Dec 10, 2020 in Analysis

Market Failure and Government Failure

Any economy has a primary objective of improving the societys welfare and generating wealth using the resources that can be accessed within that economy. However, with the unlimited human needs, available resources are usually scarce. In such an environment, some institution is needed to make sure that resources are allocated efficiently and effectively across various uses. The two institutions that are supposed to guarantee this are situated in an efficient manner and include the government and the market. The latter one has the main objective of facilitating the transaction and exchange of services and goods. In any market, rational individuals/agents act with their main aim of maximizing self-interest. Market efficiency is often described with respect to Pareto Efficiency, whereby an efficient market outcome is characterized by all agents maximizing their personal gains that the additional mutual gain is impossible. In Pareto efficiency, improving the conditions of an individual warrants worsening the conditions of another person. The allocation of resources is considered inefficient when the gains obtained from the transaction in the market eye yet to be exhausted. There is a room for the further improvement. This paper explains market and government failures.

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Market Failures

According to Bowles, market failures denote situations whereby resources are not allocated in an efficient manner in a free market. In this context, resources comprise of services and goods traded in a given market. Under such failures, the conditions of a market agent can be improved without worsening the circumstances of another market agent. It implies that the outcomes associated with the market failure are not Pareto optimal. The preconditions for efficient allocation of resources include market agents making rational choices, as well as the use of a competitive and free market structure. If these preconditions are not met, then the market failure occurs. It has been likened to situations whereby people are driven by self-interests, which yields inefficient results. They can be dealt with in order to improve the economic and social welfare of individuals. The occurrence of market failures is normally cited by supra-national organizations, governments, and self-regulatory bodies as a justification for their intervention. Its causes and measures to correct such failures are a concern for macroeconomists. In explaining the market and understanding market failures, four broad categories of such errors have been proposed. They include nature of markets, nature of goods, nature of transaction, and other causes.

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Nature of the Market

Market agents can acquire more market power, which they can use to hinder the occurrence of other mutually favorable trade gains. It creates an imperfect competition, which produces market inefficiency. This issue can take a number of forms including monopolies and oligopolies. Under a monopoly, it is not possible for the market equilibrium to be Pareto optimal. It is because it will utilize its market power to make sure that the market output is lower than the quantity required for marginal social costs to be equal to the social benefits. Monopolies use this approach in order to make sure that prices remain high in order to increase profits. The underlying argument is that the monopoly results in power imbalance in the market. It provides a monopolist to manipulate the supply in order to increase prices and profits. Oligopoly is a form of imperfect competition characterized by few sellers of a particular product/service and dominating the market. This one usually results in monopoly behavior, which is characterized by the restricted market output in order to boost prices. They, in turn, lessen consumer welfare leading to suboptimal outcome. Other market characteristics contributing to imperfect competition include monopolistic competition, monopsony, and oligopsony. The initial one, i.e. monopolistic competition, is characterized by several producers involved in selling differentiated products. As a result, no ideal substitutes can be made. Monopsony is characterized by several producers but only a single buyer within oligopsony is characterized by several producers but few buyers. All these market structures do not meet the criteria of competitive markets; hence, contributing to imperfect competition subsequently leading to the market failure.

Nature of Goods

The concept of excludability can also contribute to market failures. In the context of economics, a product/service is considered excludable if people can be prevented from using it if they did not pay for it. On the other hand, the service/goods is considered non-excludable if it is impossible to prevent consumers that have not paid for it from accessing and using it. Excludable goods comprise of private products and club goods. Meanwhile non-excludable goods comprise of common pool resources (common goods) and public goods. Public goods are often undersupplied and under-produced (when government subsidies are not implemented) with respect to the socially optimal level. It can be attributed to the fact that prospective producers of such goods are likely to realize adequate profits for the sustainable production. It is because such goods can be accessed freely. In addition, it discourages people from trading in such goods because they are not profitable. In this regard, providing non-excludable goods is considered an ideal case of positive externality resulting in market inefficiency.

The nature of goods exchanged in the market can also be described using externalities. They denote the outcomes associated with an economic activity on a third party being unrelated to the activity. Positive externalities produce beneficial outcomes whereas negative externalities yield adverse outcomes. Sellers and buyers in the market often disregard the external effects associated with their actions when making decisions regarding the supply and demand. Therefore, the market equilibrium can result in either underproduction/under-consumption, or overproduction/overconsumption. Externalities are often inherent to the production methods. An example is a firm involved in the production of steel absorbs. It requires capital, labor, and other inputs to operate. However, the firm is also involved in pollution of the environment in a process of producing steel. Yet it is not forced to incur costs associated with polluting the environment, which is then incurred by society. As a result, the selling price of its merchandise will not take into consideration the opportunity cost to society associated with producing its commodities.

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Nature of Exchange

The market failure can also be attributed to the nature of exchange that occurs in the market. In this regard, it has been associated with informational asymmetry, agency problems, and considerable transaction costs. They create inefficient markets leading to economic inefficiency and providing an avenue. Through this avenue efficiency can be improved using regulatory, legal and market measures. Informational asymmetry is characterized by people having different information by the time of making decisions, resulting in market inefficiency. Information asymmetry also takes place when sellers do not have the adequate information regarding buyers and vice versa. It leads to incomplete markets. Market failures can also be attributed to costs incurred when transacting in the market. The degree to which producers and consumers incur costs when looking for information regarding market opportunities and completing transactions affects the level of market efficiency.

Government Failure

Despite the fact that governments may have good intentions when developing policies, their application may not achieve the desired outcomes. Governments can impose regulations, taxes and control. However, it may result in worsening the market failure. In worst-case scenarios, new failures may emerge. The government failure can be insignificant, especially in cases where the intervention was ineffective. When the intervention creates new serious problems that have been previously inexistent, it might take several years for the problems to be reversed.

Measures adopted by the government to address market failures can be misdirected, unbalanced or fruitless. Several explanations exist for the government failure. They include political self-interest among those in the government; the tendency to use short-term solutions for economic issues rather than looking for long-term solutions to address structural problems in the economy; and using regulations for vested interests (regulatory capture). Besides, there are such ones as: evasion effects as a result of measures adopted by the government; formulation of policies using inadequate information; and costs related to the enforcement and administration of government measures. Regarding self-interest among politicians and those in the government, important decisions such as infrastructure development are often based on self-interest and political influence. The latter one results in resources being misallocated. Moreover, interest groups can mount pressure the government.

Concerning policy myopia, those ones criticizing government intervention maintain that politicians tend to look for short-term solutions to economic issues instead of looking for long-term solutions. The use of short-term decisions (myopic decision-making) only produces short-term relief to problems. It does not deal with the structural problems in the economy. Subsidies have also been criticized on grounds that they interfere with market functioning and result in some deeper economic inefficiencies.

Regulatory capture occurs when the industries controlled by the government through a regulatory body seem to prioritize the interests of producers and not consumers. Some economists have asserted that regulations hinder a free market operation. An example of this is the European Union Common Agricultural Policy. The latter one has been subject to criticism as an ideal case of the government failure.

Disincentive effects can also be used in explaining government failures. Economists supporting free markets have expressed concerns that government intervention aimed at lessening welcome and income inequalities tend to worsen productivity and incentives found in the economy. In this regard, free market economists have criticized the National Minimum Wage since they are of such a belief that it can result in real-wage unemployment. In addition, higher income tax rates have been considered to have a negative impact on the incentives. These ones are associated with the wealth-creation in the economy and often discourage people from looking for better paid work or working longer hours. Evasion effects are also an instance of the government failure. For instance, if the government increases taxes imposed on demerit goods, cases of tax evasion, tax avoidance, establishment of grey markets, and smuggling may occur. Other factors associated with the government failure include policy decisions. These ones draw upon imperfect information and costs associated with enforcement and administration.

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Conclusion 

Market failures are typified by the inefficient allocation of resources in a free market. For resources to be allocated efficiently in the free market, market agents must make rational decisions. The market structure should be competitive. Failing to meet these criteria creates imperfect and non-competitive markets, which contribute to market failures. Government measures are often implemented as a means of fixing market failure. However, these government interventions may be ineffective in addressing the market failure. Otherwise, they may create new problems, which, in turn, constitute the government failure. The latter one can be explained using political self-interest, policy myopia, regulatory capture, and evasion effects associated with government intervention. These are the policies that draw upon imperfect information and costs associated with enforcement and administration.

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