Areas of Market Failure

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The market system is not perfect, and sometimes there are economic inefficiencies that arise from the existence of monopoly power in imperfectly competitive markets, from externalities, and from the existence of public goods. It is believed that if individuals are left to pursue their own self-interest, they will be led, as if by an "invisible hand," to act in a manner that maximizes society's well-being. Of course, free markets will maximize the gains from trade only under a particular set of conditions. "Market failure" refers to all those instances where the conditions required for markets to be efficient are not satisfied. If the market fails, then there is some allocation of resources, that could, in principle, result in at least one person being made better off without someone else being made worse off. In other words, when the market fails, the gains from voluntary exchange have not been fully exhausted, and so it follows that the free market has not maximized the value of economic activity. In these situations, the government intervenes to correct the market failure.

One area of market failure is often seen with the externalities of merit and demerit goods. Sometimes people do not realize, or ignore the costs, of doing something related to their consumption of these goods that have negative externalities. When there becomes an over consumption of these goods in the free market, the government then intervenes to reduce demand. One example of this is seen with smoking. After the public became aware of the negative health effects of tobacco usage, there was a time when cigarette consumption was still on the rise. Finally, the government intervened and placed higher taxes on the tobacco companies, and required that they discontinue their marketing strategy with advertising commercials on television. The government’s action was to respond to the market failure with demerit goods. Alternatively, sometimes the government’s response to market...
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