MARKET FAILURE

Concept of market failure and inefficiency

(Productive and allocative inefficiency using PPC) Causes of market failure (Public goods, Market power, Externalities , Information asymmetry and Equity) Government intervention and market efficiency Case studies Prepared by: Dr. REKHA MAHADESHWAR

Market Failure : Meaning

-

A market failure is a source of inefficiency in an imperfectly competitive economy.

- When market signals dont give the best possible answer to the WHAT, HOW and FOR WHOME questions. - The invisible hand has failed to achieve the best possible outcomes of output mix.

- Economy ends up with wrong (suboptimal) mix of output

Productive Efficiency
When a firm produces its products at the lowest possible unit cost (average cost)
MC AC Cost ($) C When MC = AC a firm is productively efficient.

Q Output

They are combining their resources as efficiently as possible and resources are not being wasted

Productive Efficiency
Productive efficiency requires that all firms operate using best-practice technological and managerial processes. The concept is illustrated on a Production Possibility Frontier (PPF) where all points on the curve (A, B, and C) are points of maximum productive efficiency (i.e., no more output can be achieved from the given inputs). Point D shows suboptimal mix of output.
Production of good X A

B D

Production of other goods

Allocative Efficiency
(Socially Optimum Level)

Occurs when suppliers are producing the optimal mix of goods and services required by consumers.
Normal Demand Perfectly Elastic Demand

MC Price ($)

MC = AR Price ($)
Cost to producers = Value to Consumers

MC

D = AR = MR

MR Output Q1

D = AR Output Q2

If Allocative Efficiency exists then so to will PARETO OPTIMALITY it is impossible to make one person better off without making anyone worse off.

Allocative Efficiency
Pareto defined allocative efficiency as a situation where no one could be made better off without making someone else at least as worth off.
Production of good X

A (Optimal Mix)

B (Market Mix)

Production of other goods

Market Failure : Causes - Bradley Schiller

Public goods
Price signal fails (is flawed). Link between paying and consuming is broken. We do not have technical capacity to exclude nonpayers. For private goods benefits of consuming a particular good are available only to the individuals who purchase that good. Public goods face Free-Rider Dilemma. Individuals may conceal their demand for public goods. If public goods are marketed like private goods, everyone would wait for someone else to pay. We cannot rely on the market mechanism to allocate enough resources to the production of public goods. The society may produce suboptimal combination of goods.

Market Failure : Causes

Externalities
Price signal fails (is flawed). Externalities is a tendency of costs/benefits of some market activities to spill over onto third party. As a result there is difference between market demand and social demand (which include externalities). The market responds to consumer demand and not externalities.
Price Market Supply Market Demand

Social Demand Q1 Q2 Quantity

Market Failure : Causes

Socially optimum level of output is Q2 which is less than market output Q1.

The market will under produce goods that yield external benefits and over produce goods that generate external costs.

Market Failure : Causes

- Market power
Response to price signal is flawed. Monopoly firm attains discretionary powers over the markets responses to price signals. This discretionary power is used to increase its own profit rather than to move the economy towards the optimal mix of output. The market fails to produce the most desired goods/services.

- Equity
Market mechanism is concerned about FOR WHOME to produce output. However, market mechanism may not necessarily lead to equitable distribution of income. The market mechanism may enrich some people while leaving others at BPL. In such situations market may produce suboptimal output mix.

Market Failure : Causes

Information asymmetry
http://www.borooah.com/Teaching/Post%20Graduate%20Microeconomics/Week%203_Adverse%20S election.pdf

Information asymmetry refers to the fact that the buyer and the seller of a commodity may have different amounts of information about that commoditys attributes.
Price

P1 P2

Uninformed Demand

Informed Demand

Q1

Q2

Quantity

Market Failure : Causes

Q2 is the actual quantity purchased. Q1 is the quantity consumers would have purchased had she been fully informed. P1ABP2 is gain in producers surplus.

Government Intervention and Market Efficiency

Production of good X

A (Optimal Mix)

B (Market Mix)

Production of other goods

Government Intervention and Market Efficiency

- Public goods PPP - Market power Control of Monopoly, Anti trust Act - Externalities Measures to encourage production of goods that generate external benefits and discourage production of goods that lead to external costs. http://sutlib2.sut.ac.th/sut_contents/H120462.pdf - Information asymmetry Information - Equity Measures, Tax, Subsidy, Transfers

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