What is a Market Failure

An Argument in favor of intervention regarding market failures.

* Note, there are solutions to address the same failures that do not involve the government

 Market Failure

Government Intervention

•Government needs to correct market failures
•Encourage higher utility interaction
•Increase social utility
Market Failure
•The free market does not always allocate goods/services efficiently
•Market participants can be made better off
•Logical to increase utility and encourage activities that does so
•Externalities lead to market failure
•Both negative and positive
•Cost or benefit not reflected through prices
•Therefore “natural” equilibrium does not reflect true social equilibrium
Negative Externality
•Cost of a product imposed on third party that lowers utility
•Air pollution
•Decreased effectiveness of anti-biotic
•Noise pollution
Positive Externality
•Benefit of a product imposed on third party that increases utility
•Knowledge spillover
•Increased property valuation/Beautification
What is a Market Failure | Market Failure Wiki
How to Solve Externalities
•It is desirable to have the true, proper allocation that is truly efficient.
•Market naturally does not recognize the discrepancies , therefore an authoritative power can best push the market to the true costs and benefits to closer obtain efficient levels
Information Asymmetry
•Where one party has more information than the other in a transaction
•Leads to market failure
•Inefficient outcome derives from not having the proper information to make decisions upon
•Demand/Supply functions not properly reflected
Examples of free market Asymmetric Information
•Car Dealers
•Insurance companies
•Replica or rip-offs of real product
•George Akerlof showed that average value of commodities goes down even for quality goods due to information asymmetry
Solutions to Asymmetric Information
•Companies have incentive to hide information
–Higher profits at consumer’s expense
•Government mandates full disclosure of relevant information
•Successful examples: FDA, SEC
•By giving all sides full information, better decisions are made, which in turn leads to fewer breach of contract lawsuits based on the notion that one side did not fully understand
•Can lower cost of business
Principal-Agent Problem
•Leads to market failure
•Where a principal hires an agent to act in the principals self interest
•Conflicting interest can lead to inefficient or costly actions
•Enron and Arthur Anderson scandal cost the shareholders $11 billion
Solution to Principal-Agent Problem
•Free market  leads to conflict of interest
•Government standards clearly lays out agent’s and principal’s responsibilities and provides punishment for failure to act in public’s interest
•Government involvement therefore protects the public
Natural Monopoly
•Where the more of a product is made, the less the costs are
•Logical to have one producer
•Free market can lead to inefficient allocation and higher costs due to competition
•Example: Water lines, electrical lines
Solutions for a Natural Monopoly
•Having several companies put up their own electric lines or laying their own water pipes leads to drastically higher costs in a market where generally the more that is produced, the lower the costs should be
•Government grants the company best suited to do the job the right to conduct business, lowering costs for both business and consumers
•Aggregate energy contracts saves the public money
Public Goods
•Non-rival and non-excludable
•Example fireworks show
•People that do not pay can benefit from show as well
•They receive positive externality
•Therefore free market allocation is inefficient
•Free rider problem
Solution to Free Rider Problem and Public Goods
•A compulsory payment of the public of the fair value of the public good
•Eliminates free rider problem
•Costs and benefits more accurately reflected
Nash Equilibrium
•Nash equilibrium does not always provide the highest utility that competing parties can obtain
Solution to lower Utility
•While public may slowly agree to cooperate, government can quickly mandate cooperation and lead to higher utility for all involved parties
•Fewer resources wasted on competition and thus more efficiently allocated
•All parties involved better off
Pareto Optimal
•Where one decision maker’s decision does not lower another’s utility
•Example: Roads are needed for lower transportation cost, but must seize property for construction
•Free market may not compensate individual for their property, thus making the decision not pareto optimal
How to Obtain Pareto Optimality
•Government acts as a mediator and offers just and fair compensation to make decision pareto optimal.
•Both parties benefit while none lose utility
•Increases and maximizes social utility while free market may not maximize utility
Humans are said to be always acting in their self-interest
Analysis of each situation is not always accurate