Good Essay About What Is Meant By Market Failure And How Can Government Attempt To Correct It?

Introduction

Market failure is an economic term that is indicative of a situation in which there remains wide gap between demand and supply. In this situation, the quantity of products demanded by the customers does not equate to the quantity supplied by the suppliers as a result of which the market equilibrium allocation becomes inefficient (Pasour, 1995). Either the goods or services are over or under produced, resulting in market failure. Market failure takes place due to a variety of reasons, including monopolized market situation, negative externality, positive externality, public goods, inequality or unfair distribution of resources in a free market, and merit and demerit goods. One of biggest incidents of market failure identified by economists is the climate change. According to Nicholas Stern, the chief economist of the World Bank, climate change is the biggest market failure in the human history (Clark, 2012). Due to the externality of greenhouse gas emissions the impact of which does not fall on the firms responsible for the emissions, the firms responsible for this scenario do not take any action as how much to produce, leading to over production of goods and over production of greenhouse gases. It is the future generations who are likely to suffer from the environment costs of the thoughtless activities of the preceding generations. The only way this greenhouse gas externality and the resultant market failure can be addressed is through government intervention (Clark, 2012). The government must introduce a policy of increasing the price of activities that produce greenhouse gases. Thus, the government will force the firms causing the problem to bear an economic burden and simultaneously will stimulate the innovation of low-carbon technologies. This paper will discuss market failure in greater detail, touching upon the causes and consequences and the government’s role in market corrections.

Causes

Though there are a host of factors contributing to the scenario of market failure, the mainstream economic analysis identifies three primary reasons for market failure, and these are monopoly, externality and public goods (Heath, 2013).

Imperfect Market Condition and Market Failure

A monopolized market is the one in which a small group of firms or a single seller holds significant market share over others and can dictate the market dynamics by setting higher prices. Monopolies in the market are formed when a firm has exclusive ownership of the use of a scarce resource. For instance, British Telecom has a monopoly over the market as the majority of the telephone cabling running into the UK homes and businesses is owned by it (Stigler, 2008). Sometimes, the government also grants a monopoly status to a firm like Post Office. Many firms by issuing patents or copyrights hold an exclusive ownership to certain products and protect their intellectual property. For instance, Microsoft holds monopoly over the brand name of 'Windows' and MS Office and protects them from any unauthorized use (Heath, 2013). Sometimes, firms by merging with each other capture a dominant position in the market, owning a monopoly status.
A healthy ideal market is the one in which there are a lot of distributors and sellers of a product or service so that a healthy competition goes on, with no one particular firm dictating the terms of the market and the pricing being under control. However, in the monopoly market, such situation is far from ideal. Firms can set higher prices than is possible in a competitive market. Firms due to their exclusive ownership and power over the market can deter new entrants through predatory pricing in which the price of a product is set so low to demonstrate power that the potential or the existing rivals go out of business (Stigler, 2008). Firms can also limit pricing by setting the prices of a product or service just below the average cost of new entrants. If the new entrants try to match the prices, they will make a loss (Heath, 2013). A monopoly market is also productively inefficient as in order to keep a product in demand, the firms can produce the product in a limited number just below the demand curve so that they can keep the pricing perpetually higher and in the absence of competition or their exclusive ownership rights, they continue to earn maximum benefits out of the situation (Stigler, 2008).

Externalities

When the effect of the consumption or production of a good or service is incurred by a third party, it is called an externality. Externality can be both positive and negative. A negative externality is the one that makes a negative spillover effect on third parties (Triest, 2009). For instance, if a steel company while producing steel pollutes the atmosphere, then it does not need to pay any price for its action of polluting the atmosphere. The price of the polluted atmosphere will be borne by the society and not the steel firm. The market price for steel will not incorporate the environmental cost as a result of which the market equilibrium will not be optimal in the steel industry, resulting in market failure (Pasour, 1995). Since the steel firm does not need to bear the price of damage it is causing to the environment and the society as a whole, it will continue producing steel in more quantity than required, causing more damage to the society and adding to the environmental costs.
Positive externality that makes positive effects on society can also contribute to market failure. For instance, education affects the society by increasing the rate of productivity and higher GDP (Heath, 2013). However, market failure may result from the under-consumption of the education as the free market might be unable to take the benefits of education into account, because the marginal social benefits of good consumption is higher than private marginal benefits.

Public Goods

Public goods are goods that are non-excludable and non-rivalrous, meaning people cannot be excluded from using these goods or the use of these goods by one person does not reduce its availability to others (Triest, 2009). Public goods include knowledge, fresh air, national security, lighthouses, public fireworks, street lighting and disaster control mechanism (Heath, 2013). At times, many public goods are overconsumed leading to negative externalities that affect all the users. For instance, traffic congestion is an example of market failure caused by overconsumption of the public goods like public roads and highways. Since the entire population of a country has an access to the use of public roads and highways (non-excludable), and since the use of these roads is of low cost and produces higher benefit to the users, often these roads become congested due to over-use, decreasing its usefulness to the society. Public goods often give rise to the problem of 'free-rider' in which people continue to take the benefit of using the public goods despite not paying for it (Heath, 2013). For instance, an individual who skips on road tax may continue to enjoy the benefits of clean and concrete roads despite not paying for it, because of its non-excludability. The free-rider problem leads to over-consumption, underproduction and degradation of public goods, causing an economic burden to the society.

Government Role in Market Corrections

The government plays an important role in improving the situations of market failure. The government plays two major functions in market corrections; protective function and productive function (Pasour, 1995). The government can protect individuals and their property from invasions by maintaining a legal structure for the enforcement of laws and contracts. The government also plays a productive function by ensuring the production of goods and services that cannot be easily provided via private markets.
Taking the above causes of market failure into account, the government intervention is needed in order to save the market from the ill-effects of monopoly, externalities, and misuse and overuse of public goods. The government can reduce monopoly in the market by introducing competition through market liberalization. Since the absence of competition makes the market dictated by a handful of companies that manipulate and maneuver the market dynamics according to their self-interest without bothering about the social benefits, it is important to introduce competition to break such monopoly so that consumers have a range of options to choose from when it comes to product and services. A healthy competition also forces the companies to improve the quality of products and services without charging an exorbitant price.
The government can regulate monopolies by yardstick competition, price capping, and impeding the growth of monopoly power through various actions such as converting the monopoly into a public owned monopoly environment or fragmenting the monopoly among a number of competitors (Triest, 2009). For instance, there was a time when AT&T dominated the US phone market with the government protecting its monopoly by law. However, as a result AT&T became bureaucratic in its management in order to correct which the government had to take the action of breaking up AT&T's monopoly. After the breakup of AT&T's monopoly in 1984, a host of competitors like Sprint, MCI and others have emerged in the market creating a healthy competition in the telecommunication service (Pasour, 1995). Today most of the countries prohibit the abusive practices of monopoly by law. Some of the abusive practices prohibited by the legislation include predatory pricing, price discrimination, limiting supply, and tying and product bundling (Triest, 2009).
In order to prevent the adverse effects of externalities, the government can take a number of measures such as the introduction of indirect taxes to increase the price of products with negative externalities. For instance, if a steel company is responsible for contributing to environmental pollution, the government can levy an indirect tax to the steel products so that the opportunity cost of consumption increases and the demand of consumers decreases in a socially optimal level. Carbon tax, for example, is an indirect tax imposed by many countries, including the USA, the European Union, Australia, the UK, India and Japan (Heath, 2013). The carbon tax is levied in order to reduce the greenhouse gas externality.
The government provides subsidy to increase the consumption of goods that have positive externalities. For instance, if public transport is subsidized, it will encourage people to drive private cars less, leading to a reduction in negative externalities of carbon emissions and traffic congestion. The governments, thus, provides subsidies for various goods such as healthcare, education and the collection of litter and refuse to enable greater degree of social efficiency (Triest, 2009).
Sometimes positive externalities like education can lead to market failure if the number of educated people becomes more in supply than the jobs created for them. Hence, the government gives tax relief to offer financial assistance to business corporations to expand on their business. A reduction in corporation tax, for instance, is a tax relief offered by the government to private firms in order to create more employment opportunities and promote capital investment in business expansion (Triest, 2009). The government also introduces changes to taxation and welfare programs to promote equal distribution of income and wealth. The government in order to maintain the equilibrium of wealth and income distribution levies higher direct tax rate on high-earning groups and reduce the tax rates for the poor households.
The government can correct the free-rider problem of public goods by levying taxes. For instance, national defense, which is a public good, costs the UK a whopping £31 billion, resulting in higher taxes for the UK taxpayers (Heath, 2013). That way, the cost of national defense is indirectly borne by the UK taxpayers. This ensures that everyone using the service pays a price for it.

Conclusion

Market failure, which is an economic term, indicates a situation in which the allocation of products and services becomes inefficient due to either overproduction or under-production. Though there is an array of reasons for market failure, the three main reasons of market failure identified by the economists include externalities, public goods, and imperfect market condition arising out of monopoly. A market monopoly refers to a situation in which a single firm or a number of firms monopolizes the market share, dictating the market dynamics as and when they wish. Such unfair market situation increases the pricing of products, deters the entrance of new competitors and threatens the existing competition. As a result, the optimal level of benefits is not attained by the consumers. Externalities refer to the impact that the consumption or production of goods and service make on a third party. Public goods refer to those goods that are non-excludable and non-rivalrous, meaning that no one can be excluded from the use of these goods. Public goods often rise to the problem of 'free-rider' leading to overconsumption and degradation of products and services. Since the government is the ultimate force to make decision-making policies, laws and enforcing them, it plays an important role in market corrections. The government can correct market failure by introducing fair competition, indirect tax on products with negative externalities, subsidies, tax relief, and social welfare benefits.

Work Cited

Clark, D. 2012. Why do economists describe climate change as a 'market failure'?. The Guardian. [Online] Available at <http://www.theguardian.com/environment/2012/may/21/economists-climate-change-market-failure> [Accessed 14 March 2015]
Pasour, E. 1995. Market Failure and Government Failure. Cultural Dynamics, 7(3), 419-426. doi:10.1177/092137409500700313
Stigler, G. J. 2008. Monopoly: Concise Encyclopedia of Economics (2nd ed.). Indianapolis: Library of Economics and Liberty.
Heath, J. 2013. Market Failure Or Government Failure? A Response to Jaworski. Business Ethics Journal Review, 50-56.
Triest, R. K. 2009. The Economics of Subsidies for Community Development: A Primer. Smart Subsidy for Community Development. [Online] Available at <https://www.bostonfed.org/commdev/smart-subsidy/10-triest.pdf> [Accessed 14 March 2015]