Market Failure
Microeconomic Problems and Objectives
Inefficiency in resource allocation
Inequitable distribution of income:
A market may be efficient, but the distribution of this output to individuals to society may not be equitable.
From the point of view of society's sense of equity, the free market's distribution may not be fair and state intervention may be needed to bring abbout a fairer distribution of income and create a more inclusive society.
allocative inefficiency and productive inefficiency lead to resource misallocation, thus govt intervention is needed to maximise social benefit.
Allocative efficiency is achieved when the sum of CS and PS is maximised (NO DWL), P=MC, MSB=MSC, aka MPB=MSB, MPC=MSC.
Productive efficiency is achieved at any point on PPC, any point on long run average cost (LRAC) curve (at the firm level or the minimum pt of LRAC (at the societal level).
Dynamic efficiency results from improvements in technology, usually from investing in R&D or workers' skill training.
The profit motive incentivises firms to be productively efficient.
Market failure occurs when free markets, operating without any government intervention, fail to allocate scarce resources efficiently and hence society's welfare is not maximised.
Externalities
Information Failure
Non-provision of Public Goods
Market Dominance
Immobility of FOPs
Full explanation [using -ve consumption externalities as an example]
- describe diagram
The supply curve is the MPC... .
The demand curve is the MPB...
- Divergence btw Private and Social costs (under-priced)
However, third parties can still experience negative side effects from consumers consuming the product.
Thus they might incur external costs such as ..., which are uncompensated by the consumers, thus causing MEC>0.
As MPB does not reflect social benefits, external costs create divergence btw MPC and MSC, where MPC<MSC as MSC = MPC+MEC.
In other words, The free market has under-priced the consumption of cigarettes relative to its true social cost, leading to inefficient allocation of resources.
- difference btw current and ideal outcome (over-consumption)
If left to free market forces, utility-maxing consumers would consume Qm units of cigarettes where MPB=MPC. However, the socially optimal outcome is at Qs where MSC=MSB. Thus there is an overconsumption of Qm-Qs cigarettes and an overallocation of resources to the cigarettes market.
Since the total social cost incurred is area A and total social benefit incurred is area B, Area B-A represents the deadweight welfare loss due to overconsumption of cigs.
Imperfect Information
Asymmetric Information
Incorrect Information - consumers have received wrong information from sellers (overestimate true marginal private benefit)
Ignorance - consumers are ignorant of benefits brought by product (underestimate true marginal private benefit)
Adverse selection
Moral Hazard
When profit-seeking seller knows more about the good sold than the buyer.
As a result, buyer runs risk of being sold good of low quality.
A situation in which economic agents take greater risks than they normally would, because the costs that result would not solely be borne by themselves.
This riskier behaviour increases social cost and use of scarce resources, leading to a misallocation of resources and hence market failure.
This results in good products and good consumers being under-represented, while bad products and bad consumers are over-represented.
Free market finds it difficult to provide public goods commercially in the marketplace because of its 2 defining features: non-rivalry in consumption and non-excludability.
Non excludability in consumption refers to the situation where the consumption or use of the good or service cannot be limited to the consumers who paid for it. e.g. street lights, national defense
Non-rivalry in consumption refers to the situation where consumption or use of the good or service by one consumer does not reduce its availability to another consumer. e.g. streetlights
Implication of the characteristics of Public Goods
Free-ridership - no one has incentive to pay for the good/service
No price signals
No user charge
Since marginal cost of serving an additional user is zero, profit-maximising firms would never provide goods at zero cost, thus they have to be provided by the government as free public goods.
When the market structure departs from perfect competition. If barriers to entry become stronger, the firm has stronger market power, thus market dominance would result, allowing the firm to possess greater price setting ability, thus leading to allocative or productive inefficiency.
Occupational immobility
Geographical immobility
Leads to unemployment --- represents a loss of output, thus a waste of resources, and thus resulting in market failure.
Inequity
2 main causes of inequity:
Excessive Income Inequality - unfair market allocation. While the price mechanism could lead to an efficient allocation of resources based on dollar votes, it may not result in equitable outcomes.
High prices of essential goods and services in the free market ---The poor are unable to gain access to these goods and services due to lack of purchasing power, hence govt is expected to intervene
Solution for Negative externalities - Taxes
advantages of taxes:
- internalising the externality: This is a Pigouvian tax that improves resource allocation because it helps the market price in external costs.
- provides incentive for firms to stop the action that is causing them to pay the tax
Limitations:
- Lack of information - how to measure costs and apportion blame
- Impractical to use different tax rates for different firms who may share different portions of blame.
Solution for Positive externalities - Subsidies
Limitations:
Lack of Information - hard to quantify how much to give
Opp. costs (trade-offs as there are other alternative govt projects) due to budget constraints
Unintended Consequences
Breeds inefficiency - reduces incentive to stay efficient
Solution - Legislation
Limitations:
Lack of Compliance and high adminstrative costs
Blunt instrument and sustainable
Is a Total Ban beneficial or harmful to society?
Beneficial if it results in net welfare gain
Harmful if it results in net welfare loss
Limitations: May be costly to adminster and enforce
Soluble - Tradeable Permits
More cost-effective than regulation
Efficient distribution of permits
Incentive to reduce pollution
Benefits:
Limitations:
Lack of information
Lack of Compliance and high administrative costs
Solution for Positive externalities - Direct Provision
Limitations
May breed inefficiency and poor standards of service
Strain on Govt budget
Solution - Direct Provision with Full Subsidy
Limitations
Lack of Information
Strain on govt budget
Political Pressures
Solution - Deregulation (Lowering barriers to entry)
Solution - Prevention/Prohibition (Anti-trust/Anti-monopoly laws)
High Admin Cost and lack of compliance
Solution - Price Regulations: Marginal Cost (MC) pricing - force monopoly to charge price equal to marginal cost
Solution - Taxation: Progressive income tax where you are taxed more if you earn more
Limitation: may reduce incentive to work
Solution - Subsidy: e.g. medical subsidies or unemployment benefits
Key info: 3Ms of SG healthcare financing
Medisave is national compulsory medical savnigs scheme
MediShield Life is a compulsory low cost catastrophic illness insurance scheme
Medifund is endowment fund set up Government with govt money. It is the last safety net for those who cannot afford even after Medisave & Medishield.
Solution - Minimum wage
Wage floor for bottom earners, reducing income gap
Solution - Training and Skills Upgrading Schemes (more of long term aid)
Solution - Workfare Income Supplement (more of short term aid)
Solution - Regulation
E.g. Mandatory food labelling/health warning
Laws to protect against incorrect information (e.g. Lemon Law)
Laws to protext the ignorant
Solution - Education and Moral Suasion: An appeal to morality in order to influence or change behaviour
Limitations - it is a long term solution, long-drawn process that involves changing mindsets. for addicts, they might not change their minds even when provided with full, complete info.
Solution - Mandatory or universal coverage
Solution - Laws to prevent opportunism ie anti-lemon laws or product liability laws
Limitation - High admin cost
Solution - equalising information
Screening
Signalling
Monitoring
Solution - Retraining or reskilling (occupational immobility)
Limitations - Funding issues
Limitations - Success or take up rate may not be ideal
Solution for geographical immobility - Bring workers to work (better infrastructure and transport system) or work to workers (encourage regional business hubs and incentivise businesses to move to less economically connected regions.
Solution of immobility of capital - Incentives for investment in new capital goods or attract businesses to relocate
Lack of info on what to invest in
Lack of compliance, funds may be misused
Causes of Govt Failure
Info failure or info gap
Costs of admin and compliance
Bureaucratic inefficiency
Political factors
Tendency to look for short term solutions
Pursuit of self interest
Electoral pressures
Lack of voter support
Unintended consequences: plans may backfire to achieve the opposite effect
Policy conflicts - conflict of economic goals that require trade-offs
e.g. growth vs efficiency, growth vs equity