Explain carefully why imperfect information and the immobility of the factors of production may lead to market failure. [10]
Market failure can be defined as the failure of the free market mechanism to provide goods in a socially optimal and thus efficient manner, and is usually attributed to imperfect markets, the existence of externalities, the lack of provision of public goods, and inequity. Imperfect information and immobility of the factors of production also lead to market failure, because they directly contradict the assumptions of the free market system. The two main assumptions violated are firstly that all participants have perfect information, and secondly that the factors of production are mobile, such that they can respond to changing prices which function as a signal for producers to move resources into various areas of production. With those assumptions violated, Pareto optimality - when one person cannot be made better off without making someone else worse off - cannot be derived from perfect competition in a free market. This paper explains carefully why imperfect information and the immobility of the factors of production lead to market failure.
The free market system assumes that consumers have perfect knowledge of costs and benefits, thus the market-clearing equilibrium is able to be reached when individuals’ valuation of the good equal suppliers’ marginal cost of production; hence demand = supply. But in reality, consumers are often ignorant about the quality of the goods and durables they purchase. These are cases of imperfect information, which cause market failure as individuals are unable to fully obtain the marginal benefits of the good. As the market demand curve is derived by summing up all individual demand curves an optimal market equilibrium cannot be derived. On the supply side, firms are often ignorant of market opportunities, prices and costs, and may often make inaccurate estimations of market consumer demand or fail to respond promptly to demand changes due to errors in judgment. Thus market failure occurs.
Imperfect information is present when consumers and producers do not or are unable to consider society’s benefits and society’s costs, as reflected in the diagrams below.
Insert Economics diagrams here: HINT, draw externality diagrams. Why externality diagrams?
In the first diagram, there is an overproduction of a good distorting the market. Negative externalities, if unknown to producers, or if they merely consider their own private costs benefits and ignore society’s efficiency, also result in market failure, but this time in overproduction of a good.
In the second, there is an underproduction distorting the market. Consumers often have lower than optimal demand for desirable public goods, for example healthcare and education, as they only take into account current utilities, failing to judge the full extent of welfare and benefits the good delivers to society. This presence of unacknowledged positive negative externalities results in the underproduction of the good. Hence, the failure to acknowledge externalities is a lack of full or perfect information that distorts the market.
For private markets to function efficiently, factors such as labor and capital must be able to move freely. If factors are immobile, due to perhaps occupational rigidities and inefficient job seeking processes and bureaucratic issues, it affects the supply of these knowledge-based products. This immobility can lead to the wrong price signals and inefficient allocation of resources to these industries. For the socially optimal equilibrium to be reached, firms and labor must respond to market signals. When firms have trade unions as stakeholders, markets tend to fail as unions tend to aggressively seek minimum wage rates or protect their wage benefits or restrict entry of new labor, even in the face of declining market demand.
Hence, both imperfect information and lack of mobility of resources affect the workings of the price mechanism in the free market, and because perfect competition fails, then there is market failure, and the Pareto efficiency promised by perfect competition in the free market does not arise.
JC ECONOMICS ESSAYS - Tutor's Comments: This Economics essay is rather well written and addresses the issue of market failure well. There are many good aspects to learn about it. However, it was not written by an "A" level student but was written by a trainee teacher (trainee tutor) from education school. Perhaps, as improvement, the author should have also compared and contrasted asymmetric information with imperfect information. For more information on asymmetric information, see George Akerlof and Michael Spence (for further advanced Economics readings).
