market failure

Types of market failure

Imperfect competition

Monopolists, and other imperfect markets, restrict output in order to push up prices and maximise profits. Because of this, they are not producing at the socially efficient level of output. Any imperfect market will fail to equate MSC and MSB.

When community surplus falls from the maximum, we say there has been a welfare loss. This is because the units Q1-QE are not produced, even though the marginal social benefit is greater than the marginal social cost. The welfare loss is shown by the combination of the two triangles.

Governmental intervening

Governments may try to reduce this market failure by intervening in a number of ways.

They may use legal measures to make markets more competitive. They may pass laws that do not permit mergers or takeovers that give an individual firm more than a certain percentage of the market, e.g. 15%. In addition, they may pass laws that do not permit mergers or takeovers that enable a specified number of the largest firms in an oligopoly to control more than a certain percentage of the market, e.g. the four largest firms may be restricted to 60%.

They may set up regulatory bodies to investigate markets where it is felt that monopoly power is being used against the public interest. For example most countries have some sort of “Monopolies Commission” or “monopoly watchdog”. These bodies are then empowered to take action of some kind, or to recommend that the government should take action, if it can be shown that the public interest is being harmed.

Lack of public goods

Public goods are goods that would not be provided at all in a free market. Since they are goods that are of benefit to society, the lack of public goods in a free market is considered to be a market failure. Examples of public goods would be national defence and flood barriers. There is much debate over what actually a public good is and what is not. A number of goods often considered to be public goods could, in theory, be supplied by the free market to some extent, such as street lighting or lighthouses, and because of this, they are sometimes known as quasi public goods.

The reason that public goods will not be provided at all in a free market is that they have two characteristics – they are non-excludable and non-rivalrous. If a good does not have both of these characteristics, then it is not a public good. If a good is completely non-excludable and non-rivalrous, such as national defence and flood barriers, then it is called a pure public good.

A good is said to be non-excludable if it is impossible to stop other people consuming it once it has been provided. If a private individual erects a flood barrier to protect a house, the other people in the area will gain the benefit, even though they have paid nothing. This is known as the free-rider problem. Logically, no one will pay for a flood barrier, in the hope that someone else will do it. The good will not be provided by the free market.

A good is said to be non-rivalrous when one person consuming it does not prevent another person consuming it as well. If a person eats an ice-cream, then another person can not consumer that ice-cream as well. However, if one person is protected by a flood barrier, it does not stop other people from being protected at the same time. The private benefit from a flood barrier would be very small relative to the cost, although the social benefit to all of the people who were protected by it would be huge and probably greater than the cost. Thus there is no incentive for a private individual to erect a flood barrier.

Government intervening

Governments may try to reduce this market failure by intervening in a number of ways.

They may provide the public good themselves. This is usually the case with such things as national defence, flood barriers, roads, pavements, street lighting, and lighthouses. The use of taxpayers’ money to fund the provision spreads the cost over a large number of people who would not be prepared to pay individually.
They may subsidise private firms, covering all the costs, to provide the good.