Chapter 10

Market Failures

Introduction

The price system has been used by many economies, mostly market economies, in their allocation process. With the determination of the price using the forces of the market the price is determined through the interaction of the demand and supply.

In a competitive market, it is said that the price determined by the market is efficient in allocating resources particularly in answering the three basic questions in economics, what to produce, how to produce, and for whom to produce. These answers were explored in detailed in the previous nine chapters. The price is considered appropriate in the allocation of resources because the price reflects the marginal utility of consumers, on the one hand, and the marginal cost of producers, on the other hand. From this efficient allocation the consumers are able to maximize their consumer surplus while the producers are able to maximize producer surplus. These surpluses accrue to the society at large and social welfare is maximized.

The maximization of social welfare is an important objective of a society since resources are limited and have alternative competing uses by various sectors of a society. Thus, the loss in social welfare due to inefficiencies must be minimized as much as possible in the light of limited resources and the competing uses for these resources. However, there are instances when the market system is inadequate in allocating resources efficiently. This means that the price set by the market does not reflect the benefit enjoyed (marginal social benefit) and the cost (marginal social cost) incurred by society at large. Because of these inadequacies resources are not efficiently utilized. And when resources are not efficiently allocated social welfare is not maximized.

In this chapter, we will analyze what are the conditions and situations when the market fails as a social mechanism for efficient allocation of scarce resources. Specifically, we will discuss in this chapter the concept of market failures, situations when the market fails and alternative measures in addressing market failures.

II. Concept of Market Failure

Market failures are instances when the market mechanism fails to account for the correct benefits and costs to society of transactions made by consumers and sellers. This implies that the price determined by the interactions of the buyers and sellers is not reflective of social benefits enjoyed (marginal social benefit =MSB) and social cost (marginal social cost =MSC) incurred.

When the price determined by the market mechanism does not reflect social benefits and social costs, this may lead to inefficient allocation of resources. Inefficiencies may surface when there are over consumption or under consumption, over

production or under production of goods and services. When the production and consumption of goods and services are not optimal the inefficiencies in production and consumption may result in wastage and misuse of scarce resources.

It is assumed that a competitive market is a good candidate for optimal allocation of resources since the price set in a competitive market reflects marginal private benefits/utility and marginal private cost and at the same time equivalent to the marginal social benefits and marginal social costs (In symbols, MPB = MSB and MPC =MSC). However, a competitive market may also lead to market failure if there are divergences between social marginal benefits and private marginal cost, on the one hand, and the social marginal costs and private marginal cost, on the other hand. This may occur when there are externalities in transactions in the market.

Aside from the existence of externalities, government regulations, market imperfections, existence of public goods, and asymmetric information can contribute for market failure to surface. We will discuss these causes in the following section of this chapter.

2.1. Externalities

Externalities are spill over effects of any transaction to third parties. These spillover effects may have either positive consequences or negative impact on the third parties outside the transaction. For example, education of children may have positive effects on the community as it decreases the incidence of juvenile delinquency and enhances the human capital of the community. Although business enterprises are external to the transaction since they did not participate in the transaction for the educational services they are, however, affected positively since they are exposed to a lower level of criminality and the availability of qualified workers. In this case, the market for educational services has beneficial spillover effects or has positive externality.

Similarly, a firm engaged in manufacturing of leather or raising hogs may pollute the environment as they dump their wastes in the river. In such a situation, those families dependent on the river as a source of income may be adversely affected by the pollution caused by their indiscriminate dumping. Thus, although these families are external to the transactions of the manufacturing of leather and hog raising, they suffer the cost of such transactions. This is an example of an adverse spillover effects or negative externality.

To illustrate this effect of positive externality on the price, production and consumption of educational services let us examine Table 10.1. For simplicity, we assume that the supply curve is denoted by equality of marginal private cost and marginal social cost (MPC=MSC). To highlight the positive externality of education, the MSB is higher than the MPB.

(INSERT GRAPH 10.1)

Graph 10.1Positive Externality Demand for Education

Normal Competitive Situation

With Social Benefits

Price <Quantity <Consumer Surplus <Producer Surplus <Net Welfare Gain

Since consumers do not consider the social benefits of education, their demand \curve is reflected by the marginal private benefit (MPB) curve. Given the supply curve,

B

W

M

MSB

C

MPBT

MPC=MSC

0

Price

Education

MPC =MSC, the price will settle at Pc and output will be at Ec. Consumer surplus is denoted by PcMBC and producer surplus is denoted by TPcC.

However, if the social benefits are considered, price will settle at Pw and at a higher output of Ew. Consumer surplus will be PwMW while producer surplus will be TPwW. By ignoring the positive social benefits of education, society has lower level production and consumption of educational services. Because of this under-production and under-consumption the possible welfare gains denoted by triangle CBW are not realized. Thus, if the market is left with its normal price determination mechanism it will yield lower levels of social benefits.

To illustrate the effects of a negative externality let us examine Table 10.2 with

the demand for hogs as an example. For simplicity, we assume that the demand curve is shown by the curve where there is equality of MPB = MSB. The supply curve faced by the producers is shown at MPC. However, because hog raising has a negative externality, the marginal social cost is higher with the cost of pollution borne by the third parties.

(INSERT GRAPH 10.2)

Graph 10.2Demand for Hogs

R

B

W

J

N

A

GC

Price

MSC

D=MPB=MSB

MPC

0Hogs

Normal Competitive Situation

With Social Benefits

PriceQuantityConsumer SurplusProducer Surplus

Loss Due to Overconsumption

Accrues to ProducerSurplus

Accrues to ConsumerSurplus

Triangle WRC = ANRC - [ANGC + GWC]

Under normal competitive situation, the producer will equate his marginal private costs with the demand conditions and the market will settle at equilibrium at point C with price at Pc and output at Hc when MPB = MSB = MPC. Consumer surplus is shown by PcBC while the producer surplus is APcC.

However, if we consider the adverse effects or negative externality of this

activity, the marginal social cost, MSC will be higher than the MPC. The optimal level of production is at Hw and price at Pw as determined by the equilibrium point W. Consumer surplus is shown by triangle PwBW while the producer surplus is only NPwW. Comparing the production and consumption levels with a competitive market, there is an over production and over consumption of hogs.

By producing Hc, the cost was computed based on MPC equivalent to OACHc. However, the cost to society was really ONRHc. A portion of the difference ANRC has been enjoyed by producers in terms of producer surplus (ANGC) with higher production and the consumers in terms of consumer surplus (GWC) with lower price. This social costs equivalent to ANWC has been offset by producer surplus and consumer surplus (ANGC + GWC = ANWC). Thus, the net social welfare loss due to over-production and over-consumption of a commodity with a negative externality is shown by the triangle WRC.

2.2. Government Regulations

Government interventions and regulations can also create market failures since the price paid by the consumers may not reflect their marginal social benefits and marginal social costs. Taxes for example can limit production and consumption by increasing the price beyond the marginal social cost. Price ceiling can limit production and can cause divergence between marginal social cost and marginal private cost. In the same light the provision of subsidies through price floors can encourage production beyond what is

optimal. These government interventions can lead to wastage, misallocation of resources and lower social welfare.

To illustrate the impact of government regulations, let us examine Table 10.3 with the imposition of price ceiling on rice consumption. Let us assume for simplicity that the demand curve is represented by a downward sloping curve where MPC = MSB. On the other hand, the supply curve is represented by an upward sloping curve where MPC =MSC.

(INSERT GRAPH 10.3)Graph 10.3

Price Ceiling on Rice

With Price Ceiling OptimalPriceOutputConsumer SurplusProducer Surplus

MPB=MSB

MPC=MSC

Price

Rice

Loss CJW

Given these assumptions, under competitive market, the price would settle at point W with price at Pw and quantity at Rw. Consumer surplus is PwBW while producer surplus is APwW.

However, if the price Pw is perceived to be too high for the consumers, the government may impose a price ceiling with Pc as the maximum price. At this price, producers will only supply Rc even if consumers are willing to consume more and pay a higher price. As a result, the price ceiling Pc = MPC = MSC but lower than the MPB = MSB (Pc < Pj). With this consumer surplus will now be PcBJC while producer surplus is APcC. Although consumers have increased their consumer surplus with a reduction in price, they also reduced their consumer surplus with the reduction in consumption. On the other hand, price ceilings hurt the producers most since their producer surplus is reduced with lower price and lower production.

2.3. Market Imperfections

We have discussed the impact of market imperfections in the previous chapters. The reason why non-competitive markets are not ideal market structures and may lead to market failure is because the price they set may not reflect the social costs and social benefits. Because these markets have some degree of market power, they can set the price in order to maximize their producer surplus or profit at the expense of consumers who have to pay higher prices and contend with lower levels of output and consumption.

In a monopolistic market, the control of the seller or buyer can limit production and consumption. Although the profits of a monopolistic firm is maximized, social welfare is not since the price = MSB > MSC. See Table 10.4 for illustration.

(Insert Graph 10.4)

Graph 10.4Monopoly

Competitive Market Monopoly Dead Weight LossPrice

JMCQuantity

Consumer SurplusProducer Surplus

Oligopolistic firms as well as monopolistically competitive markets determine their output that will maximize profit with the dictum that MC = MU. However, the price in

M

J

A

C

B

0

MR

Quantity

Price

MPB=MSB

MC

these markets is higher than the marginal costs. Again, some degree of social welfare is lost as a consequence of this.

2.4. Existence of public goods

The existence of public goods may also contribute to the failure of the market in allocating resources efficiently. The market system is very effective in allocating resources if the goods and services provided are mostly private goods and services. The price set in the market system reflects the private benefits enjoyed and internalized by the buyers, on the one hand, and the private costs incurred and internalized by the sellers, on the other hand. Since the consumption of public goods does not exclude others, the benefits from the consumption of public goods cannot be fully internalized. Since these goods are jointly consumed it may be difficult to measure its marginal social benefits. In addition, because of the non-exclusion of its consumption, once an individual finances its production other consumers may not be able to internalize the social costs of providing this public good. Because of this situation a free rider problem can emerge since once the product is produced, it is enjoyed by every one. If this is the case, no one is willing to pay for the cost of its production. In an environment where consumers can free ride and their satisfaction is not reflective of the true social benefits from public goods, there will be an underproduction of public goods if the provision of these goods is left to the market system.

The incentive to free ride is inherent in public goods because these goods are jointly consumed. The enjoyment of the product or service is not exclusive. The non-exclusivity of the product implies that if one individual consumes, the product is there for others to enjoy and consume it as well. There are many examples of public good including national defense, provision of security, among others.

Thus, because of the inadequacy of the market to provide for public goods, it is not the market that provides the provision of these goods but the government. Usually, the government taxes its citizens and from the revenues collected they use it to produce public goods and services.

2.5. Imperfect Information

One of the conditions for perfectly competitive market is the provision or access to full or perfect information to all players. However, this condition is an ideal one because in reality, the information to the actors of a market is not evenly distributed. This imbalance or uneven distribution of information is called asymmetric information. It means the distribution of information is uneven to the players. We know that all perfect information is not possible but even there is full information, the available information is not evenly distributed among the players.

This imbalance can lead to market failures because it can lead to decisions that may lead to inefficient allocation of resources. Sometimes the failure of the market is due to imperfect information among the players in the market. The imbalance in the information

provided to the consumers and producer lead to inefficient results. There three main examples where information asymmetry may occur: adverse selection, moral hazard, and agency problem.

In adverse selection, without proper disclosure of information about the product a consumer may end up with low quality product as products with high quality are mixed with low quality products. As such, the demand for the product may decrease as some consumers end up with low quality products. With the decline in demand, the price of the good will likewise decrease. With this decline, the supply of high quality products may decline as well since they are perceived as well as low quality products and therefore should demand lower price. In order to address this problem of adverse selection, the government may require producers to disclosure information, such as labels, about the product they produce and service they provide. Companies may also want to signal using advertising to market their products and enhance information.

Another example of disclosure is through signaling mechanism which is done by college graduates when they apply for jobs. They signal their productivities by enhancing their resume through the enumeration of curricular and extra-curricular activities as well as the academic performance. With this enhanced resume, employers are in a better position to select the quality graduates from the rest.

Another example of adverse selection can occur in the insurance industry where people, healthy as well as terminally ill, can purchase medical and life insurance. To address the problem that people with terminal illness may cause the insurance company all people who wanted medical insurance coverage are asked to disclose information about their health and medical history through medical examinations. Those found with terminal illness may not be covered or they have to pay a higher insurance premium if they want to be covered.

Moral hazard, on the other hand, are decisions made by market participants to undertake unnecessary behavior because they are protected or insured or covered in their behavior. The most classic case is the case of insurance. Because individuals are insured they can be careless in their behavior. They may drink or may not take care of their health because they are covered by medical insurance. Because of this possible behavior of those insured, insurance companies, covering medical and car insurance, are now asking those insured to pay the initial amount in case of an illness or a car accidents. In this case those insured will be forced to temper their behavior because there is an additional cost in getting ill or being careless in driving.

The agency problem, on the other hand, arises due to the dichotomy of the interests of

the principal and the agents. In many transactions, it is possible that a main actor of a transaction is not directly involve in the transaction but assigns it to an agent to do the specific and dirty tasks. This is well pronounced in the separation between the owners and the managers of modern business enterprises particularly corporation. There are also examples that you assign agents to represent your interest in certain transactions. As far the principal is concern, aside from paying his agent, he will be satisfied if a set of his

concerns are fulfilled. As far as the agent is concern so long as the needs of the principal are fulfilled, he can focus his attention in maximizing his own interest. However, promoting the agent’s interest may lead to uneven information.

In pursuing his interest, the agent may maximize his own utility while giving the principal a level of utility that would satisfy him and not necessary the maximum utility. The agency problem arises because of the governance structure of companies. Large corporations are managed by a select group of professionals who are not actually owners of the company. Although they are report to the owners, they can conceal information from the owners as long as they maintain the utility of the owners. As long as the owners are satisfied, they may not exert enough effort to be efficient in the operation of the corporation. There is a case of under-performance or sub optimal results. Because of the unevenness of information between the agent and the principal, the agency problem can also lead to unethical behavior.

III. How do you address the market failure?

3.1. Role of Government

One of the reasons for the existence and relevance of the government sector is to address market failures. In the promotion of public interest and enhancement of the social benefits of commodities with positive externalities, the government can use its fiscal powers by giving incentives or subsidies to these activities, commodities and services that promote social welfare.

The government can use its taxing powers to temper the production of private goods with huge negative externalities. It can tax pollutants to make the corporations or companies polluting the environment to internalize the social costs it has brought as a consequence of its production. With the internalization of the tax which is an additional cost, the supply curve shifts to the left implying higher cost at every level of production. With this shift, the price will set at a higher level and production and consumption will settle at a lower level than what used to be market determined. For products and services that have positive externalities, the government can provide incentives to encourage the production and consumption of these merit and socially beneficial commodities.

For market imperfection as manifested by monopolistic and oligopolistic market structures the government can also use its regulatory power to temper the monopolistic power of big corporations. It can set a price limit to make sure that the monopolist can charge the price it wants that will maximize its profits. Another way of addressing the monopoly power of these companies is to have higher or progressive taxes or their corporate income or profits.

Lastly, the government can provide public goods as in the case of public order, national defense, the conduct of foreign policy and the management of the monetary affairs that can be enjoyed by all its citizens. Using tax revenues, the government can directly provide these publicly or jointly consumed commodities.

For imperfect information, the government can use its regulatory power to set standards for the disclosure, protection of the consumers from unscrupulous companies, sellers and service providers by requiring them to label their products and services, mandating warranty and other consumer protection measures.

3.2. Role of collective action

There is also a strong possibility that the government may fail in its programs in addressing market failures. Instead of addressing the inefficiencies caused by market failures, the government may not able to address these problems but somehow worsens the situation through the incompetence of government personnel, graft and corruption, inefficiencies, lack of institutional capability and other problems associated with government intervention.

In such a situation, what option is left to a society in the management of its resources so that it can produce the highest social welfare? In this case we may need to seek other societal alternatives. One possible alternative is the use of culture as a mechanism for allocation. Specifically, the role of collective action and the use of social capital may be crucial alternative allocation mechanisms in the light of market and government failures.

To illustrate this option, consider a situation where a place has been devastated by a natural disaster. As a consequence, the normal functioning of the market is not operative. This means that the basic needs of people are not meet because the institutions of the market are impaired. The government is likewise damaged and may not also be able to response to the needs of the people. To make it worse, because of inefficiencies, red tape, restrictions, and institutional weaknesses the government becomes powerless in providing the needs of the people. Unless a national emergency or police power is imposed, the government may not be able to function and deliver what it is suppose to deliver.

In such an extreme and unfortunate situation, societies usually tend to culture and the operation of the social capital to provide the needs of the people. This is done usually through volunteerism, community contributions, support from extended family and other social action programs. Another example where collective action can work is the protection of public goods, like environmental protection. The market mechanism of environmental taxes failed the degradation of the forest. Even the use of government police power is inadequate in protecting the environment because the institutions are weak. However, through cooperative actions, done through community effort, they are able to protect the environment because the community sees the value of its protection. Because of the economic and tourism value of a river members of the community are not polluting it. There are not government agents that monitors or checks the pollutants but people still keep the river clean because in the end, it attract more tourists and tourism brings income to the community and to their households.

3.3.1. Role of culture and social capital.

There are many aspect of Filipino society that we can explore to form social capital and pursue to answer failure of the market and failure of the institutions or government. For one we have the bayanihan. This concept is very difficult to translate literally because it captures beyond community cooperation. The word is rooted in bayani or hero; thus bayanihan is community cooperation plus a tinge of local heroism. This has been ingrained in our society for centuries. But lately, we have cooperatives that espouse mutual assistance among members at the community level. The family ties are also very strong in the Philippines but we have not extended their positive contributions beyond our families. The inability of our young individuals to go to school because of inadequate family income, lack scholarship and limited access to credit can be addressed by the provision of assistance from the generosity of family members and other relatives. The role of hermano/hermana mayor in the celebration of the town fiesta is another example of cooperation at the community level. If we could only extend these community cooperative measures and traits to the national level we can evolve a national consciousness which can be our own social capital.

Conclusion

In this chapter we have discussed various manifestations when a market fails. Although many economies in the world today use the market system as a mechanism for allocation of their scarce resources we know that the presence of externalities, public goods, asymmetric information and market imperfections can lead to market failures.

This means that price set by the market in the interactions of demand and supply, or consumers and buyers, they may not account for the true social costs and social benefits of the production and consumption of these goods.

There is a need for government intervention to mitigate these problem that bring about market failure. But even the government can fail because it is not really meant to provide private goods and does not have its institutional capacity to allocate resources efficiently. In such a situation, we may turn to culture or collective action, social capital to have efficient allocation.

Key Terms Consumer surplus………….. benefits derived by the consumers arising from the

difference between the marginal utility and the prevailing market price of the commodity

Externality……………… benefits and costs incurred by a third party that is independent from the actors of any transaction

Market failure…………….. a situation when the price of a commodity does not reflect

the marginal social benefits and marginal social costs of a product due to market imperfections, information asymmetry and presence of externalities

Market imperfections……… a situation when actors of any transaction exercise their market power to extract more surplus resulting in the divergence of the price and the marginal cost or marginal benefits.

Producer surplus……………. benefits derived by the producers arising from the difference between the marginal cost and the prevailing market price of the commodity

Public goods ………………. goods and services produced in the economy but whose consumption does not exclude others.

Social capital ………………type of wealth arising from the positive effects of the interactions of people in a society

Exercises

Exercises

A. Evaluate if the following are true or false statements:

1. The price determined in a competitive market will always reflect the marginal

social benefits and marginal social costs.

2. When the government imposes a subsidy in the production of a commodity,

there is an overproduction of the commodity since the price is lower than the

marginal private cost.

3. When the marginal social cost is higher than the marginal private cost while

the marginal social benefit is equal to marginal private benefit, the price

determined by the market will lead to under-production of the commodity.

4. In adverse selection, with proper disclosure of information about the product a

consumer may end up with low quality product as products with high quality are

mixed with low quality product.

5. The government cannot do anything about market failures because government intervention is what leads to inefficiencies in the market.

B. Answer the following questions

1. What type of externality is present in the following activities, and explain why is it an

externality:

a. Your next door neighbor is playing rock music on high volume in the evening.

b. You decided to buy beautiful garden fixtures for your front lawn.

2. Why is the existence of a monopoly considered a market failure? If that is so, is it good to break up a monopoly? 3. What is information asymmetry? What are the three situations under information asymmetry? Why is it a market failure?

4. What is a public good? Explain why it is a market failure. Give examples of a public good.