PLEKHANOV RUSSIAN UNIVERSITY OF ECONOMICS

INTERNATIONAL BUSINESS SCHOOL

COURSEWORK IN MICRO ECONOMICS

MARKET FAILURES AND THE ROLE OF THE GOVERMENT

Student:Kuchinskaya M. Group: 5103

Supervisor:Ermalaev S.

Moscow 2012

INTRODUCTION EXAMPLES OF POTENTIAL MARKET FAILURE

Externalities Public Goods Imperfect information Market Power

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GOVERNMENT INTERVENTION AND MARKET FAILURE

Options for government intervention in markets

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CONCLUSION

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Introduction The primary goal of my project is to show you all the importance of the role of goverment,when market failures occur. Defined as a situation where a market is not producing efficient outcomes, there are in fact several different kinds of market failure. The main category is comprised of externalities, which occur when a transaction between two parties has a significant impact on a third party lacking any direct involvement in the original deal. A prime example is a firm generating pollution when it manufactures a good on behalf of a customer. Insofar as other citizens suffer from this pollution without benefiting from the good's production (as either employees or consumers), the market can be said to have failed them. Market failure can also lead to positive externalities for third parties. For instance, when an employer hires graduates of a state school system but pays them far less than the benefits it derives from having such well-trained staff members, they get undue advantages referred to as a 'free ride'. Education can be analysed as a state investment whose benefits, in this instances, have accrued to private parties, i.e. future employers, who have not earned this benefit in the sense that they did not contribute to the costs of graduates' schooling. This too is unfair and therefore inefficient. Another case of market failure is the existence of 'public goods', defined as goods that are 'nonexclusive' (benefiting even those people who have not paid for them) and 'non-rival' (some people's consumption does not prevent others from consuming them as well). An example of a public good is street lighting. Once they have been set up everyone can use them, and their use by one person does not prevent their use by another. It would be very difficult for private parties to make profits running streetlights since there is no pricing mechanism that could reward them satisfactorily for consumers' use of their good. Yet streetlights are necessary to society, if only because they support other productive activities. This is another situation where the market system fails, and often one that will be funded by governments using tax revenues. A third example of market failure is the imperfect distribution of information between participants to a transaction, creating a situation where one side can take advantage of the other and be rewarded without having provided commensurate value in the exchange. A recent example of this is provided by the investment products whose disintegration sparked the 2008 credit crunch. These instruments were sufficiently complicated (based on generally undisclosed assumptions about financial market correlations) for many buyers not to have fully understood the nature of the risks they were assuming. The subsequent meltdown in the assets' value, after financial institutions had already received large sums upfront for selling them, led to a massive transfer of wealth to one small sector of the economy (banks) to the detriment of all others (investors in general). The market failure was patent, given that the original transactions had been between private parties operating without effective supervision. Normally, it is only
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through strong government regulatory systems that these kinds of dysfunctions can be minimized. A final category of market failure occurs when one (or a few) participant(s) in a marketplace accumulate disproportionate power, preventing normal supply and demand mechanisms from determining fair prices. In situations where there is a single seller ('monopoly') or buyer ('monopsony'), or else a cartel of sellers ('oligopolies') or buyers ('oligopsonies'), market participants who are not members of one of these groups will not be given a fair chance to influence outcomes. A prime example is the OPEC oil cartel, which can decide its oil production quantities for strategic reasons that have nothing to do with market forces. A not dissimilar example is the power that Russia has over the European energy markets due to its large gas reserves. Russia may not have a monopoly but it is in a position to impose its pricing policies more or less irrespective of consumer behaviour. This is due to the lack of substitute products and comprises one reason why so many EU governments are looking to build an infrastructure in home grown renewable energies. In terms of government policy, many countries have competition authorities whose purpose is specifically to prevent the kind of market failure that is caused by inadequate competition. In Adam Smith's market theory, competition is considered absolutely crucial to a market finding its equilibrium price (i.e. the level where prices constitute accurate indicators of value) - a precondition for the optimal allocation of resources. Conversely, where market prices are inaccurate due to some participants' power strategies, business decisions will be irrational (people will consume too much or produce too much) and the economy will suffer from dis-equilibrium. This is the very opposite of market efficiency. 1 In the next paragraphs I will show more precisely all market failures and tell you about how the goverment can help market to solve its problems.

Buckley. P. and Casson, M. (1976), The Future of Multinational Enterprise, London: MacMillan.

Hymer, S. (1960), The International Operations of National Firms, Ph.D dissertation, Massachusetts Institute of Technology.

Market failure is a situation which occurs when resources are not allocated effectively or efficiently. This concept in economics can take a number of forms and appear in a variety of situations, and it is often viewed as something which needs to be corrected through intervention, usually on the part of the government, when it appears in the real world. For example, when fisheries experience market failure, the government is expected to step in with policy decisions which will resolve the issue. When market failure occurs, it means that the system is not Pareto efficient. Pareto efficiency refers to a situation in which any improvement to one area would cause a corresponding harm to someone else. For example, if a fried potato franchise lowers the price on its product, bringing about an improvement for consumers, it would also have to lower the price it pays to potato farmers, thereby causing harm. When a system reaches Pareto efficiency, it means that it is operating at optimum level, with everything in balance.

There are a number of factors which can contribute to market failure. Markets can fail because of: 1. Negative externalities (e.g. the effects of environmental pollution) causing the social cost of production to exceed the private cost. 2. Positive (or beneficial) externalities (e.g. the provision of education and health care) causing the social benefit of consumption to exceed the private benefit 3. Imperfect information means merit goods are under-produced while demerit goods are over-produced or over-consumed 4. The private sector in a free-markets cannot profitably supply to consumers pure public goodsand quasi-public goods that are needed to meet peoples needs and wants 5. Market dominance by monopolies can lead to under-production and higher prices than would exist under conditions of competition 6. Factor immobility causes unemployment hence productive inefficiency 7. Equity (fairness) issues. Markets can generate an unacceptable distribution of income and consequent social exclusion which the government may choose to change Market failure results in

Productive inefficiency: Businesses are not maximising output from given factor inputs. This is a problem because the lost output from inefficient production could have been used to satisfy more wants and needs
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Allocative inefficiency: Resources are misallocated and producing goods and services not wanted by consumers. This is a problem because resources can be put to a better use making products that consumers value more highly

Governments can intervene to address this issue in a variety of ways, including through bailouts, legislation, policy changes, controls on wages, and taxation. One of the issues with government intervention is that it can also contribute directly to market failure and make the problem worse by failing to allocate resources appropriately. Knowing how and when to intervene is a difficult decision which can be complicated by political and social issues which may influence people and institutions involved in decision making.

EXAMPLES OF POTENTIAL MARKET FAILURE There are plenty of reasons why the normal operation of market forces may not lead to economic efficiency.

Externalities
Externality - an economic side effect that affects an uninvolved third party. These are also examples of market failures. There are two types of externalities:

Negative externality- harmful side effect that affects an uninvolved third party. In most events, it constitutes external cost.

Positive externality- beneficial side effect that affects an uninvolved third party. An externality, by definition, is an economic side effect that either benefits or harms a party not directly involved in the activity. A negative externality is an action that harms a third party resulting in external cost. An example of this would be the construction going on on the LIE. Because the roadway is being widened, trees along side have been taken down, thus exposing the once secluded service road and the homes that are alongside it.
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This construction has annoyed drivers, who have to put up with the mess and homeowners as well. A positive externality is if the economic action benefits a third party. Such an example can be drawn from the previously mentioned one. The construction on the LIE may cause traffic tie-ups, but local businesses may benefit from the traffic, which detours by their shops, and the workers who may require services from one of the businesses. Production Externalities and the Failure of Competitive Markets Figure 1.1 MPC = marginal private cost (this is the inverse of the private supply curve) MEC = marginal externality cost (suffered by people damaged by pollution) MSC = social cost (vertical sum of MPC and MEC) Social optimum at B (where MSB=MSC) Social Benefits = ABQ*O. Social Costs = OBQ*. Social Welfare = ABO. Free market outcome at C Social Benefits = ACQcO. Social Costs = OCQc + OEC = OEQc. Social Welfare = ABO - BEC. Deadweight Loss = BEC. An example of a case where pollution is directly related to output: Fertilizers: Use of fertilizers leads to nitrate / phosphate contamination of ground water. Thus, the output of fertilizer might be a good example to keep in mind. 2

Public Goods
Public goods are those goods and services provided by the government because a market failure has occurred and the market has not provided them. Sometimes it is in our benefit to not allow for a market provision. In the case of police, national defense and public education it can be argued that private provision of these services would be less desirable for a variety of reasons.

Department of Agricultural and Resource Economics EEP 101 University of California at Berkeley David Zilberman Spring Semester, 1999 Chapter #3

Public goods are economic products that are consumed collectively, like highways, sanitation, schools, national defense, police and fire protection. All members of society should theoretically benefit from the provision of public goods but the reality is that some need them more then others. For example the wealthy do not need welfare and the elderly still pay for school taxes. This leads to the inevitable argument about paying for public goods taxes.

Imperfect information Imperfect information can be caused by

Misunderstanding the true costs or benefits of a product: E.g. the social costs and benefits of different classes of drugs and the private and social benefits from higher education when there are so many universities and courses to choose from

Uncertainty about costs and benefits e.g. should younger workers be buying into pension schemes when we can only guess at economic conditions in 40 years time?

Complex information e.g. choosing between makes of computers requires specialist knowledge of hardware. Do I buy an Apple or PC computer? The problems of choosing a quality second hand car or when deciding whether or not to buy a property

Inaccurate or misleading information e.g. persuasive advertising may oversell the benefits of a product leading to a higher demand and consumption than is optimal

Addiction e.g. drug addicts may be unable to stop consumption of harmful substances

Imperfect information are equity release schemes being mis-sold? The consumer watchdog group Which? has criticized the advertising of housing equity release schemes which they claim can be very expensive and inflexible leaving homeowners, and especially older property owners, with virtually no equity in their properties later on in their life. Which? claims that, for example, borrowing 80,000 through a lump sum equity release scheme on a 350,000 property could end up costing 256,570 after 20 years or 343,350 after 25 years. Although the equity release schemes give property-owners the cash (or liquidity) that might be needed to meet short term spending needs, Which claims that such schemes are incredible expensive and that downsizing your property or even borrowing money from family is a much better option. Which? believe some suppliers of equity release schemes have engaged in irresponsible advertising which can lead to a miss-selling of the product. Norwich Union, for example, suggests its scheme could pay for a trip to New York or 'something for the family'. Health warnings for snacks in bid to improve consumer information The food industry has made its first move towards issuing health warnings for snack foods. The decision comes as food companies come under in-creasing pressure to provide more information
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about the nutritional value of their products amid concern about rising levels of obesity. It marks a shift in the food industrys attitude towards consumers. Food companies have argued that consumer education is not their job. However, the threat of legislation to regulate the promotion of food to children has prompted the food and drink industry to become more proactive. The European Commission released a green paper in December questioning whether companies self-regulation for the marketing of sugary snacks and soft drinks was adequate. Last month, soft drink producers agreed to a voluntary ban on advertising to children in Europe. They also said they would provide better nutritional information on beverages and public education campaigns to promote healthy lifestyles. Food and drink manufacturers have already made efforts to cut down on fats, salts and sugars, and provide more nutritional information. This week, Walkers crisps said it had made a multimillion pound investment in sun seed oil to reduce levels of saturated fats. Last month, Nestl said it would put calorie information on the front of confectionery packets.3 The effects of asymmetric information Asymmetric information occurs when somebody knows more than somebody else in the market. Such asymmetric information can make it difficult for the two people to do business together Examples include the following:

A government selling mobile phone or broadcasting licences does not know what buyers are prepared to pay for them (an auction is usually the preferred solution to this).

A lender does not know how likely a borrower is to repay their loan in future years. A used-car seller knows more about the quality of the car being sold than do buyers.

Asymmetric information can distort people's incentives to buy and sell goods and services at the right prices and as a result can lead to inefficiencies and market failure. One of the classic examples of asymmetric information comes from research on the used car market by the Nobel Prize winning economist George Akerlof in his theory of the market for lemons!

Source: Adapted from news reports, February 2006

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The Market for Lemons Take problem of buying a used car. Assume that used cars come in two types: those that are in good repair, and duds (or lemons as Americans and most economists call them). Suppose further that used-car shoppers would be prepared to pay $20,000 for a good one and $10,000 for a lemon. As for the sellers, lemon-owners require $8,000 to part with their old banger, while the one-owner, careful-driver old lady with the well-maintained estate won't part with hers for less than $17,000. If buyers had the information to tell wheat from chaff, they could strike fair trades with the sellers, the old lady getting a high price and the lemon-owner rather less. If buyers cannot spot the quality difference, though, as is often the case in the real world, there will be only one market for all used cars, and buyers will be ready to pay only the average price of a good car and a lemon, or $15,000. This is below the $17,000 that good-car owners require; so they will exit the market, leaving only bad cars. This result, when bad quality pushes good quality from the market because of an information gap, is known as adverse selection. This was the simple but powerful insight of George Akerlof, now a professor at the University of Berkeley in California, in a seminal 1970 paper. A great many markets, including those for shares, labour, insurance and banking, often resemble a used-car sale more closely than a McDonald's restaurant.

Market Power
When an economic agent in a market has market power as the result of an imperfectly competitive market, a market failure can occur. Monopolies and oligopolies can take advantage of their control of finite resources or other barriers to entry in a market in order to charge prices that are much higher than the cost of production. This puts consumers at a disadvantage. On the
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other hand, monopsonies (one buyer of a good or service) and oligopsonies (few buyers) can take advantage of their situation by playing sellers off each other to artificially drive down prices and make demands that increase suppliers' costs. Monopsonies and oligopsonies are not often given much attention by regulators, but most countries, including the U.S., have strong antitrust laws to prevent monopolies. It is a concensus among economists that unregulated natural monopolies can have negative effects on a market, however economist Milton Friedman has argued that laws against monopolies do more harm than good and these problems can be better solved with free trade[7].

GOVERNMENT INTERVENTION AND MARKET FAILURE Government intervention may seek to correct for the distortions created by market failure and to improve the efficiency in the way that markets operate
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Pollution taxes to correct for externalities Taxation of monopoly profits (the Windfall Tax) Regulation of oligopolies/cartel behaviour Direct provision of public goods (defence) Policies to introduce competition into markets (de-regulation) Price controls for the recently privatised utilities

Options for government intervention in markets

There are many ways in which intervention can take place some examples are given below Government Legislation and Regulation Parliament can pass laws that for example prohibit the sale of cigarettes to children, or ban smoking in the workplace. The laws of competition policy act against examples of pricefixing cartels or other forms of anti-competitive behaviour by firms within

markets. Employment laws may offer some legal protection for workers by setting maximum working hours or by providing a price-floor in the labour market through the setting of a minimum wage. The economy operates with a huge amount of regulation. The government appointed regulators who can impose price controls in most of the main utilities such as telecommunications, electricity, gas and rail transport. Regulation may be used to introduce fresh competition into a market for example breaking up the existing monopoly power of a service provider. A good example of this is the attempt to introduce more competition for British Telecom and also for the postal service industry. This is known as market liberalisation. Direct State Provision of Goods and Services Because of privatization, the state-owned sector of the economy is now much smaller than it was twenty years ago. The main state-owned businesses in the UK are the Royal Mail which is still subject to direct price controls and Network Rail. State funding can be used to provide merit goods and services and public goods directly to the population e.g. the government
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pays private sector health firms to carry out operations for NHS patients to reduce waiting lists or it pays private businesses to operate prisons and maintain our road network. Fiscal Policy Intervention Fiscal policy can be used to alter the level of demand for different products and also the pattern of demand within the economy. 1. Indirect taxes such as changes in VAT and excise duties can be used to raise the price of demerit goods and products with negative externalities designed to increase the opportunity cost of consumption and thereby reduce consumer demand towards a socially optimal level. 2. Subsidies to consumers will lower the price of merit goods such as grants to students to reduce the internal costs of staying on in full-time education and subsidies to businesses employing unemployed workers on the New Deal programme. They are designed to boost consumption and output of products with positive externalities a subsidy causes an increase in market supply and leads to a lower equilibrium price (see the separate revision focus article on producer subsidies). 3. Tax relief: The government may offer financial assistance such as tax credits for business investment in research and development. Or a reduction in corporation tax designed to promote investment and employment. 4. Changes to taxation and welfare payments can be used to influence the distribution of income and wealth for example higher direct taxes on rich households or an increase in the value of welfare benefits for the poor to make the tax and benefit system more progressive. Intervention designed to close the information gap Often market failure results from consumers suffering from a lack of information about the costs and benefits of the products available in the market place. Government action can have a role in improving information to help consumers and producers value the true cost and/or benefit of a good or service. Examples might include: 1. Compulsory labelling on cigarette packages with health warnings to reduce smoking.
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2. Improved nutritional information on high-fat foods to counter the risks of growing obesity. 3. Anti-speeding television and cinema advertising to reduce road accidents. 4. Advertising health-screening programmes / information campaigns on the dangers of drug and alcohol addiction. These programmes are really designed to change the perceived costs and benefits of consumption for the consumer. They dont have any direct effect on market prices, but they seek to influence demand and therefore the level of final output and consumption. The effects of government intervention Decisions on our future energy sources government policy intervention can have huge effects on both the short term and the long term allocation of resources in the future One important point to bear in mind is that the effects of different forms of government intervention in markets are never neutral since financial support given to one set of producers rather than another will always create winners and losers. Taxing one product more than another will similarly have different effects on different groups of consumers. Judging the effects of intervention To help your evaluation of government intervention it may be helpful to consider these questions: 1. Efficiency of a policy: i.e. does a particular intervention lead to a better use of scarce resources among competing ends? E.g. does it improve allocative, productive and dynamic efficiency? For example - would introducing indirect taxes on high fat foods be an efficient way of reducing some of the external costs linked to the growing problem of obesity? 2. Effectiveness of a policy: i.e. which government policy is most likely to meet a specific economic or social objective? For example which policies are likely to be most effective in reducing the scale of the UK road congestion problem? Which forms of intervention are most effective in improving the incentives of consumers to actively search for work in the labour market? Which policies are more effective in preventing firms from exploiting their monopoly power and damaging consumer welfare? Evaluation can also consider which policies are likely to have an impact in
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the short term when a quick response from consumers and producers is desired. And which policies are likely to prove most cost-effective in the longer term? For example, how best to encourage recycling in the long run and also provide incentives to increase the supply of energy in the long run that comes from renewable sources such as wind power. 3. Equity effects of intervention: i.e. is a policy thought of as fair or does one group in society gain more than another? For example it is equitable for the government to offer educational maintenance allowances for 16-18 year olds in low income households to stay on in education after GCSEs? Would it be equitable for the government to increase the top rate of income tax to 50 per cent in a bid to make the distribution of income more equal? 4. Sustainability of a policy: i.e. does a policy reduce the ability of future generations to engage in economic activity? Inter-generational equity is an important issue in many current policy topics for example decisions on which sources of energy we choose to rely on in future years.

Conclusion I have explained above the role markets play in an economy. Markets have many weaknesses and fail the society on many fronts. Still, they are
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great social institutions of value and benefit since times immemorial. Preventive and corrective measures may mitigate their failures and increase their advantages. Successful local economy building, one that is equitable, inclusive and empowering requires singularity and clarity of purpose and a well-defined prioritization and ranking of focused interventions directed at utilization and maximization of resources at hand. At the end of the day, the major themes of economy building revolve around the appropriate mixture of private (market), government and civil society interventions directed at the object and participant of development: the poor and marginalized economic players. The following are the major strategies in building equitable and participative local economies: 1. Re-channeling and harnessing private investments for businesses and value-added creation that is local-based and is inclusive of small economic players; 2. Making available suitable development financing (from both public and private lenders) for the small and marginalized sectors along viable and local entrepreneurship-engendering economic activities; 3. Good, pro-poor and transparent local governance; 4. Stimulating and increasing social capital of the small and marginalized economic actors; and 5. Civil society focuses on helping the small and marginalized economic sectors organize themselves and increase their organizational capacity and maturity If scarcity and choice are central analytical focal points in any economic model, the same social phenomena internally omnipresent in development organizations characterize their choice of development
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interventions. It is essential that these development actors prioritize what18 they do best and cooperate with the other like-minded entities in doing the rest of the job.

"Market failure" http://conservapedia.com/Market_failure. (..). 18

"What is a market failure" http://tutor2u.net/economics/content/topics/marketfail/market_failure.htm. (..). "What is a market failure" http://www.wisegeek.com/what-is-a-market-failure.htm. (..).

Market Failure- Introduction

http://tutor2u.net/economics/revision-notes/a2-micro-market-failure-introduction.html

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