Market Failure

Market failure describes the circumstances in which distortions prevent the invisible hand from allocating resources efficiency. It covers all the circumstances in which equilibrium free unregulated markets i.e., markets not subject to direct price or quantity regulation by the government. The following sources of distortions can lead to market failure.

Is utility regulation an effective measure to respond to market failures? What are the sources of market failures? How does the government try to control it?

Competitive markets fail for four basic reasons: market power, incomplete information, externalities, and public goods. We will discuss each in turn.

i) Market Power: It has seen that inefficiency arises when a producer or supplier of a factor input has absolute market power. If a producer has monopoly power it chooses the output quantity at which marginal revenue (rather than price) is equal to marginal cost and sets price on the basis of average revenue curve in that quantity, which is clearly higher than perfect competition price and output level is lower than output produced by the firm operating in perfect competition market. The lower output will mean a lower marginal cost of food production. Meanwhile, the freed-up production inputs will be allocated to produce other commodities, whose marginal cost will increase. As a result, the marginal rate of transformation will decrease because MRTFC = MCa/MCb.

ii) Incomplete information: If consumers do not have accurate information about market prices or product quality, the market system will not operate efficiently. This lack of information may give producers an incentive to supply too much of some products and too little of others. In other cases, while some consumers may not buy a product even though they would benefit from doing so, others buy products that leave them worse off. Finally, a lack of information may prevent some markets from ever developing. It may, for example, be impossible to purchase certain kinds of insurance because suppliers of insurance lack adequate information about consumers likely to be at risk. Each of these informational problems can lead to competitive market inefficiency.

iii) Externalities: The price system works efficiently because market prices convey information to both producers and consumers. Sometimes, however, market prices always do not reflect the activities of either producers or consumers. There is an externality when a consumption or production activity has an indirect effect on other consumption or production activities that is not reflected directly in the market prices.

Suppose, for example, that a steel plant dumps waste matter in a river, thus making a recreation site downstream unsuitable for swimming or fishing. There is an externality because the steel producer does not bear the true cost of wastewater and so uses too much wastewater to produce its steel. This externality causes an input inefficiency. If this externality prevails throughout the industry, the price of steel (which is equal to the marginal cost of production) will be lower than if the cost of production reflected the waste matter cost. As a result, too much steel will be produced and there will be output inefficiency. Externalities have the following characteristics.
  • Externalities can be caused by the acts of individuals or by acts of institutions. For example, music clubs in students’ hostels are often accused of playing loud music, disturbing the peace that ought to prevail at night.
  • When externalities are generated, there arises a question that ought to own the property. In the example still plant, there always arises a question who should own the ‘clean water.’
  • Externalities can be positive and negative.
  • Externalities, especially the negative externalities, cannot be done away with. For example, if we aim for one hundred percent clean air, there can be no factories and no production. A balance has to be struck between the benefits and costs of the activity before imposing restrictions.
iv) Public goods: The last source of market failure arises when the market fails to supply goods that many consumers value. Public goods can be made available cheaply to many consumers, but once it is provided to some consumers, it is very difficult to prevent from consuming it. For example, suppose a firm is considering whether to undertake research on a new technology for which it cannot obtain a patent. Once the invention is made public, others can duplicate it. As long as it is difficult to exclude other firms from selling the product, the research will be unprofitable. Market therefore experiences undersupply of public goods. Government can sometimes resolve this problem either by supplying a good itself or by altering the incentives for private to produce it. Some of the major characteristics of public goods are as follows:

  1. Non-rival: Public goods are non-rival in nature. A good or service is non-rival if, even on consumption by some individuals, the quantity available for others is not reduced. The classic example of a service which is non-rival is the defense services. We do not get this character in private goods. For example, the purchase of a pair of shoes by one reduces the availability of shoes for others. This is because the marginal cost of providing shoes for an additional consumer is positive. Rival goods, therefore, get allocated to consumers, but in the case of non-rival goods, no such allocation is made, and they are available to everyone.
  2. Non-excludable: Unlike, private goods, public goods are non-excludable i.e., people cannot excluded from the consumption of such goods or services. 
A public good is, therefore, one that is non-rival and non-excludable, a good which can provide benefits to consumers at zero marginal cost, and no one can be excluded from its consumption. This makes price meaningless and a private producer will not enter an area where price does not exist. Hence, public goods are to be provided by the state.

Some goods are exclusive, but non-rival. A recreation park is non-rival, but entry into this park can be exclusive. Also, some goods are non-exclusive, but rival. The sea is itself non-exclusive but coral harvesting is a rival activity and so is fishing. Public goods are both non-rival and non-excludable.

Correcting Marketing Failure

If the firm that generates the externality has a fixed proportions production technology, the externality can be reduced only be encouraging the firm to produce less. This goal can be achieved through an output tax. Fortunately, most firms can substitute among inputs in the production process by altering their choices of technology. For example, a manufacturer can add a scrubber to its smokestack to reduce emissions.

Consider a firm that sells its output in a competitive market. The firm emits pollutants that damage air quality in a neighborhood. The firm can reduce its emissions, but only at a cost.

We can encourage the firm to reduce emission to E* in three ways: (1) emissions standards, (2) emissions fees, and (3) transferable emissions permits. We will begin by discussing standards and fees and comparing relative advantages and disadvantages. Then we will examine transferable emissions permits.
  • Emissions standards: An emissions standard is a legal limit on how much pollutant a firm can emit. If the firm exceeds the limit, it can be monetary and even criminal penalties.
  • Emissions fee: An emissions fee is a charge levied on each unit of a firm’s emissions.
  • Transferable emissions permits: Transferable emissions permit is a system of marketable permits, allocated among firms, specifying the maximum level of emissions that can be generated. If we knew the costs and benefits of abatement and if all firm’s costs were identical, we could apply a standard. Alternatively, if the costs of abatement varied among firms, an emissions fee would work. However, when firm’s costs vary and we do not know the costs and benefits, neither a standard nor a fee will generate an efficient outcome.
We can reach the goal of reducing emissions efficiently by using transferable emissions permits. Under this system, each firm must have permits to generate emissions. Each permit specifies the number of units of emissions that the firm is allowed to put out. Any firm that generates emissions not allowed by permit is subject to substantial monetary sanctions. Permits are allocated among firms, with the total number of permits chosen to achieve the desired maximum level of emissions. Permits are marketable: They can be bought and sold.

Marketable emissions permits create a market for externalities. This market approach is appealing because it combines some of the advantages features of system of standards with the cost advantages of a fee system. The agency that administers the system determines the total number of permit and, therefore, the total amount of emissions, just as a system of standards would do. But the marketability of the permits allows pollution abatement to be achieved at minimum cost.

Utility Regulation

Some public utilities are publicly, or municipally, owned – for example, water supply systems and sewerage systems. The proper scope of municipal ownership remains a subject of debate. The relative cheapness and efficiency of service coupled with local conditions are the chief factors to be considered in deciding between public and private ownership. Sufficient methods of financing municipally owned undertakings must also be planned so as not to increase municipal debt beyond prudent limits. In addition, recent changes in federal tax laws have made it more difficult for municipalities to raise capital for the acquisition of utility property through tax-exempt financing.

The vast majority of public utilities in the US are owned by private corporations. These private firms differ from other businesses in that utility companies are obligated to serve all who ask for their services and in that they must usually make a very large capital investment in relation to the revenues they receive.

Control of most public utilities lies with public service commissions, agencies formed to protect the safety of the people and property under their jurisdiction. These commissions operate at the federal, state, and local levels, sharing the responsibility for determining rates and supervising the service provided. The grant by a governmental authority to a privately owned utility company giving the company the right to use public streets for placement of poles, wires, mains, tracks, and the like is called a franchise. Franchises are now extended to public utilities for a limited number of years, in contrast to the previous practice of unlimited franchises. Present franchises usually allow for governmental review of revenues, expenses, and income; provide for arbitration of disagreements; and explain the conditions that must be met by the utility in order for it to retain the franchise. The purpose of granting a franchise is to protect the public interest and to allow the utility the right to use public property.

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