On Market Failures
The previous post dealt with market imperfections: Since perfect competition does not exist in practice – its closest approximation are financial markets – often the conditions for efficient resource allocation are not met. This event is said to be a market failure. Generally three sources of market failure are distinguished: imperfect competition, inadequate information, and externalities.
Market failure due to imperfect competition
If markets are to allocate resources efficiently they need to be competitive. The degree of competition in a market depends on the number of competitors and their relative position in the market place. Generally, competition increases with the number of firms supplying a particular good. Furthermore, prices must correctly reflect the opportunity costs of goods. Firms with excessive market power will price their goods in excess of marginal cost.
Some product markets lack serious competition, because they are inherently monopolistic, like gas, electricity, telephone , and water supply industries. These situations are called natural monopolies because to duplicate their networks is extremely costly. One solution to curbing the power of such natural monopolies is public ownership of these industries, another is private ownership coupled with strong government regulatory supervision. The government can promote allocative efficiency by an appropriate competition policy. Firms collude in a number of ways, such as price fixing, voluntary sales restraints, partitioning the market, to mention just a few. When firms do so, they restrict competition and raise barriers to entry for new competitors [1]
Market failure due to inadequate information
Uncertainty, moral hazard, and asymmetrically distributed information among economic agents is a central source of market failure (Arrow 1974 [2]). The result is imperfect competition and sup-optimal trades. Many types of informational failures have been suggested. Arrow (1975) emphasized uncertainty in the upstream supply of a good and the consequent need for information by downstream firms. The basic conclusion is that even when the initial conditions meet the requirements to produce a competitive result, the likely upshot will be nonetheless a tendency towards imperfect competition. Arrow continues by showing that the value of non-market decision making, in other words the rationale of creating organization that do not meet the criteria of the market as a whole, is partially determined by the characteristics of information flow and the costs of information. Complicating the issue further is the fact first ob-served by March and Simon (1958 [3]). They term this complicating factor “bounded rationality”. Bounded rationality acknowledges that human behavior is intended to be rational but, in reality, it is only so to a limited extent.
Market failure due to externalities
An externality occurs when the actions of one economic agent affect the welfare of others in a way that is not reflected by market prices. An externality can have positive or negative effects. Examples of positive externalities, or external benefits, are telephone networks, where the benefit to one user increases disproportionately with each additional user. Environmental pollution, an example of a negative externality, engenders external costs not paid for by the responsible party. Social costs reflect the complete cost to all members of society and are composed of private costs and external costs associated with it. Social benefits are similarly defined. Discrepancies between social costs and private costs, and social benefits and private benefits indicate a socially inefficient market allocation. Government intervention (e.g. environmental regulation) can to some extent correct this market failure and eventually force the internalization of external costs (Williamson 1971 [4]).
Streets, lighting of those streets, and national defense are common examples of collective goods, another class of externality problems. The benefits are available to everyone and in addition, no one can be excluded from receiving them, because the costs of doing so would be prohibitively expensive. Common goods, such as the sea and the air, can be consumed by everybody because assigning property rights is very difficult. Again, the market system will not provide an optimal solution. Government intervention can, for example, provide a collective provision of that particular good and impose a tax to pay for it (e.g. public broadcasting services; Levacic 1991 [1]).
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[1] Levacic 1991: Levacic R., “Markets and government: An overview”, in Thompson G., Frances J., Levacic R., and Mitchell J. (eds.), Markets, Hierarchies and Networks – The coordination of social life, London: Sage Publications, 1991, pp. 35-47.
[2] Arrow 1974: Arrow K.J., “Organization and Information”, in Arrow K.J. (ed.), The Limits of Organization, New York: Norton, 1974, pp. 33-43.
[3] March and Simon 1958: March J.G and Simon H.A., Organizations, New York: John Wiley & Sons, 1958.
[4] Williamson 1971: Williamson O.E., “The Vertical Integration of Production: Market Failure Considerations”, American Economic Review, LXI (2), May 1971, pp. 112-123
Market failure due to imperfect competition
If markets are to allocate resources efficiently they need to be competitive. The degree of competition in a market depends on the number of competitors and their relative position in the market place. Generally, competition increases with the number of firms supplying a particular good. Furthermore, prices must correctly reflect the opportunity costs of goods. Firms with excessive market power will price their goods in excess of marginal cost.
Some product markets lack serious competition, because they are inherently monopolistic, like gas, electricity, telephone , and water supply industries. These situations are called natural monopolies because to duplicate their networks is extremely costly. One solution to curbing the power of such natural monopolies is public ownership of these industries, another is private ownership coupled with strong government regulatory supervision. The government can promote allocative efficiency by an appropriate competition policy. Firms collude in a number of ways, such as price fixing, voluntary sales restraints, partitioning the market, to mention just a few. When firms do so, they restrict competition and raise barriers to entry for new competitors [1]
Market failure due to inadequate information
Uncertainty, moral hazard, and asymmetrically distributed information among economic agents is a central source of market failure (Arrow 1974 [2]). The result is imperfect competition and sup-optimal trades. Many types of informational failures have been suggested. Arrow (1975) emphasized uncertainty in the upstream supply of a good and the consequent need for information by downstream firms. The basic conclusion is that even when the initial conditions meet the requirements to produce a competitive result, the likely upshot will be nonetheless a tendency towards imperfect competition. Arrow continues by showing that the value of non-market decision making, in other words the rationale of creating organization that do not meet the criteria of the market as a whole, is partially determined by the characteristics of information flow and the costs of information. Complicating the issue further is the fact first ob-served by March and Simon (1958 [3]). They term this complicating factor “bounded rationality”. Bounded rationality acknowledges that human behavior is intended to be rational but, in reality, it is only so to a limited extent.
Market failure due to externalities
An externality occurs when the actions of one economic agent affect the welfare of others in a way that is not reflected by market prices. An externality can have positive or negative effects. Examples of positive externalities, or external benefits, are telephone networks, where the benefit to one user increases disproportionately with each additional user. Environmental pollution, an example of a negative externality, engenders external costs not paid for by the responsible party. Social costs reflect the complete cost to all members of society and are composed of private costs and external costs associated with it. Social benefits are similarly defined. Discrepancies between social costs and private costs, and social benefits and private benefits indicate a socially inefficient market allocation. Government intervention (e.g. environmental regulation) can to some extent correct this market failure and eventually force the internalization of external costs (Williamson 1971 [4]).
Streets, lighting of those streets, and national defense are common examples of collective goods, another class of externality problems. The benefits are available to everyone and in addition, no one can be excluded from receiving them, because the costs of doing so would be prohibitively expensive. Common goods, such as the sea and the air, can be consumed by everybody because assigning property rights is very difficult. Again, the market system will not provide an optimal solution. Government intervention can, for example, provide a collective provision of that particular good and impose a tax to pay for it (e.g. public broadcasting services; Levacic 1991 [1]).
---------------------------
[1] Levacic 1991: Levacic R., “Markets and government: An overview”, in Thompson G., Frances J., Levacic R., and Mitchell J. (eds.), Markets, Hierarchies and Networks – The coordination of social life, London: Sage Publications, 1991, pp. 35-47.
[2] Arrow 1974: Arrow K.J., “Organization and Information”, in Arrow K.J. (ed.), The Limits of Organization, New York: Norton, 1974, pp. 33-43.
[3] March and Simon 1958: March J.G and Simon H.A., Organizations, New York: John Wiley & Sons, 1958.
[4] Williamson 1971: Williamson O.E., “The Vertical Integration of Production: Market Failure Considerations”, American Economic Review, LXI (2), May 1971, pp. 112-123
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