Market Failure - How Do Markets Fail and What Can Be Done About It?

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Jordan AlexanderFebruary 14, 2012
Economics Essay – Market Failure

1. Markets fail when they under or over allocate resources of production or consumption, relative to the best interests of society. Market failure occurs due to four main factors: the existence of externalities, asymmetric information, the abuse of monopoly power, and inequalities and wealth and development. The existence of externalities means that the market mechanism does not always work efficiently. Markets run on a mechanism that only takes into account the private benefit and cost for a good. Besides the marginal private cost and marginal private benefit, there are the marginal social cost and marginal social benefit, which are external. As a result, governments must find responses to try to solve these market failures.

2. Externalities are the effects of market activities on other people that are external to the market. They are either positive externalities or negative externalities. When the social benefit of a good equates the social cost, it is known as the social optimum. Goods that have large positive externalities can either be public goods or merit goods. Public goods are non-rivalrous and non-excludable, while private goods, such as a merit good, are rivalrous and excludable. When a good has large positive externalities, the government should support its production. When a good has large negative externalities (demerit good), the government should limit or stop its production and consumption. Markets can fail in regard to externalities in four ways: lack of public goods, under provision of merit goods, over provision of demerit goods, and environmental degradation.

Graph 1 demonstrating MPB and MPC to the individuals participating in the market. Graph 2 demonstrating positive externalities, when the social benefit is added to the private benefits. This means that total demand for the product will be greater, because society will be willing to pay a higher price, for example, for beautiful buildings. Graph 3 demonstrating negative externalities, when the social cost is added to the private supply cost, giving a new supply curve, which raises the price and decreases the quantity.

3. Public goods are goods that are non-rivalrous and non-excludable. This means that the use of it by one person does not prevent the use of it by another, and also that people cannot be excluded from using the good. Public goods have very large positive externalities, but small private benefits, and this means that in a market system, they would barely be produced. This is defined as a market failure, and therefore, the government must find a solution to reallocate more resources of production to public goods.

4. To solve the market failure of lack of public goods, the government mainly uses one solution: the direct provision of public goods. This means that the government provides these services directly, paying for them using money from the taxation system. This is a way for everyone to receive the benefits of public goods. The problem with the method of direct provision is that it can be expensive, and also, there will always be the problem of ‘free-riders’, which benefit from the public good, yet do not pay a share of its cost. Another problem with this is that often, government is inefficient in its allocation of public goods, for example, between allocating too many resources to tanks than to police officers. Also, there might be inefficiency of government employees because the profit motive is not present.

5. Merit goods are private goods, which have large positive externalities. Due to the market system, the private optimum (equilibrium between private benefits and private costs) will be produced, instead of the social optimum. The government will want more produced because merit goods benefit other external people, despite it being a private good.

6. The government has three ways to allocate more resources towards merit...
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