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Market Failures

Market Failures

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Published by Erik F. Meinhardt
This paper sets out to define and describe market failures, how government intervention prevents them or minimizes their effects, and the arguments against government intervention.
This paper sets out to define and describe market failures, how government intervention prevents them or minimizes their effects, and the arguments against government intervention.

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Published by: Erik F. Meinhardt on Jun 03, 2007
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Market Failures
by
Erik F. Meinhardt 
 This section sets out to define and describe market failures, how governmentintervention prevents them or minimizes their effects, and the argumentsagainst government intervention.
I.
Definitions and descriptions
Market failure occurs when free markets do not bring about economicefficiency, that is to say when a Pareto sub-optimal allocation of resourcesexists in a particular economy. Market failures remain one of the best reasonsfor government intervention within an economy on moral and economicgrounds, arguably, in the best interest of the public. The following are detailed descriptions of several market failures in noparticular order:
A.
Public goods
—Public goods are goods wherein the consumption of them does not necessarily prevent another person from alsoconsuming it, nor does that consumption make less of the goodavailable for consumption by others. Scholars commonly presentbreathable air as an example of a public good for virtually everyonehas access to consume it and its consumption does not limit theamount available.Public goods pose a problem for the market because by their nature itcannot provide for them. The private sector will not make a profit froma good which everyone can enjoy whether or not they pay for it. Thelighthouse example comes to mind: no matter who pays for theconstruction of a lighthouse on a particular island, every passing shipwill benefit from the protection it provides and no way exists forexcluding those who did not pay. In addition, not every rationalconsumer (including those who did originally pay) will keep paying fora public good if they can still benefit from it without paying. Theprivate sector knows the nature of public goods, and would never buildthe lighthouse in the first place. These things combined mean that the private sector cannot profit andit will thus under-provide the good. In the case of a lighthouse, if anisland fishing industry relies on the protection from a lighthouse, thisunder-provision means that the fishing market will collapse. Hence, wehave a market failure. The market fails to provide essential publicgoods. Other examples of public goods are: defense and police forces,street lighting, roads and infrastructure, public parks, et cetera.Similarly, “merit goods” include public health services, public
 
education, public libraries and museums, public radio/television etcetera.
B.
Imperfect competition
—Imperfect competition occurs when anagent in the market gains market power and the market can no longermeet the conditions necessary for perfect competition. This means theagent can alter the price of a good or service within the market withoutlosing customers because it controls either all or a large portion of themarket. The problem of imperfect competition plagues most marketsand requires government intervention to achieve efficiency, provingthat a pure market cannot be Pareto optimal. The monopoly, a prime example of imperfect competition, serves as anappropriate way to demonstrate market failure. In a monopoly, onefirm remains the only seller of a certain product or service, the marketproves difficult to enter into as a seller, there are no comparableproducts for consumers, and the firm in control can alter the price of itsgood or service as it wishes. This leads the firm to overprice its productand under-produce it in order to maximize profits. Since it has nocompetitive pressures upon it, the firm can do this without losingcustomers. Society suffers as a result of the monopoly causing higherunemployment (no need to hire more employees if a firm can under-produce) and higher prices. This leads to allocate inefficiency of theproduct and a Pareto sub-optimum equilibrium; hence we have amarket failure.
C.
 Asymmetric information
—Information asymmetry occurs when oneparty to a transaction has more or better information than the otherparty involved. There are two specific examples of the asymmetricalinformation problem, which I will explain using the automobileinsurance market as my model:
1.
 Adverse selection
—A risky driver would get a bargain if he/shepurchased automobile insurance; whereas a non-risky driver wouldactually lose money. This comes as a result of the insurancecompanies not knowing information about whether or not certaindrivers are risky or not. The insurance company must raisepremiums for everyone in order to compensate for the amount itwill dispense on behalf of the risky drivers. Some non-risky driverswill thus not buy the insurance, leading to a higher rate of riskydrivers buying insurance in general, raising the premiums evenmore. The outcome which results from the lack of informationleaves the non-risky drivers priced out of the automobile insurancemarket and is inefficient.
 
2.
Moral hazard 
—An easy example to explain, this problem occurswhen those who have insurance take greater risks. An uninsuredperson would less likely drive riskily than an insured person. Whensomeone purchases automobile insurance, the cost of his/heraccident is externalized to the insurance company. Thus, it seemsthey have a higher likelihood to be more careless and risky whendriving. The insurance company cannot monitor the driving of itsclients and thus, has incomplete information. Again, the insurancecompany must raise premiums in order to compensate for thosewho will drive riskily as a result of having insurance. This prices outthose who would not drive riskily if they had insurance and leads toinefficiency.
II.
Government intervention
Some scholars argue that government intervention is a good way to preventmarket failures from occurring and to lessen their effects. They argue thatthe government does this in the best interest of the people. Many methodsexist for a government to utilize when intervening in the economy. I describesome of them as follows: 
A.
Taxation and subsidies
—The government frequently uses taxation(taking money away from agents) and subsidizing (giving money toagents) in order to correct market failures. Taxation can discouragecertain behaviors like monopolizing and overpricing. It is used toprovide for public sector production of public goods and is also used toenforce the other government intervention methods. It collects moneyto provide for national defense, public infrastructure and roads, publicsafety and health services and public schools, libraries and museums.Subsidies, on the other hand, encourage certain behaviors likeproducing a certain good. They can help reduce the cost of paying formerit goods like education, healthcare, and the arts, for example. Also,they can encourage production of certain crops and also reducescientific research costs for public interest.
B.
Public sector production
—The government employs this method todeal with the problem of public good market failures. Using taxation,the government collects money and then provides public goods—likenational defense or law enforcement, for example—to the citizenry. Thegovernment can also nationalize industries to prevent monopoly andprovide public goods. Public works such as the Hoover Dam canprovide for beneficial infrastructure. Also, by providing for healthinsurance, the government can reduce costs and provide a public goodat the same time. By pooling a massive amount of people together tobuy insurance, the cost of insurance is driven down

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