Market failure

Market failure occurs when resources in a free market economy are misallocated on allocated inefficiently.

Advantages of the market economic system:

• There is a wide variety of goods and services that will be produced as firms will constantly compete so they will invest more in research and development in order to get new and innovative products.

• There is quick responsiveness of changes in consumer tastes

• Profit motivation leads to firms developing new products and more efficient production methods. Here, most firms aim to make as much profit as possible to increase their sales at the expense of the rival products.

Causes of Market Failure:

Occurs when free markets fail to produce outcomes in terms of prices and quantity that are socially or economically desirable. Occurs when the market fails to produce the products that are in demand, in the right quantities and at the lowest possible cost. Caused by the externalities produced

Examples:

• Products that increase social welfare such as education and healthcare may be overpriced and underproduced

• Products that reduce social welfare because they create pollution/harm to the environment may be underpriced and overproduced.

• Private Costs: the cost borne by those directly consuming or producing a product

• Private Benefits: the benefits received by those directly consuming or producing a product

• External Cost: Cost imposed on those who are not involved in the consumption and production of activities of others directly.

• External Benefits: benefits enjoyed by those who are not involved in the consumption and production of goods of activities of others directly

• Externality: harmful or beneficial impact on third party due to the consumption and production of products without being directly involved.

• Social cost: private cost + external cost

• Social benefit: private benefit + external benefit

Consequences of Market Failure:

Public goods will not be provided:

Street lighting, policing and flood barriers are examples of public goods. Once these goods have been provided, it is impossible to exclude individuals from using it just because they haven't paid for it. It is impossible to charge individual customers a price according to how much they have used and benefited from public goods. Due to this reason, private firms will be unable to cover the costs of supplying the public goods because they will not be able to do so profitably.

Few merit goods will be supplied and consumed

Merit goods are under consumed and under produced. Healthcare and education are examples of merit goods because their provision is socially and economically beneficial. More the consumption of merit goods, the better it is. Supplying large numbers of healthcare and education can become really expensive. Private firms will only provide them if they are able to charge a high price for it, that cover their costs and earn them some profit.

Therefore, private firms are likely to produce merit goods for those who can afford to pay for these high prices because they are wealthy/earn high incomes.

Demerit goods will be over supplied and consumed

Demerit goods are over consume and over produced. Examples of demerit goods are cigarettes that can cause lung cancer. People who buy and consume cigarettes may not only be unaware to the damage they are causing to their own health but also the damage to the health of family members and to others who might breathe in their smoke (passive smoking). Private firms will be ready to supply goods and services to consumers who are willing to pay for them, even if the use or consumption is harmful to them and others. Similarly, drinking too much alcohol can cause antisocial behaviour. The consumers may not realise the cost they impose on others who may have to pay more taxes to the government to provide additional healthcare and policing. If the production and sale of demerit goods is profitable then private firms will supply them in the free market to the customers who are willing to buy it.

Exploitation of consumers and workers

Some large powerful firms in the free market may reduce the supply of a product to force up the market price the consumers must pay. If this firm becomes a monopoly then consumers will find it difficult to switch their demand to alternatives. Since consumers have no choice but to pay for it, it will leave them with less income to spend on other goods and services.

Similarly, some firms will pay the workers less in order to make profit and by providing them with unhealthy conditions to work in. It stops market from allocating resources with their most efficient use. Workers may be working in jobs they are not particularly skilled at, reducing efficiency and output. A monopoly is a market structure where only a single seller exists. They control market supply and prices. This leads to high priced and low quality products. It also leads to the humiliation of consumers.

Government intervention to address market failure:

Direct provision of goods

For example: investing into schools and hospitals and employing teachers, nurses and doctors to provide public education and healthcare. Many goods and services can be provided by the government - free of charge to consumers so that they are encouraged to use those products. Many state-owned enterprises have been created through this process called nationalisation: this occurs when a government takes over the ownership of a private sector or even complete industries. For example, train and bus services are nationalised.

Regulations

For example: capping the prices some large firms are able to charge for their product. People who fail to comply with regulations could have to pay fines. Regulations are used to control the forces of demand and supply in regulated markets to produce outcomes that are more socially desirable than those that would otherwise occur

Examples of regulations:

• Ban or restrict the production and consumption of demerit goods and products that create significant external costs

• To set minimum acceptable service standards including product safety and quality

Price controls

Are legal maximum or minimum prices set by the government in the markets for a certain product

Maximum Price:

Some private firms seeking to maximise their profit may attempt to exploit the consumers by charging them very high prices. To prevent this from happening, governments can cap the prices they can charge by setting a maximum prices the private firms cannot exceed. The maximum price of a product is below the equilibrium point

Minimum price:

Governments may force firms to charge higher prices for products that can cause excessive pollution. The people and the economy will be better off if fewer demerit goods are produced. It can help cut the demand for products that result in significant external costs when they are produced.

Indirect taxes

To raise the prices and reduce the consumption of some undesirable products such as cigarettes. Imposed on the producers/suppliers of specific goods and services. There is an additional cost of production that private firms must pay to the government. Therefore, the private firms will attempt to pass on this cost to the consumers by charging higher prices. However, this will result in the demand contracting, making their production less profitable.

Subsidies

Financial support provided by a government to private firms to reduce their cost of production and to encourage desirable activities. To reduce the cost of production of some desirable goods so that the private firm supplies more of them. Subsidies generate a lot of positive externalities. They are provided to increase the production of merit goods. The producer does not pass on the complete benefit of the subsidies onto the customers and keeps some profit to themselves.