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Market Failure

The market economy

In a market economy the decisions on consumption are taken by households; decisions to produce are taken by firms.

A market economy allows the price determinism mechanism to determine the output of goods and services, and what prices they are charged at.

Perfect and imperfect competition and efficiency

Productive efficiency is defined to be the production of goods and services at minimum cost. This means that it is not possible to produce more of any one good without producing less of another.

Allocative efficiency, which is also called Pareto efficiency [1] is defined to be a situation where it is not possible to improve one consumer's welfare without making another consumer worse off. [1. After the Italian economist, Vilfredo Pareto, who introduced it in his work Manuel D'Economie Politique (1909).]

All allocatively efficient economic systems are productively efficient, but not all productively efficient systems are allocatively efficient.

According to economic theory, which is examined in closer detail in a further unit, when markets operate according to perfect competition, the result is both productive and allocative efficiency.

Perfect competition arises when firms are small in comparison to the market, and they are consequently price-takers. In other words, the market determines the price at which the goods are sold. Each firm faces a perfectly elastic (horizontal) demand curve.

In loose terms we can see why. In perfect competition firms are driven by competition towards optimal productive efficiency. The market ensures that the price each person pays for the goods produced is equal to the cost of producing them — that is, when the costs of capital (interest payments) are also taken into consideration.

Let us examine the concepts of normal and supernormal profits.

Normal profit is the rate of return required to keep an investor's money in a business. It varies from business to business as different businesses involve different levels of risk. When the risk is high, the return to the investors for placing their money with the business must also be high. Investors have the option of putting their money into the bank, or investing it in government bonds. The interest rate the government pays on investments is called the “base rate”. Any rate of interest, over and above the base rate can be called a “premium”. The rate of interest over and above the base rate that an investor must receive in order to invest in a possibly risky business is called the “risk premium”.

So, normal profit is the base rate + the risk premium.

Supernormal profit is any profit over and above normal profit. Capitalists wish to find businesses that provide supernormal profits.

Economists regard normal profits as an economic cost. From an economic point-of-view the normal profit is the cost of the capital invested in the business. It is, therefore, incorporated into the cost curve of the company. Any profits above normal profits are called economic profits, abnormal profits or supernormal profits. All the terms mean the same thing.

The theory shows that companies in perfect competition only make normal profits.

Imperfect competition arises when firms have some measure of control over the price they charge for the goods and/or services they produce, and this results in falling demand curve that exhibits some kind of inelasticity.

A demand curve exhibiting variable elasticity

When demand is inelastic companies can charge prices that result in supernormal profits. These supernormal profits mean that companies are siphoning off profits and redistributing wealth and income from the consumer generally to the shareholders. In other words, where there are supernormal profits then there is also productive and allocative inefficiency.

There are three market structures that lead to imperfect competition: these are, monopoly, oligopoly and monopolistic competition.

So the existence of monopolies and the other market structures described here are likely to result in a misallocation of resources, in the sense that production becomes productively and allocatively inefficient.

Externalities

Externalities are costs imposed on, or benefits given to, firms or households which are not parties to the transactions that give rise to these effects. For example, the production of electricity in coal-fired power stations in the UK has traditionally involved the creation of sulphur dioxide emissions that result in acid rain in Norway. The electricity generators pay only for the raw materials and labour required for production, and do not have to pay compensation to the Norwegians whose forests are stripped bare as a result of the pollution. The pollution is an external cost that is not paid for by the company producing it.

Other examples of social costs include slum housing, traffic congestion and depletion of the ozone layer.

There are different types of external cost:

(1)		Producer to producer external costs. An example is water pollution. The pollution of a river by an upstream firm when clean water is required by a downstream firm, imposes an external cost on the downstream firm.
(2)		Consumer to consumer external costs and (3) consumer to producer external costs. An example is alcohol consumption. Alcohol consumption causes road accidents that impose costs (that is, injuries and damages) on other people who are not consuming alcohol. The accidents also remove from the workforce people who are needed by businesses, thus imposing a cost of replacement on producers. Another example is street fighting. The resultant hospital bills are imposed on individuals and society who are not party to the “entertainment” of street fighting.

Examples of external costs that cross national boundaries are (1) acid rain; (2) global warming; (3) ozone depletion.

Social benefits are benefits from goods and services that the companies producing the goods and services cannot charge for. An example could be private education. Parents choosing private education for their children pay for the benefit that they and their children can be expected to reap from the education received. But educated people are generally more productive and more capable of offering services to the community as a whole than people with lower levels of education, and society as a whole benefits from education, not just the people who directly receive it.

Other examples of social benefits are public transport, well-maintained housing and health care.

In practice it is very difficult to evaluate social costs and benefits.

Another term for a social cost is negative externality. Another term for a social benefit is positive externality.

Over or under production

When social costs are not taken into account the result is under-pricing and over-production.

Conversely, when social benefits are external to the market and not subject to a demand schedule determining prices, the result is under-production.

The reason is that the firm that is producing the goods (or services) does not have to pay for all the costs. The external costs are born (“paid for”) by other people. Consequently, the cost of producing the goods (or services) is less than it should be. Consequently, firms can produce more for any given sales price. The result is overproduction.

Conversely, when there are external benefits, the result is under-production.

Hence, externalities cause production to be not allocatively efficient.

Social costs are also not fair (not “equitable”). This is because costs are imposed on third parties who receive no compensation, and benefits are gained by third parties who make no payment.

In other words, and to sum up, external costs and benefits are both inefficient and unfair.

Factor immobility

Factor immobility occurs when a factor of production cannot move easily from one region of an economy to another. The obvious example concerns the movement of labour. Suppose, for example, there is an increase of demand for labour of all kinds in London, whilst the North of England experiences a decline in demand. Other things being equal, workers will migrate from the North to London in order to take up the jobs on offer there. However, many things may arise to hinder this process. For example, (1) there could be a lack of information; workers in the North of England might not know that they could get well-paid jobs in London; (2) There could be a lack of housing; workers that migrate to London may not be able to find accommodation, or the cost of renting the accommodation could erode the increased benefits of taking the job in London; additionally, they may not have enough money to provide a deposit for rented accommodation. Any one of these factors may prevent workers from migrating; (3) Workers in the North of England may have a different culture from those in the South; workers may be reluctant to leave their communities behind and learn a different way of living.

Similar immobility can occur between different segments of the labour market. Broadly speaking the labour market is divided between skilled and unskilled (manual) labour. It takes time for someone who is unskilled to train to become a skilled worker. In some cases, it may be impossible for a worker to learn new skills. Hence, a shortage, for example, in the market for skilled labour may develop.

These are examples of structural imperfections in an economy.

The movement of capital can also be restricted, resulting in factor immobility. However, where there is a single currency union, such as operates throughout the United Kingdom (with sterling) or through the European Union (with the Ecu), this does not tend to be a problem. Barriers to the free-flow of capital can exist between different currency unions. Some countries may prevent their currency being exported abroad by legal measures.

Public goods — missing markets

Certain goods, such as defence, cannot be provided by a market. Since there can be no market in defence, this is called a missing market. Such goods, for which the market mechanism wholly fails, are called public goods.

Merit goods — information failure

Another source of market failure concerns certain goods, called merit goods, that are underprovided by the market. Examples of merit goods include health care and education. The reason why they are underprovided is that the public are unaware of their benefits. Thus, the underprovision arises from a failure of in the flow of information.

Market failure

Market failure exists when a market is unable to achieve optimum allocation of resources. Market failure results in allocative (Pareto) inefficiency.

We have examined here five sources of market failure:

1		Where competition is not perfect
2		Where there exist externalities
3		Where there is factor immobility
4		Where there are missing markets
5		Where there is failure of information