Understanding Economics (11)-Market Failure |05 March 2008
It is not necessarily a physical location and the interaction between the sellers and buyers may not need to be face-to-face for a transaction to take place. Ideally, in view of limited economic resources, their allocation and production should be done in the most efficient manner. This implies that production cost is at a minimum and the price levied not only maximises profit but also consumer welfare. When the allocation and production of a good or service is not allocatively and productively efficient, this is referred to as market failure.
In such a situation, economic efficiency is not optimised. An example could be a monopoly condition where the firm fails to provide the right amount of its goods or services to meet consumer demand at the price where the quantity on offer (supply) is equal to the amount consumers are willing and able to buy (demand).
Due to the fact that optimal allocation of scarce resources (land, labour, capital and entrepreneurship) is not attained, market failure situations are not ideal in an economy since it implies some wastage of resources.
A market may fail due to the degree of market power of operating firms. With market power, a firm is normally able to cut back production in order to drive up prices and increase profits. When this arises, insufficient levels of goods or services are produced in a non-competitive market and sold at above optimum price. In a market where each individual firm does not have enough power to maximise profit by raising price level, increasing the volume of output may be the desirable option. However, this may lead to a situation where too many goods or services are being produced in a competitive market.
Market failure may also be associated with the impact of an economic activity on firms or individuals not directly participating in the market. These are called externalities and are when the market ignores the costs imposed on society by, for example, a firm which is polluting the environment. Externalities in such a context are harmful side effects which are viewed in the form of a cost. In some cases, the actions of an individual or firm can have externalities which are native to the methods of production, type of good or other conditions important to the market.
The characteristics of certain goods and the nature of their exchange may also result in market failure. As an example, a public good or service provides a benefit to the general population. Nobody can be excluded from consuming it whether that person pays for it or not. This means that it is almost impossible for the supplier to make a profit because there is no effective control on who consumes the product. A classic example of such a good is street lighting. All drivers and pedestrians will benefit from using it and would be willing to pay for it, but once it is in place, there is no way of excluding non-payers. Rationally, self-interested people would not be willing to pay for something they can get for free. Therefore, no profit seeking firm would offer a good or service in such nature. Other examples of public goods are police services, defence and road network. Public goods are hence offered by the government with the underlining cost being financed from government revenue.
Another type of goods which is normally provided by a government is what is called merit goods. These refers to goods that when consumed generate positive externality effects and the social benefits exceeds the private cost incurred. Examples of merit goods are health services, education and public libraries. They are characterised as those goods that if not supplied by the public sector will result in an undesirable under-consumption although they may be provided by both the public and the private sectors.
In some cases, the government is able to correct the distortions created by market failures and improve the efficiency in the way that market operates. However, this does not necessarily imply that the government should attempt to solve this problem although certain situations may call for government intervention.
Moreover, there are disagreements as to whether the government should intervene and if its interventions are successful.
When the government does intervene, there are many different types of policies that may be employed to correct market failure, and this may be in the form of: (1) Regulation, (2) Financial Intervention, (3) State production, and (4) Income and other transfers. Such issues will be discussed further in the next article.
Contributed by the Central Bank of Seychelles. E-mail: cbs@seychelles.sc
