The Theory of Market Failure - Essay Example

The Theory of Market Failure by [Name of Student] [ECON] [Course Title] [Name of University] [Date] The Theory of Market Failure Although perfect competition does offer many desirable results, situations arise when perfectly competitive markets cannot efficiently allocate resources resulting to Market failure. Accordingly, some stakeholders within the market receive undue advantages over others (Jhingan, 2006). This situation requires alternative allocation mechanisms, such as taxation by the government. Market failure can occur when the provision of public goods and merit goods is lacking. Another cause of market failure is externalities in the form of natural disasters, political conflicts and civil unrests; environmental pollution, in particular, can make the social cost of production exceed private costs (Depken, 2005). Failure to regulate a monopoly leads to market failure when the monopoly becomes strong to the point of destroying the equilibrium that perfect competition brings (Depken, 2005). In this case, markets can be dominated by low-quality or highly priced products. The immobility of essential factors of production, such as labour and raw material, is a major contributor to market failure. Immobility of labour can cause unemployment that in turn drives production costs up and makes the process of production difficult. The end result is the collapse of the production sector and eventually, the market (Jhingan, 2006). Negative Externalities Negative externalities occur when the marginal social cost (MSC) is greater than the marginal private cost (MPC). The social marginal benefit (SMB) and private marginal benefit (PMB) of a project or production are interwoven concepts. If the SMB of a provision surpasses its PMB, the society is said to be better off because a positive externality is created by this provision. When taxes are imposed or any other form of intervention is made the government, the actual production will be at Q1 as shown in Figure 1 below. This is at point of intersection between MSC and MPB thus equilibrium. The tax is because the manufacture of low-quality cars leads to pollution of the environment causing what is referred as environmental marginal damages cost. Cases in that the MSC of exceeds the MPC can be observed when a negative externality occurs in car production. A productive process that causes pollution occurs when the MSC is greater than the MPC caused by negative externalities. The graph below shows how negative externality occurs. Figure 1: demand and supply curve The potential buyer of a car has relatively little information about the true quality of the car in the market. The only way that the buyer can find out about it is to purchase the car and use it for sometime. By contrast, the seller usually has much greater information about the quality of the car than the buyer because he or she is the manufacturer. In situations in that the buyer and the seller have asymmetric information, the buyer typically wants to pay only a price that reflects the low quality of the manufactured car in the market and not a price that reflects the high value of the car. On one hand, at the optimum output, the price that firms charge exceeds the marginal cost. On the other hand, monopolistic competitive firms operate above their capacity. This scenario means that the profit-maximising output of the monopolistic competitive firm is lower than the output that accompanies the minimum average cost of production. The similarity between perfectly competitive firm and a monopolistic competitive firm is that they both operate at the point in that their demand curves or price equates the average cost of production. In perfect competition, firms achieve equilibrium when a perfectly elastic demand curve intersects the average cost; however, the demand curve of monopolistic competitive firms is not elastic, so in the long run, the demand curve of monopolistic competitive firms will be tangential to the long-run average cost curve (Jhingan, 2006). From the manufacturer’s point of view, given that the price of poor-quality cars reflects normal qualities, all car manufacturers will want to cheaply produce cars but still make a huge profit. The logical result of this adverse selection is a disproportionate number of low-quality cars in the market and thus relatively low sales than would exist if information were symmetric. Therefore, low-quality cars will be overpriced, whereas high-quality ones will be underpriced. Tax Policy by the Government to Correct Negative Externalities The government has no better way to ensure that cars are produced and sold at a reasonable price than taxation policy. The theory behind this is that through macroprudential regulation, low-quality car production is lessened by the correction ofthe harmful externalities caused by such a production. The economic theory of regulation is understandable: governments should regulate in cases of market failure. The negative externality of low-quality carsmeans that private markets cannot efficiently work out the problem, sogovernment intervention is required. In theory, the government can correct this negative externality. At least two avenues are open to the government: special taxes and legislative regulation or prohibition. The externality problem originates from the fact that the air as a waste disposal place is costless to the firm but not to society. The government can make the manufacturers of low-quality cars pay taxes for dumping their pollutants into the air and for producing low-quality cars. The government can attempt to tax car manufacturers commensurate to the cost to third parties from smoke in the air and the prices of the low cars manufactured. In effect, this will be a pollution tax on the manufacturer and the user of the car. The ultimate effect is a reduction in the supply of low-quality cars and an increase in car price for consumers. In short, the price becomes equal to the full cost of production to society. Let us introduce tax to the previous graph. Figure 2:Tax Imposed on a Negative Externality. The government can impose a tax equivalent to the private cost/external cost that leads to the upwards shift in the MPC curve to MSC and thus the Pareto optimal level of production. This scenario will induce the manufacturer to reduce the production of low-quality cars to optimum level Q1, where the MSC is equal to the price of the low-quality car. From the graph above, Q1 represents the optimum quantity, whereas Q2 is the equilibrium quantity. The graph shows that the optimum quantity is lower than the equilibrium quantity. The reason for this is that the market equilibrium reflects only the private cost of production from inefficiencies in the market. The per-unit tax would shift the PMC curve upward by the amount of the tax; and “PMC + external cost” then represents the new marginal cost curve of the producer. If the tax, is set correctly , the new cost curve will intersect price P at point Q2, the optimal level of output. By imposing a tax, the government forces indirect internalization of the externality and the firm faces the social costs of its actions in making its internal decisions. At this point, the marginal social curve lies above the demand curve. Impact of Government Intervention Although the theory of market failure prescribes government intervention in the form of tax on producers, the resultant tax can nevertheless be sub-optimal when negative production externalities are present in the competitive output market. This scenario represents price elasticity that is the variable that comes into play when the supply of a good significantly influences prices. We must retrace the argument for the price elasticity of cars in the context of taxation; given entrepreneurs’ profit-maximising orientation, the prices of cars decrease through changes in policy, relocation or substitution with cheap manufacturing sites. The scale of activity of car manufacturers is reduced and thus leads to unemployment. This scenario means that the tax imposed should not affect productivity to the point of reducing a country’s economic activities. Apart from imposing social tax to protect the environment, policymakers need to develop policies that will ensure economic stability. Policies that lead to job losses and reductions in the purchasing power of the economy should be reviewed. If the tax imposed to monopolies then cost is transferred to customers, leaving the monopoly with huge profit. The firms operating in the industry may also merge leading to redundancy. This is internalising externality is considered by the party that generates the externality because such an externality now directly affects profit. The government can be forced to set a price, so that the people are also not exploited after taxation. In the diagram below, the measure to curb this problem is highlighted, with the government setting a fixed price for the products and services supplied by the firm. We all know that the government regulates the production of firms for health and safety reasons, oversees their waste disposal to minimise damage to the environment, and taxes various aspects of their activities. However, the government has a direct and often overlooked role in production. Some firms, such as trucking businesses, directly use roads; others indirectly rely on them. The government undertakes adjustment policies, such as deregulating some industries, with the railroads sector being one of these. Deregulation is the core to the expansion of the economy; the railroad industry has undergone deregulation, so it has experienced massive capital investment in its infrastructure. As a result, the overall industry output is improved, and the overall economy is boosted through increased revenue, job creation and improved tax generation. We know from many anecdotes that grossly deficient public input into production considerably retard productivity. However, in a country such as the US, these gross deficiencies are not common as in less-developed countries. Therefore, how important is government input? Economists answer this question by examining industrial productivity and general economic activity in different cities and states. They define public capital stock as an input in production; each production area has public capital stock, that consists mostly of sewer facilities, roads, bridges, tunnels, water supply facilities and port and airport facilities. Variations in public capital stock across cities or states are partly responsible for differences in productivity and income levels across the same geographic units. Economic efficiency is a standard used in economics to evaluate the production cost of an input. Any product or good is said to be economically efficient when the production cost of the given output is as low as possible (Bradley, 2003). Recent debates about the taxation system have also been rationalised through the validity of economic efficiency because increasing tax rates have been found to produce negative results. The principle of economic efficiency works in defeating rising inflation, unemployment and high costs. This principle is applied to evaluate the costs for the given output to determine the efficiency of an economy (Mankiw, 2011). The government it must assess the extent of pollution damages by evaluating the cost of the harm done to residents at different output and pollution levels. This will ensure, the government must separate out the harm to the community caused by low-quality cars, as opposed to that caused by other polluters. In assessing damages, not only must the government know current damages at Q2, but also what future damages will be as output declines to Q1. It must be able to assess marginal damages doing calculations of pollution damages at any output level, let alone the efficient output level, involves great uncertainties about health damages from increases in pollution and the economic cost of those damages. To know the optimal future output level, and hence impose the correct tax, the government must also know the firm’s PMC curve, as well as the value of externalities. It needs that information to know at what output level it occurs, because to calculate tax, it sets price equal to PMC plus the marginal external costs of pollution. Regulating all polluters precisely requires collecting and evaluating enormous amount of cost information. Conclusion For the economy to achieve sustainable development, dealing with negative externalities, such as the quality of air and social exclusion, is inevitable. Emissions of carbon dioxide released into the air take a toll on the economy in the long run because of costs associated with the treatment of people suffering from diseases related to this cause. Fuel costs are very critical in the transport and logistics sector. The cost of fuel of directly affects the economy of the world. At high fuel prices, inventories and the volume of freight considerably decline. Freight rates decrease and suppliers of logistic services experience reduction in their margins. Ultimately, credit rates decrease, and vacancies at warehouses adjust upwards (Berman, 2008). These issues affect both the profit returns that the transport and freight sector receives, as well as the travel decisions made by passengers, hence the increasing costs and pressure on public transporters. References Bradley, R. C.(1991).Essentials of economics.New York: McGraw-Hill, Inc. Connor, J. M.(2008).Global price fixing(2nd paperback edition). Heidelberg: Springer. Depken, C. (2005).Microeconomics demystified.New York: McGraw Hill. Jhigan, M. L. (2006). Advanced economic theory. New Delhi: Vrinda Publisher. Myerson, R. B. (1991). Game theory: Analysis of conflict. Cambridge: Harvard University Press. Perloff, J. (2008).Microeconomics theory and applications with calculus.New York: Pearson. Read More