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Market Failures by Erik F.

Meinhardt This section sets out to define and describe market failures, how government intervention prevents them or minimizes their effects, and the arguments against government intervention. I. Definitions and descriptions

Market failure occurs when free markets do not bring about economic efficiency, that is to say when a Pareto sub-optimal allocation of resources exists in a particular economy. Market failures remain one of the best reasons for government intervention within an economy on moral and economic grounds, arguably, in the best interest of the public. The following are detailed descriptions of several market failures in no particular order: A. Public goods—Public goods are goods wherein the consumption of them does not necessarily prevent another person from also consuming it, nor does that consumption make less of the good available for consumption by others. Scholars commonly present breathable air as an example of a public good for virtually everyone has access to consume it and its consumption does not limit the amount available. Public goods pose a problem for the market because by their nature it cannot provide for them. The private sector will not make a profit from a good which everyone can enjoy whether or not they pay for it. The lighthouse example comes to mind: no matter who pays for the construction of a lighthouse on a particular island, every passing ship will benefit from the protection it provides and no way exists for excluding those who did not pay. In addition, not every rational consumer (including those who did originally pay) will keep paying for a public good if they can still benefit from it without paying. The private sector knows the nature of public goods, and would never build the lighthouse in the first place. These things combined mean that the private sector cannot profit and it will thus under-provide the good. In the case of a lighthouse, if an island fishing industry relies on the protection from a lighthouse, this under-provision means that the fishing market will collapse. Hence, we have a market failure. The market fails to provide essential public goods. 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 et cetera. B. Imperfect competition—Imperfect competition occurs when an agent in the market gains market power and the market can no longer meet the conditions necessary for perfect competition. This means the agent can alter the price of a good or service within the market without losing customers because it controls either all or a large portion of the market. The problem of imperfect competition plagues most markets and requires government intervention to achieve efficiency, proving that a pure market cannot be Pareto optimal. The monopoly, a prime example of imperfect competition, serves as an appropriate way to demonstrate market failure. In a monopoly, one firm remains the only seller of a certain product or service, the market proves difficult to enter into as a seller, there are no comparable products for consumers, and the firm in control can alter the price of its good or service as it wishes. This leads the firm to overprice its product and under-produce it in order to maximize profits. Since it has no competitive pressures upon it, the firm can do this without losing customers. Society suffers as a result of the monopoly causing higher unemployment (no need to hire more employees if a firm can underproduce) and higher prices. This leads to allocate inefficiency of the product and a Pareto sub-optimum equilibrium; hence we have a market failure. C. Asymmetric information—Information asymmetry occurs when one party to a transaction has more or better information than the other party involved. There are two specific examples of the asymmetrical information problem, which I will explain using the automobile insurance market as my model: 1. Adverse selection—A risky driver would get a bargain if he/she purchased automobile insurance; whereas a non-risky driver would actually lose money. This comes as a result of the insurance companies not knowing information about whether or not certain drivers are risky or not. The insurance company must raise premiums for everyone in order to compensate for the amount it will dispense on behalf of the risky drivers. Some non-risky drivers will thus not buy the insurance, leading to a higher rate of risky drivers buying insurance in general, raising the premiums even more. The outcome which results from the lack of information leaves the non-risky drivers priced out of the automobile insurance market and is inefficient.

2. Moral hazard—An easy example to explain, this problem occurs when those who have insurance take greater risks. An uninsured person would less likely drive riskily than an insured person. When someone purchases automobile insurance, the cost of his/her accident is externalized to the insurance company. Thus, it seems they have a higher likelihood to be more careless and risky when driving. The insurance company cannot monitor the driving of its clients and thus, has incomplete information. Again, the insurance company must raise premiums in order to compensate for those who will drive riskily as a result of having insurance. This prices out those who would not drive riskily if they had insurance and leads to inefficiency. II. Government intervention

Some scholars argue that government intervention is a good way to prevent market failures from occurring and to lessen their effects. They argue that the government does this in the best interest of the people. Many methods exist for a government to utilize when intervening in the economy. I describe some of them as follows: A. Taxation and subsidies—The government frequently uses taxation (taking money away from agents) and subsidizing (giving money to agents) in order to correct market failures. Taxation can discourage certain behaviors like monopolizing and overpricing. It is used to provide for public sector production of public goods and is also used to enforce the other government intervention methods. It collects money to provide for national defense, public infrastructure and roads, public safety and health services and public schools, libraries and museums. Subsidies, on the other hand, encourage certain behaviors like producing a certain good. They can help reduce the cost of paying for merit goods like education, healthcare, and the arts, for example. Also, they can encourage production of certain crops and also reduce scientific research costs for public interest. B. Public sector production—The government employs this method to deal with the problem of public good market failures. Using taxation, the government collects money and then provides public goods—like national defense or law enforcement, for example—to the citizenry. The government can also nationalize industries to prevent monopoly and provide public goods. Public works such as the Hoover Dam can provide for beneficial infrastructure. Also, by providing for health insurance, the government can reduce costs and provide a public good at the same time. By pooling a massive amount of people together to buy insurance, the cost of insurance is driven down

C. Antitrust legislation—The government passes these laws to limit the formation of monopolies and prevent imperfect competition. They make anti-competitive behavior like price fixing, geographic market allocation (cartels), and bid rigging illegal. D. Regulation—The government can require businesses to behave in certain ways. For example, by forcing car companies to make automobiles with seatbelts, the government is, in a way, providing a public good and also reducing insurance costs. Another example of this is requiring cigarette companies to put health warning labels on their products. This increases information and reduces insurance costs yet again. III. Contra government intervention

Other scholars counter that government intervention to prevent market failures might not actually solve the problems better than the market. I summarize some of their arguments as follows: A. Government failure—The main argument against government intervention is that the government itself is very inefficient at regulating the market. Political self-interest has politicians often pork barrel spending–using taxes and subsidies to favor their own districts rather than achieving efficiency. Also, lobbyists of certain organizations can petition for harsher laws against their competitors which create more imperfect competition. It is also argued that government intervention in the form of taxes causes disincentives to productivity. Finally under this heading is the problem of imperfect information— Pigou argued that regulatory agencies are worse than individual actors in an economy at gathering information. The government cannot ever really know enough about people’s wants and needs based on how they vote. B. Private production of public goods—Some people think that public goods can actually be provided for without government intervention. The simplest example of this relies on charitable giving to provide for citizens’ education and healthcare. C. Natural monopoly—Sometimes government intervention is not needed, as in the case of natural monopolies. This falls under the theory of contestable markets, but it basically says that competitive markets and efficiency can be achieved under certain monopoly situations. Low cost airlines are the best example of a natural monopoly.