Market Failure

What is market failure?
Economists have assumed for many years that if the market is left to operate freely the result will be an optimal level of output. That is, the point of “equilibrium” will also be the point at which the greatest number of people achieve the highest level of satisfaction.

Today, we can see that there are certain circumstances in which this is not true. We call these circumstances “market failures” – the time at which the market mechanism does not produce the optimal level of output. In other words, the market fails to allocate resources efficiently.

Types of market failure
There are four different types of market failure that will be studied in our course. Each requires a unique reaction from the policy makers, so it is important that the right type of failure is identified:

1. Market Power: In a market that is operating freely it is possible that one firm (or a small group of firms) may come to dominate. In this case, they may have more power than the market can bear, and as such operate inefficiently. This is true of both monopolies and oligopolies. In these cases firms may well reduce their output to artificially create shortages, and therefore increase the price to maximise their profits. In Australia monopolies (such as Australia Post) are carefully regulated, but this is not true on a world scale. For example, the oil cartel in the Middle East does have a lot of market power over the production of oil and the subsequent price.
2. Public Goods: Some goods are in very high demand, but even so they will not be produced by the free market. The reason is that in producing the goods it will be impossible to exclude those who do not pay. For example, imagine that only some people were willing to pay for a defence force. It would not be feasible for the army to be defending our shores, only to turn around and say “Wait a minute! This guy didn’t pay – they can have his house”. As such, the defence force is maintained by the government. Other examples include street lights and the police force.
3. Merit Goods: Some goods and services are highly desirable. It is felt that all people should have access to them, and as such even though they are provided by the free market the total level of demand is not satisfied. The best example is schools, but others include hospitals, museums and libraries. The government will aim to make these things available to all by either providing them or by subsidising existing facilities. In this way the cost is reduced, and access is more widely available. (Even private schools are subsidised by the government – without that money fees would be much higher.)
4. Externalities: In a free market, the firm will measure the cost of production against the benefits of production mainly in terms of money. If there is an opportunity to make a profit, then the firm will commence production. However, this will not always produce the best output for society as a whole. Externalities are the side effects of production (or of consumption). They occur because the operation of the free market encourages people and businesses to look at the small scale picture, rather than a more global view. The most obvious example is pollution, but there are many more.

A negative externality occurs when the social cost is greater than the private cost. In this case, the product is said to be over-produced.

In this case, the optimal level of output is at point Z. At this point the marginal social cost is equal to the marginal social benefit. However, actual production will be at point Y, and so the item is being over produced and a negative externality results. The social cost of this item is higher than we would like.

The government responds by trying to move the MPC curve up to meet the MSC. This can be done either by legislating to reduce output, or by taxing the firm in the hope of increasing their private costs.

It should be noted that there are also positive externalities. This happens when the marginal private benefit is lower than the marginal social benefit. In this case, the government will aim to provide subsidies to producers or consumers.

Types of Externality

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