Market Failure


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Market Failure

  1. 1. Market FailuresThe normative theory of market-failure predicts that regulation will be institutedto improve economic efficiency and protect social values by correction marketimperfections. Six types of market-failures are explained here: Natural monopoly,Externalities, Public Goods, Asymmetric information, Moral hazard, Transaction cots. Anyoneof these six failures legitimates regulation.Natural MonopolyA monopoly is natural if one firm can produce a given set of goods or services at lower cost thancan any other number of firms. A natural monopoly results when costs are decreasing in the scaleof a firm (economy of scale) or in the scope of its products or services (economy of scope). Innatural monopoly situations the monopolists will raise his costs and tariffs because he lakesincentives for efficiency and is interested in the maximization of profit.Before concluding that regulation is warranted under the natural monopoly rationale, twoquestions must be answered. The first is whether there are any natural monopolies, and if thereare, whether significant economic efficiency or social welfare would be gained by regulation.Economies of scale and scope certainly exist over some sets of goods and services, but theseeconomies can be exhausted at output levels that allow more than one supplier to persist in themarket. Empirical studies indicate, for example, that the large electric power plants in the UnitedStates have exhausted the achievable economies of scale. A natural monopoly can also result ifhaving more than one supplier would result in an uneconomical duplication of facilities. Localelectricity distribution systems within cities may remain a monopoly to avoid duplicate sets ofdistribution wires. This rationale does not necessarily apply in the telecommunications industry,since cable television and wireless communications systems provide alternatives to the local wireconnections.If there is a natural monopoly, it does not necessarily follow that there is substantial economicinefficiency. First, if entry into the industry is easy, the threat of potential competition may limitthe extent to which an incumbent monopolist can restrict output (and raise prices). Second amonopolist may choose to use a pricing policy, involving fixed charges and a low unit price,which can both increase profits and benefits consumers. Third, if there are a number of possiblesuppliers of a monopoly service, competitive bidding for the right to be the monopolist can beused to lower the supply price and increase economic efficiency. Similarly, an alternative to theregulation of the electric power industry is for communities to own the local distribution systemand bargain with power companies for the supply of electricity.
  2. 2. ExternalitiesFor information in Hebrew on Externalities double-click herePrivate market activities create so-called spillovers or externalities. They include any cost orbenefit not accounted for in the price of goods or services. A positive externality exists when aproducer cannot appropriate all the benefits of the activities it has undertaken. An examplewould be research and development that yields benefits to society (e.g., employment in industry)that the producer cannot capture. Thus, the producers incentive is to under-invest in the activityunless government subsidized or protect it. With positive externalities, too little of the good inquestion is produced. With negative ones too much is made. Negative externalities such as airpollution occur when the producer cannot be charged all the costs. Since the external costs do notenter the calculations the producer makes, the producer manufactures more of the good than issocially beneficial. With both positive and negative externalities, market outcomes need somekind of regulation to be more efficient.Public GoodsFor information in Hebrew on public goods double-click hereA pure public good is one whose consumption by one person does not reduce its availability forothers. When a person consumes a private good such as an apple, it is not available forconsumption by others. When a person consumes a good such as national defense or a radiobroadcast, however, the amount of the good available for consumption by others is notdiminished.For some public goods, such as national defense, bridges, and roads, government provision iscustomary. Public provision, however, does not imply that a good has the characteristics of apublic good. Many goods, such as public housing, food stamps, and solid-bank programs, areprovided by government for redistributive purposes rather than because they are public goods.Also, public goods can be supplied by the private sector. Radio and television broadcasts areprovided by private enterprises subject only to non-economic regulation.A fundamental problem with either private or public provision centers on the "revelation ofpreferences" for public goods. If those who benefit from a public good are asked to contribute anamount reflecting their valuations, an individual may decide to free ride on the payments ofothers. Because of the free-rider problem, public provision may be warranted. This, however,does not resolve the problem of determining the publics aggregate valuation of the good andthus whether it should be supplied. If individuals could be excluded from consuming the public
  3. 3. good the revelation and free-rider problem could be resolved - at least in principle. For example,not allowing satellite-dish ownership free reception of cable television induces customers to payfor the service.Fire protection has the properties of a local public good is typically supplied by municipalitiesand paid for by the taxes of the beneficiaries. It can be provided privately, though, if exclusioncan be practiced. Tim Emerson of Illinois learned this the hard way when his nearly completedhouse caught fire from a space heater. He called the Taylorville firefighters. They responded tohis call. When they got to the house, they asked if the house were covered by the fire protectionplan. Emerson, who had not paid the $25 fee, said, "No". The firefighters asked if there wereanyone inside. When Emerson replied "No", they drove away, letting the house burn to thegrounds.Asymmetric InformationIf people have different (private) information at the time they act, markets may not performefficiently, even when there are advantageous trades that could be made. Akerlof presents anexample of a sued car market in which each seller knows the value of the car she/he wants to sellbut the buyers known only the probability distribution of the values of the cars that might beoffered for sale. There is a potential buyer who is willing to buy each used car, but the buyercannot through causal inspection determine the value of any particular used car offered for sale.All he knows is that the car might be a lemon or might be of high quality.Because of this asymmetry of information, the maximum amount the buyer is willing to pay isthe average of the values of the cars believed to be offered for sale. Because buyers will only paythe average value, those potential sellers who have high-quality car then find that the amountbuyers are willing to pay is less than the values of their cars. They thus will not offer their carsfor sale. … This is clearly inefficient, because for every used car there is a buyer who wishes tobuy it if he only knew the true value.This phenomenon also occurs when sellers have incomplete information about customers.Insurance is, in principle, to provide coverage for individuals with similar risk characteristics.When those characteristics cannot be readily assessed, however, people with quite different risksare placed in the same pool. The higher risk individuals then have an incentive to buy insurance,which can drive up the price of insurance a cause some low-risk individuals not to buy insurance.Insurance companies respond to this adverse reaction by requiring a physical examination for lifeinsurance and basing auto insurance rates on accident and traffic citation records and on thenumber of years of driving experience.When market participation havincomplete information and acquiring information is co, marketsmay not function efficiently. The mandated provision of information through regulation maythen be warranted. Regulation may not be warranted in all situations involving asymmetricinformation, however. Information has value, so there is a demand for it. In the used carexample, a potential buyer may take the car to a mechanic for inspection. More generally,
  4. 4. individuals may invest in information acquisition or hire agents who are more knowledgeablethan they are.Information, however, can remain under-supplied because it is the self-interest of its possessornot to supply it. Manufacturers are understandably reluctant to release negative informationabout potential hazards associated with their products because doing so may reduce demand.Consequently, consumers may be poorly informed about hazards. Similarly, an employee may beincompletely informed about possible health and safety hazards in the workplace. In suchsituations, the liability system may serve as partial alternative to regulation.Moral HazardMoral hazard refers to the presence of incentives for individuals to act in ways that incur coststhat they do not have to bear. For example, in medical care, a fully insured individual has aneffectively unlimited demand for medical care, since she/he doesnt bear the cost of the care theyreceive. In addition, the individual may not have the proper incentive to take socially efficientpreventive measures, since she/he knows that the cost of any illness or accident will be coveredby insurance. Similarly, the provision of federally funded flood insurance encourages people tolive in areas prone to flooding and can lead to socially inefficient local decision.Regulation is one response to moral hazard problems, but regulation can also cause moral hazardmaking regulation itself less effective. In a controversial article Peltzman argued that theautomobile safety regulation induced drivers to take more risks, thus reducing the effectivenessof mandatory safety standards.The principal means of dealing with moral hazards is to structure incentives so that the inducedbehavior is taken into account. In the case of medical insurance, co-payments can be requiredand reimbursement limits imposed. Moral hazard can also be addressed by monitoring thebehavior of individuals to increase the likelihood that they take proper care. Fine for not wearinga set belt is an example of monitoring.Transactions CostsMarket failures can also result from costs associated with making market transactions. To theextent consumers and producers incur costs in becoming informed about market opportunitiesand completing market transactions, markets will not perform efficiently. Regulation to reducethose transactions costs then can improve efficiency. For example, in the auto industry globalauto emissions standards can enhance efficiency, as auto producers would not have to producedifferent models for different states.
  5. 5. As an example, a common problem in markets is the incentive for sellers to shirk on the qualityof the goods or services they sell. When quality can only be observed through use, a seller mayhave an incentive to shirk. As long as a high quality good is more costly to produce than a low-quality good and a consumer cannot tell the difference until after it is purchased, the sellersstrategy can be to cut back on quality.