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]

  1. describe diagram

The supply curve is the MPC... .

The demand curve is the MPB...

  1. 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.

  1. 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.

image

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:

  1. internalising the externality: This is a Pigouvian tax that improves resource allocation because it helps the market price in external costs.
  1. provides incentive for firms to stop the action that is causing them to pay the tax

Limitations:

  1. Lack of information - how to measure costs and apportion blame
  1. 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