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MARKET FAILURE

Market Failure

What is market failure?

Market failure occurs when freely-functioning markets, fail to deliver an efficient allocation of resources. The result is a loss of economic and social welfare. Market failure exists when the competitive outcome of markets is not efficient from the point of view of society as a whole. This is usually because the benefits that the free-market confers on individuals or businesses carrying out a particular activity diverge from the benefits to society as a whole.

There are many instances when the free market fails to deliver an efficient allocation of resources.

Market failure results in

• Productive inefficiency: Businesses are not maximising output from given factor inputs. This is a problem because the lost output from inefficient production could have been used to satisfy more wants and needs

Allocative inefficiency: Resources are misallocated and producing goods and services not wanted by consumers. This is a problem because resources can be put to a better use making products that consumers value more highly

CAUSES OF MARKET FAILURE

Markets can fail because of:

1.     Negative externalities (e.g. the effects of environmental pollution) causing the social cost of production to exceed the private cost.

2.     Positive (or beneficial) externalities (e.g. the provision of education and health care) causing the social benefit of consumption to exceed the private benefit

3.     Imperfect information means merit goods are under-produced while demerit goods are over-produced or over-consumed

4.     The private sector in a free-markets cannot profitably supply to consumers pure public goods and quasi-public goods that are needed to meet people’s needs and wants

5.     Market dominance by monopolies can lead to under-production and higher prices than would exist under conditions of competition

6.     Factor immobility causes unemployment hence productive inefficiency

7.     Equity (fairness) issues. Markets can generate an ‘unacceptable’ distribution of income and consequent social exclusion which the government may choose to change

HOW MARKET FAILURE CAN BE CONTROLLED?

Options for government intervention in markets

There are many ways in which intervention can take place – some examples are given below

Government Legislation and Regulation

Parliament can pass laws that for example prohibit the sale of cigarettes to children, or ban smoking in the workplace.

The laws of competition policy act against examples of price-fixing cartels or other forms of anti-competitive behaviour by firms within markets.

 Employment laws may offer some legal protection for workers by setting maximum working hours or by providing a price-floor in the labour market through the setting of a minimum wage.

Regulation may be used to introduce fresh competition into a market – for example breaking up the existing monopoly power of a service provider.

Fiscal Policy Intervention

Fiscal policy can be used to alter the level of demand for different products and also the pattern of demand within the economy.

1.     Indirect taxes such as changes in VAT and excise duties can be used to raise the price of demerit goods and products with negative externalities designed to increase the opportunity cost of consumption and thereby reduce consumer demand towards a socially optimal level.

2.     Subsidies to consumers will lower the price of merit goods such as grants to students to reduce the internal costs of staying on in full-time education and subsidies to businesses employing unemployed workers on the New Deal programme. They are designed to boost consumption and output of products with positive externalities – a subsidy causes an increase in market supply and leads to a lower equilibrium price (see the separate revision focus article on producer subsidies).

3.     Tax relief: The government may offer financial assistance such as tax credits for business investment in research and development. Or a reduction in corporation tax designed to promote investment and employment.

4.     Changes to taxation and welfare payments can be used to influence the distribution of income and wealth – for example higher direct taxes on rich households or an increase in the value of welfare benefits for the poor to make the tax and benefit system more progressive.