Market Failure

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A) Using appropriate theory, diagram and examples, analyse the way in which the market ‘fails’ with regards to the environment

World market existed from the basic economics of supply and demand theory where demand is the amount or quantity of goods or services that buyers are willing to pay at certain price in exchange for its value or benefit while supply refers to the quantity of goods or services that suppliers are willing to produce at certain cost. Figure 1 and 2 below explain how demand and supply changes with price.

Figure 1 shows an inversely proportional relationship of demand and the price. Demand increase from Q1 to Q2 when price drops from P1 to P2. This explains why post Christmas sales attracts huge crowd to the shopping mall. Figure 2 shows a direct proportional relationship of supply and the price. Supply quantity increase from Q3 to Q4 as the price of goods or services increase from P3 to P4. Supplier tends to produce more at higher selling price as it means higher profit for the supplier. This can be seen in agriculture industries where Malaysia and Indonesia where palm oil production increased significantly when the profit is high.

However, supplier cannot keep producing without limit as price is determined by whether there is demand. When the supply is more than the demand, the price will drop. When demand is more than the supply, the price will increase. Due to the opposite nature of the demand and supply with respect to price, supply and demand will have to keep re-adjusting itself until a point where supply S is equal to demand D. This is the point where all the demand will be fulfilled by the supply at a optimum price (Peq). This is when market reaches its equilibrium (Fig 3). This is the state where market is most efficient in its resource allocation.

In the real world market, the basic supply and demand curve sometimes fails to allocate its scarce resources to the socially optimal outcome when externality exits. Externality is defined as the costs or benefits of activities that are indirectly imposed to the third parties at certain cost or benefit which is not been considered by the producers or the consumers. When there is a cost imposed on third parties, it is called negative externality. For example, when a pig farm is build next to a residential village, the villagers will have to bear the smell of pig farming. The pig farming activities may also pollute the river. This indirectly imposes higher cost to the villagers who drink the water from the river which causes higher health costs. Similarly, when third parties benefited from an activity in which they are not directly involved or paid for, it is called a positive externality. (A.C Pigou, 1932). Both negative and positive externality can cause market to fail.

Figure 4 below illustrates the effect of external externality to the market equilibrium.

When a firm produces a good and pollutes the air, the Marginal Private Cost (MPC) will represent the cost of producing the goods without taking into consideration any cost of polluting. This will produce QMKT quantity of goods at the cost of PMKT. Since the firm is polluting the air, there will be cost involved as there is 3rd party who suffers from the pollution. As such the true cost of producing will need to take into consideration of externality cost. It’s called Marginal External Cost (MEC). The true cost is reflected as Marginal Social Cost (MSC) which is the sum of MPC and MEC. A new supply demand equilibrium will occurs at MSC equal to D curve which gives the quantity of QMSC at price of PMSC. This shows how market fails in free unregulated market where it was producing too much goods / services (QMKT) at low price (PMKT).

Positive externality exists when 3rd party enjoy the benefit from certain economic activities without paying for it. An example will be when a property developer builds a shopping mall...
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