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(a) What are the various sources of market failure? [10]


(a) What are the various sources of market failure? [10]

Market failure is the failure of the free market to allocate goods in an efficient manner. In a free market economy, there are many types of market failure. This economics paper focuses on three main types of market failure, namely: externalities, both positive and negative, public goods, and imperfect competition in the market. This paper argues that market failure or the inefficient allocation of resources occurs when production is not at the socially optimum level.

First, externalities are said to exist when the actions of producers or consumers affect third parties who are offered no compensation for sustaining the loss generated. Externalities can be known as external diseconomies and economies as well as third party spillover effects. They exist because the market cannot deal properly with the side effects of many economic activities. Externalities involve an interdependence on utility and production functions. An external benefit or a positive externality refers to the benefit from production or consumption experienced by people other than the producers or consumers. This occurs when an externality-generating activity raises the production or the utility of the externality-affected party. Hence, the economic activity provides incidental benefits to others for whom they are not specifically intended.

Suggested Market Failure Figure 1: External cost in production

A negative externality or external cost refers to the cost of production or consumption borne by people other than the consumers or producers. The undesirable effects on the allocation of resources by an externality can be explained by the Marginal Social Cost (MSC). The Marginal Social Cost is a sum of the Marginal Private Cost (MPC) and the Marginal External Cost (MEC). MPC is a share of marginal cost caused by an activity that is paid by the people who carry out the activity and MEC is the share borne by others. When the firm’s activities generate negative externalities, its MSC will be greater than MPC. Since, in equilibrium, the market will yield an output at which consumers marginal benefit is equal to a firm’s MPC. Thus, as shown in Figure 1, MPB is less than MPC, hence the costs that is incurred to society outweighs the benefit derived from the good. Consider the soap industry which, in a free market would discharge waste products into the air and into rivers. The owners of soap factories being profit maximisers will only consider their private costs and ignore the wider social costs of their activities. Thus, MSC is more than MPC.

Suggested Market Failure Figure 2: External benefit in consumption.

An example of an activity which generates an external benefit in consumption is vaccination. If an individual makes a decision to be inoculated against a particular disease, then he will receive the private benefit of not being infected by that particular disease. However, there are also other possible benefits to all others with whom he comes into contact as they will not contract the disease from him. The vaccination protects not only the person who is vaccinated but also the entire community that person lives in, by preventing the spread of contagious diseases. Thus, MSB is greater than MPB. The individuals consider only private benefits and costs in their consumption decisions. Hence, they will consume OQ1 units where MPB=MPC. However, the socially efficient output occurs at OQ2, where MSB=MSC. There is thus an underconsumption of Q1Q2 of the good which results in a deadweight loss equal to the area of E2BE1. Insufficient scarce resources are being devoted to the production of this product. The market has failed to allocate resources efficiently.

Secondly, one major source of market failure is the failure of the free market to provide public goods without government intervention. Economic goods can further be subdivided into public and private goods. A public good is one that has two characteristics that private goods do not. Firstly, public goods are non-exclusive. This means that a producer or seller cannot separate nonpayers from benefiting from the good, so that someone who has not paid for the good cannot be prevented from consuming it. As a result, the payer too, eventually does not want to pay, because of the so-called free rider problem. As a consequence, the market will not produce a public good. This is market failure.

Using the concept of externality for public goods, there are no private benefits or revenue for the producer at all but more benefit for the society. Examples of public goods are street lighting, defence and radio broadcasts. The second characteristic is that public goods are non-exhaustible or non-rival. This means that the use of the good by one person does not reduce the quality or the amount available to another. As a result, there is no rivalry in consumption. As a result, there is no additional opportunity cost for the second and third person to use. Assuming that the allocative efficient level is P = MC, and MC = 0, then it stands to reason that P = MC = 0, and the good should be provided free of charge if it is to be produced at the socially optimal level. 

Third, there is the existence of imperfect competition which distorts a free market economy. In a free market economy, there is nothing to prevent the emergence of oligopolies and a monopoly in various industries. An oligopolistic market can be defined as a market structure where there are a few dominant firms which are rivals to each other, each producing either homogeneous or differentiated products, while a monopoly can be defined as one dominant firm producing a highly differentiated good with no close substitutes. The more successful firm (or firms) acquires other firms or puts them out of business. When these imperfect market structures occur, there will be allocative inefficiency because they generate shortages in order to hike up prices and increase profits.

Insert Economics diagram. Either oligopoly or monopoly diagrams. 

Hence, market failure usually results from the presence of externalities, the lack of provision of public goods and the allocative inefficiencies from imperfect competition. Thus there is a role for government intervention in the market to achieve a better outcome in terms of allocation of resources.

JC Economics Essays: Tutor's Comments - This economics response is a well-written and well-crafted Economics essay, that was written under model examination conditions; good work MJ! Special thanks to MJ for her kind contribution. Excellent. NOTE: This economics essay has been edited to make the language flow better but the main points were still written under examination conditions. Thank you for reading and cheers. 

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