We have already learned from the previous lessons that individuals are always trying to maximise their satisfaction of wants. Individual Economics, therefore, is about managing resources available to him/her to satisfy as much wants as possible.
When we look into a higher level, a country also tries to maximise the best use of its resources to deliver the best outcome, that is the satisfaction of wants of its people in general. And that is how the types of economic systems have come into place.
We have also seen the types of economic systems and one of them is market economy. In a market economy, resources are allocated by the forces of demand and supply. When something is demanded by the consumers, suppliers try to produce that good. Therefore, in theory, it should deliver the maximum satisfaction of wants.
However, there are reasons why market forces may not always allocate resources efficiently. In this situation we say there is market failure.
Market failure could result in productive inefficiency which means the firms are not producing the best output from the resources they have.
Market failure could also result in allocative inefficiency. This means that businesses are not producing those goods which are most wanted and needed by the consumers. In this case satisfaction of wants of the people will not be as good as it ought to be.
Reasons for market failure
- Negative externalities – When production is done, there are two categories of costs that are incurred. They are, private costs and social costs. Private costs are those incurred by the business or individual who does the production. When production is done, the society as a whole also bears some costs. For example, air pollution. These are known as social costs or external costs. Negative externalities occur when the social costs exceed private costs.
- Positive externalities – Production gives benefits to the business or individual who does the production. This is known as private benefits. production also gives benefit to the society as a whole. This is known as social benefits. Social benefits = private benefits + external benefits. Positive externalities occur when the external benefits is greater than the private benefit. In this case the individual or the business may be discouraged to do the production, leading to fall in output.
- Public goods – Market forces may not be able to provide public goods. Goods like street lights, light houses, drainage system on the roads, cannot be provided by the private sector. For example, once a lighthouse is provided, the ships at sea cannot be prevented from benefiting from it, and there is no way to charge a price from the ships that benefit from the lighthouse. Therefore, public goods have to be provided by the government as the private sector has no incentive to produce/provide them.
- Imperfect information – For markets to work, there needs to be perfect and symmetric information ie consumers and producers must have the same level of knowledge about the products, and they must know everything there is to know about them. In many cases, however, information may be asymmetric (producers know more than consumers) or incomplete/imperfect. In these situations, we have market failure. In the private healthcare market, doctors know more than patients about healthcare and treatments (asymmetric information). There is an incentive, therefore, for doctors to prescribe more expensive treatment than that is necessary in order to increase their profits. This is an inefficient use of resources. Many consumers in the healthcare market take out insurance to help pay for treatment; this, however, leads to a problem of moral hazard, where they take more risks and therefore require more treatment because they are insured. Again, this is a consequence of asymmetric information in the market where consumers know more than insurers about their intended future actions.
In many markets, such as the tobacco, alcohol or pensions markets, providers of these goods and services often withhold information deliberately from consumers. For example, many tobacco companies knew of the link between tobacco and lung cancer before consumers were aware of it, and they continued to advertise tobacco as being ‘healthy’ and ‘sociable’, leading to over-consumption of tobacco, and therefore market failure.
- Monopolies – A monopoly is a situation where there is only one seller in the market, and everyone else is a buyer. Free markets sometimes result in monopolies, which can charge high prices from consumers and there is under-production of the particular goods that the monopoly provides.
- Factor immobility – Factors of production, such as labour may not be able to move from one place to another for many reasons. If they cannot move to the place where production is done, then there will be unemployment.
- Unfair income distribution – When the production is done for those who can pay for the goods and services, this could leads to the rich becoming richer and the poor becoming poorer.
- Uncertainty – the price of certain goods are subject to fluctuations in the market, which leads to uncertainty for those who produce those goods.