Market Failure and Functions of Government: Decreasing Costs

1 year ago

Atiqur Rahman

17 minutes

Introduction

A perfect market is based upon many assumptions like perfect competition, perfect information, complete markets, no transaction costs, etc. When any of these perfect assumptions are violated, there occurs a market failure.

Under market failure, the market may produce more than or less than what is socially desirable or not at all. Also, many a time, there may be consumption and production spillovers which may affect those who are not directly involved in market exchange.

Market failure in short implies a loss of allocative efficiency or a situation in which the allocation of goods and services is not efficient. In such a situation, the potential total surplus in the market may not be maximised and deadweight loss may exist.

Market failures are often associated with information asymmetries, non-competitive markets, principal-agent problems, externalities, or public goods. The existence of a market failure makes the case for the intervention of the government to bring in optimum solutions in a particular market. Government policy intervention can be in terms of taxes, subsidies, bailouts, wage and price controls, and regulations which may lead to an efficient allocation of resources.

When there is an imperfection in the form of an imperfect market structure like monopoly, oligopoly, monopolistic competition etc., these lead to lesser production and charge higher prices in the market than in a perfectly competitive market.

In the case of natural monopolies, a single firm gains from economies of scale originating from large-scale production. This implies that there is cost efficiency in this market structure compared to perfect competition. However, such a natural monopoly may take advantage of its position by charging higher prices even when its costs are so low.

Thus, the government by taking over such monopolies or by regulating these will lead to higher gains for the society as a whole in the form of decreases.

Let us analyse in detail the market failure and the role of government in decreasing the cost.

Market Failure and Its Remedies

A market failure is a situation in which the market fails to efficiently provide or allocate goods, services and resources. This occurs due to the presence of certain imperfections in the market which constrain the market from achieving the optimum welfare.

The following reasons cause the market failure and prevent the market from achieving productive and allocative efficiency.

1. Imperfect Market Structure:

These include monopoly, oligopoly, duopoly and monopolistic competition, which leads to the non-achievement of Pareto optimal solutions because markets may fail to control the abuses of monopoly power.

2. Missing or Incomplete Markets:

For some goods and services, the relevant markets may not exist at all, resulting in a failure to meet a need or want, such as the need for public goods, such as street lighting, highways, etc. It may also happen that for certain goods, the markets may be incomplete. For example, incomplete markets may fail to produce enough merit goods, such as education and healthcare.

3. Presence of Externalities:

Externalities are said to occur in an economic system when a decision-maker does not bear all the costs or reap all the gains from his actions. It means that externalities can be adverse as well as beneficial.

Externalities which are not desirable are called negative externalities. These occur when consumers and producers fail to take into account the effects of their actions on those who are not directly involved in the market exchange.

Similarly, there are certain external effects of an individual’s actions which confer benefits to others. It means that the social marginal benefit of such positive consumption and production is high. But private individuals underproduce or underconsume these.

In the case of externalities, parties external to the exchange bears cost or enjoy benefits. These can be called as third parties, and these are individuals, organisations, or communities indirectly benefiting or suffering as a result of the actions of consumers and producers attempting to pursue their own self-interest. As the allocation in the presence of externalities is not Pareto efficient, so market failure occurs.

4. Imperfect Information:

An allocation will be efficient only when all the parties involved have perfect information. But sometimes markets may not provide enough information because it may not be in the interests of one of the parties (involved in exchange) to provide full information to the other party. This also causes the market to fail to produce optimally.

5. Provision of Public Goods:

Public goods are those goods which are non-excludable and non-rival. Due to these characteristics of public goods, the market system fails to provide them efficiently and leads to allocative inefficiency.

Remedies for Market Failure

The government is expected to step in whenever free market forces result in inefficiency in allocation. The government has four types of role in an economic system:

Legislative or Regulatory
Allocative
Distributive
Stabilization

For accomplishing these roles, there are basically two strategies with the government in order to reduce or eliminate market failures:

1. Using the Price Mechanism:

Market failure occurs because the price mechanism is not working efficiently on its own. So, the government influences the price mechanism to change the behaviour of consumers and producers. This would mean taxing the ‘harmful’ products, thereby increasing their prices and providing subsidies for the ‘beneficial’ products. In this way, behaviour is altered through financial incentives, in the same way in which markets work to allocate resources.

2. Using Legislation and Force:

Another strategy for remedying market failure is by using the regulatory framework of law to change market behaviour. This includes various command and control policies, regulatory policies, etc. This may involve banning cars which are harmful to the environment and imposing higher social costs, or having in place a licensing system for the sale of alcohol, or by penalising polluters in order to control the unwanted behaviour. In the majority of cases of market failure, a combination of these remedies is most likely to succeed.

Role of Government in Reducing Distortions Arising from Imperfect Market Structure

In a perfectly competitive market, prices that are charged to consumers are equal to marginal cost. However, under imperfect competition, individual firms face downward-sloping demand curves, and they charge prices which are higher than the marginal cost of production.

As a result, consumers in such markets are faced with prices that exceed marginal costs, and the allocation of resources becomes inefficient. So, in a free market, firms may gain monopoly power, which enables them to set higher prices for consumers. In such a case, government regulation of monopoly can lead to lower prices and greater economic efficiency.

An imperfectly competitive private market will always under-produce a good; it will be less than what is socially efficient. The government agencies in order to correct such inefficiency, either prohibit monopolies or regulate the prices charged by these monopolies.

The figure shows the case of imperfect competition. The firm facing a downward-sloping demand curve D will select the output QM at which the marginal cost curve MC intersects the marginal revenue curve MR. So, a monopoly firm produces QM units and charges a price PM.

However, the perfectly competitive firm will produce QC output and will provide it at a lower price PC. The efficient level of output, QC, could be achieved by imposing a price ceiling at PC. The potential gain from such a policy is the elimination of the deadweight loss shown by two triangles.

Thus, the government’s role in such a situation is to move the solution closer to the efficient level, defined by the intersection of the marginal cost and demand curves.

Imperfect competition, such as monopoly, is generally seen as inferior to competition because monopolies earn economic profit. The monopoly also raises the price above the level it would be in the competitive situation while output is lower. Also, the prices which individuals pay under a monopoly are higher than they do under a perfectly competitive market structure and the output produced is lower.

However, it must be noted that this argument does not consider the positives of market concentration. There are some reasons for which market concentration is not necessarily bad. The cost curves for monopolists are lower than those for competitors and innovation is more likely to take place in larger firms that can finance large R&D expenditures.

Also, there is a case of the natural monopoly, those industries where the average cost curve is falling which means that the least cost level of output would be large enough that a single seller can cater to the needs of the whole market.

Recognizing the potential market failure associated with imperfect competition, the government needs to step in through direct regulation of industry and the establishment of antitrust legislation. This should be done while taking advantage of decreasing costs that these imperfect markets gain on account of large-scale production. Also, if we do not introduce adequate competition among the firms in an industry, then we would need to regulate their behaviour.

Natural Monopolies, Decreasing Costs and Rationale for Government Intervention

All those circumstances under which prices cannot coordinate efficient choices in consumption and production reduce the market efficiency, and this departure from efficiency is termed as market failure. This market failure makes for the role of government in allocating resources in a market economy.

The perfect competitive market is considered to operate optimally at the minimum cost with no distortion. However, there are other decreasing-cost industries which are characterized by such technologies where the marginal costs decline due to scale economies when a single firm meets the needs of an entire market.

For example, there are some industries like power and electricity which experience lower marginal costs as the scale of operation is increased. In this case, the single producer could potentially provide the service at lower unit costs than could a number of competitive operating systems with higher average costs.

This implies that the productive efficiency is higher with a single producer catering to the entire market. However, monopolists with such market power cannot be left unregulated because they may under-provide the goods and charge higher prices.

So, the regulation would be required to ensure that the monopolist would pass along the cost savings to its customers. This situation is referred to as a natural monopoly, and these are generally found in industries like electrical generation, electrical transmission and distribution, Water lines, oil and gas pipelines, and other operations for which there were significant economies of scale.

Thus, under a natural monopoly, it is logical to have one producer because free markets may lead to inefficient allocation and higher costs due to competition. For the natural monopolist to share the savings on costs due to economies of large scale, it is desirable that the government grants the most optimum company the right to conduct business, thereby decreasing the costs for both business and consumers. This will bring in efficiency in production and will save the public money.

If we compare monopolies with perfectly competitive markets, we encounter a lot of differences between the two. When competition exists, the equilibrium quantity will be higher, and the price will be lower.

With this, it can be argued that competition is better for consumer welfare. However, the monopolist is better off due to its ability to earn abnormal profits due to the lack of any competitors in the markets.

1. Monopoly and Productive Efficiency

In terms of productive efficiency, a monopolist has an advantage. This is because it is more likely to produce at the lowest possible cost for the level of demand. If competition is brought in, the monopoly will lead to an increase in average costs as output per firm falls.

2. Monopoly and Allocative Efficiency

As the monopolist charges a price above the marginal cost, there is allocative inefficiency associated with a monopoly. Higher prices earn abnormal profits for the monopolist, while the competitive firm ends up with only normal profits.

3. Monopoly and Dynamic Efficiency

Monopolists will be dynamically efficient as there is an incentive involved to invest in research and development and create innovative products because these can reap future profits for the monopolist. However, due to the presence of perfect knowledge under perfect competition, firms will be unwilling to invest because any innovation will quickly become general knowledge to all firms in the industry, thereby removing any future rewards.

Looking at the above analysis, we can see that there is a dynamic efficiency and lower costs associated with the monopoly, which can be used to improve the overall efficiency of the market. Governments can use a variety of policy measures in order to regulate monopolies.

● 1. Subsidies could be used in order to compensate the monopolist for their productive efficiency and to induce him to lower the equilibrium price and increase the quantity in an attempt to achieve efficiency.

● 2. Some form of price controls can also be implemented in order to regulate monopolies. Different regulating bodies can be set up to ensure that monopolists do not exploit consumers. Many such regulatory authorities have actually been set up to regulate the behaviour of large natural monopolies

Price controls in the form of price ceilings will encourage monopolists to reduce their costs in order to increase profits, thereby improving productive efficiency. Monopolists, however, oppose such ceilings, arguing that it hamper their ability to sustain dynamic efficiency in their operations.

● 3. Privatisation and Deregulation are other government measures to improve the efficiency of these natural monopolies. Public ownership is generally equated to inefficiency, therefore, deregulating the monopolies but with certain caveats may raise the allocative efficiency. Deregulation allows competitors to enter markets that are protected by legal barriers to entry. Competition would hopefully drive down the price, and this may lead to the creation of regional monopolies, like railways and water companies.

● 4. Taxing monopolies in order to alter their pricing behaviour by taking away abnormal profits is another tool that the government can use. Taxes, however, are unlikely to improve efficiency. This is because taxes would have no incentive for firms to reduce prices or costs. In fact taxes may discourage research and development and innovation due to loss in current profits.

Our analysis implies that if there is a natural monopoly, it does not necessarily mean that there is substantial economic inefficiency. There are several ways which may restrict and optimize the behaviour of a monopolist.

● (a) The ease of entry into the industry by other firms should be established so that the threat of potential competition can limit the incumbent monopolist’s ability to restrict output.

● (b) An optimal pricing policy involving fixed charges and a low unit price could be chosen by the monopolist, which can increase its profits as well as benefit consumers.

● (c) The grant of monopoly rights through bidding to the supplier with minimum price quotes can raise economic efficiency.

Transactions Costs Linked with Deriving Information in the Market

Transaction costs are the cost of engaging in a market exchange. In a perfect market, it is assumed that all the consumers and producers involved in the market exchange possess perfect information about the market.

However, in reality, information is less than perfect. In the exchange between two parties, one party is always better informed, and the other party has to incur costs in order to obtain information about the market.

When parties to economic transactions have different amounts of information and different objectives, they will behave strategically. This situation constitutes a market failure in the sense that if each party had equal information available to it, a socially superior bargain could have been struck.

When trying to assess market information, parties need to incur costs which make the cost of market transactions high. So, whenever consumers and producers incur costs in becoming informed about market opportunities and completing market transactions, markets will not result in efficient outcomes.

In such a scenario, a regulatory framework to reduce these transaction costs and information asymmetries can improve efficiency. In the provision of this regulatory framework, government has an important role.

The achievement of Pareto optimality provides a rationale for government intervention in market outcomes. There are a large number of regulatory mechanisms available to promote efficient behaviour and divide gains from it among the parties, thereby decreasing costs.

When information is provided by the government on a large scale, it becomes a public good whose marginal cost of provision is almost zero. Markets resolve some of these problems by signalling, but a complete solution in the form of government regulation is required for markets to work efficiently.

Market Failure and Functions of Government: Decreasing Costs

Introduction

Market Failure and Its Remedies

1. Imperfect Market Structure:

2. Missing or Incomplete Markets:

3. Presence of Externalities:

4. Imperfect Information:

5. Provision of Public Goods:

Remedies for Market Failure

1. Using the Price Mechanism:

2. Using Legislation and Force:

Role of Government in Reducing Distortions Arising from Imperfect Market Structure

Natural Monopolies, Decreasing Costs and Rationale for Government Intervention

1. Monopoly and Productive Efficiency

2. Monopoly and Allocative Efficiency

3. Monopoly and Dynamic Efficiency

Transactions Costs Linked with Deriving Information in the Market

Read More in: Theory of Public Finance

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Introduction

Market Failure and Its Remedies

1. Imperfect Market Structure:

2. Missing or Incomplete Markets:

3. Presence of Externalities:

4. Imperfect Information:

5. Provision of Public Goods:

Remedies for Market Failure

1. Using the Price Mechanism:

2. Using Legislation and Force:

Role of Government in Reducing Distortions Arising from Imperfect Market Structure

Natural Monopolies, Decreasing Costs and Rationale for Government Intervention

1. Monopoly and Productive Efficiency

2. Monopoly and Allocative Efficiency

3. Monopoly and Dynamic Efficiency

Transactions Costs Linked with Deriving Information in the Market

Read More in: Theory of Public Finance

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