TOPIC 8

EVALUATION OF THE MARKET, MARKET FAILURE AND

GOVERNMENT INTERVENTION

INTRODUCTION
Recall the economic problem as outlined in Topic 1 of this unit. To judge the success or otherwise of an economic system, the allocation of resources to the production of goods and services should be efficient. This has been our focus to date. But it is also crucial that the distribution of goods and services to satisfy wants and needs should be linked to equity (or fairness) considerations. Failure to achieve this can result in social breakdown. Further, the system should also accommodate dynamic efficiency (to support growth and improved living standards over time). In this topic we reiterate the pros and cons of market systems and show that under certain conditions, markets may not produce a socially desirable allocation of the scarce resources in our economy. At these times we say market based economic systems do not meet the efficiency criteria and equity criteria. This suggests a role for government as both a provider of some goods and services and a regulator of market excesses, be they monopolistic excesses or anti-competitive behaviour. Resource: Textbook
Jackson, J. and McIver, R. & Bajada, C.(2007) Chapter 5 pages 144-5; chapter pages 155-6; Chapter 6, page 179; chapter 6 pages 194-5; Chapter 7, pages 203207 in Economic Principles, 2cnd edition. Review questions: Chap 7, Qs 1-7 page 222. Problem-solving exercises: Chap 7, Qs 1, 3 & 4. Application questions: Chap 7, Qs 1 & 2 page 223.

47

Resource: BSG Text-Study guide

Bredon, G. (2007) Chapter 7 Study guide to accompany Economic Principles, 2cnd edition. Fill-in Qs: Chap 7, Qs 1-13 page 77. True-False Qs: Chap 7, Qs 1-4, 6-9 and 12-14 page 78.. Multiple choice Qs: Chap 7, Q1-11 pages 78-9. Discussion Qs: Chap 7, Qs 1-9 page 80.

LEARNING OBJECTIVES
After studying this topic you will be able to: understand how to evaluate the performance of economic systems explain why the market economy represents an efficient allocation of resources. distinguish between private goods and public goods explain the free-rider problem explain what an externality is and how that concept can be applied to the analysis of environmental issues explain how and why the various types of market failure occur explain how the government attempts to resolve market failures in a number of different ways describe the distribution of income and wealth in Australia today.

IMPORTANCE OF EFFICIENCY AND EQUITY

How does one decide how well any economic system is performing? Economists use two major sets of criteria to help them make a judgement on the performance of the market economy. They are efficiency and equity criteria. Economists tend to focus on efficiency criteria, but we should not forget the importance of equity considerations. Efficiency influences 'the size of the cake', that is, the aggregate wellbeing of society. A bigger cake means that the system is more efficient and social welfare has improved. Society has done well because it has used its scarce resources to efficiently produce a lot of goods and services in aggregate, and thus maximise social welfare. The bigger the cake, in general the more wants can be satisfied in total. Equity measures how the cake is split up or distributed amongst the members of society. In a market system the simplest version of equity means equality in income distribution, but can be extended to incorporate some wider concepts of fairness, such as equality in opportunity. Equity issues may influence efficiency. For example in an attempt to improve equity in an economy, efficiency may suffer. The size of the cake may shrink as an attempt is made to make the slices more even. For example, raising taxes to improve equity may have a disincentive effect on work effort and thus total output. The performance of the economy over the long run may be affected by attempts to make the system fairer. Most economists believe that the market system generates a high degree of efficiency (large cake) but that the goal of equity is generally not achieved (an undesirable distribution of slices). There is a big and ever widening gap between the 'haves' and the 'have-nots'. As a result of this dilemma, it is often thought that there
48

should be some kind of trade off between the two criteria or goals. Some efficiency should be sacrificed in order to improve equity.

REVIEW OF EFFICIENCY ISSUES

Firstly let us discuss/review the main types of efficiency. They include: Allocative efficiencyinvolves producing the optimum combination of goods desired by the consumer. Is the economy producing the 'right' products? The 'right' products are those that the community most wants to consume (the actual/correct position on the PPF curve, rather than just anywhere on the curve). Productive (or economic) efficiencythe state in which the cost of producing a given output is as low as possible, i.e. producing at least cost by using the least cost combination of resources and the optimum technology available (that is somewhere on the PPF curve, rather than inside it). This means that the economy has maximised the output level with full employment of resources and that resources can't be reallocated to produce any more goods and services. Dynamic efficiencywhere an economy responds adequately (speedily and with flexibility) over time to change in demand and supply conditions. Dynamic efficiency refers to the capacity of an economy to respond to changes in technology (supply curve) and consumer preferences (demand curve). This involves new equilibrium prices and quantities. An economy should be responsive to and not sheltered from change. Therefore firms should foresee changing demand patterns of consumers and change their product mix accordingly and ensure that they engage in research and development to develop new processes and products. You should make sure you understand why perfect competition delivers allocative, productive and dynamic efficiency. You may like to revisit those sections of the textbook now (pages 144-5). Perfect competition also delivers productive efficiency. The competitive process drives inefficient firms out of business and price is driven down to minimum AC when profits signal new entrants into the industry. Dynamic efficiency is also achieved in perfect competition because the market responds to any demand or supply shock delivered to it. The effect of the different imperfectly competitive market structures (monopoly, monopolistic competition and oligopoly) on economic efficiency were discussed in chapters 5 & 6.

EQUITY: THE DISTRIBUTION OF INCOME AND WEALTH

The conclusions reached about the ability of competition to deliver allocative and productive efficiency assume that the distribution of income is given. In a market economy the distribution of the cake (equity) depends on income and wealth distribution. Inequality is due in part to differences in individuals' endowments (for example, an individuals innate talent) and by economic choices people make, such as how many hours to work, whether to further one's training and education, how much to save and how much to pass on to children.

49

Market failure
In Topic 6 we learned that perfectly competitive markets tend to achieve allocative efficiency. However, this is not always true. In some cases, such as with public goods and goods that generate negative externalities, even competitive markets will fail. Market failure occurs when an unregulated market fails to achieve the economists' criterion for allocative efficiency, which is an economy producing a level and combination of output such that no one can be made better off without making someone worse off. In other words, allocative efficiency is when each good is produced to the point where its marginal cost is equal to the marginal benefit to consumers created by producing them. Market failure also occurs when equity criteria are not being met, as we saw in the last topic. Finally, markets also fail when firms are not productively or economically efficient. Specific examples of market failure follow in the next few pages of this Study guide.

PUBLIC GOODS
One reason for market failure is due to the nature of particular types of goods called public goods. A public good or service is one which can be consumed by all without exclusion. Thus pure public goods are non-rivalrous and non-excludable. The difficulty with public goods is that they give rise to the free-rider problem. This problem occurs because individuals can consume a good without paying for it therefore, why pay? If provision of the good is left to the market, the supply would be insufficient. In the case of a public good, the government must determine the level of output to be supplied. Since it is desirable to make this level equal to the allocatively efficient level of output, we must weigh the total benefit of a good or service against its total cost. The allocatively efficient level of output is the level of output where net benefit to society is maximised or when marginal benefit is equal to marginal cost. Pages 206-7 are relevant to this discussion.

Externalities
Externalities are another source of market failure and can be in the form of external costs and external benefits. Goods such as paper produced from a mill that dumps its waste into the river or electricity produced from burning fossil fuels produce negative externalities, (or external costs) while services such as education and health care provide positive externalities (or external benefits). External costs are those costs of products or services borne by people other that their producer. External benefits are those benefits from a product or service received by those other than its buyers. An external cost will result in inefficiency as too many resources are allocated to the production of the good compared with the social optimum. The opposite is true for a benefit. The effect of an externality is illustrated in figure 7.1 of text.

DECLINE OF COMPETITION (IMPERFECT COMPETITION)

We have seen that capitalism is a type of economic system under which both businesses and persons are motivated by self-interest and the market mechanism
50

facilitates the pursuit of self-interest by all participants. The system then relies on competition acting as a control device to ensure that market outcomes reflect both efficiency and equity so that the social interest is also served. However, the reality is that perfect competition does not exist in any extensive way and never has, to the effect that it does not perform the role of automatic regulator of the market or price mechanism. In fact, we have seen that market concentration in many industries is relatively high and steadily increasing. Over time, business people have striven to reduce competition and the 20th century phenomenon of mass production technology has been geared to few firms rather than to very many firms in an industry.

Income inequality
The market mechanism works to the advantage of the economically strong relative to those with little or no economic power and the weaker competition is, the more this will be the case in general. Those advantaged by inherited or acquired wealth and abilities can command high incomes and, through this, relatively high command over goods and services. On the other hand, the market has no social concern for the physically and mentally disadvantaged nor the relatively unskilled and can leave them with no incomes and no command over even the necessities of life. Thus most societies see fit to alter the market's 'for whom' outcome by undertaking some redistribution of income and wealth in the interests of what is perceived to be equity

Imperfect information
A perfectly competitive market assumes perfect information for all producers and consumers. However there are many situations where this is not the case and either sellers have more information than buyers (the usual case) or the reverse. This is called asymmetric information. Two problems resultmoral hazard and adverse selection, both of which lead to an inefficient allocation of resources. Moral hazard is a tendency for a person to use private information to his/her own advantage in such a way that he/she causes a bad outcome. For example you may take less care to protect your house from a fire if you are insured for fire damage than if you had no insurance. Adverse selection is when individuals in society with private information pursue their own best interests through a unit of action not in the best interests of society. An example would be when a second hand car dealer knows about the faults of a car but still tries to sell it to the buyer, who has no information about these faults.

Government intervention
There are a number of ways in which the government can deal with each market failure. With respect to public goods, their provision can be financed out of government taxation revenue. ExternalitiesGovernments have methods for dealing with externalities to achieve allocative efficiency. First, they can establish private property rights. Second, they can tax activities that generate external costs and subsidise those that generate external benefits to a level where marginal social cost equals marginal social benefit to ensure output is allocatively efficient
51

Alternatively the government could directly provide a good with very high benefit externalities Solving externality problems also achieves, in most cases, allocative efficiency. These two market failures (cost and benefit externalities) can be considered together. Imperfect competitionGovernments approach to this problem is frequently to attempt to maintain as much competition as possible in order to increase efficiency. One of the ways of doing this is for the government to regulate a natural monopoly, which inhibits competition. Another possible policy with respect to maintaining competition and preventing monopolisation is to use trade practices legislation. In Australia this is attempted by means of the Trade Practices Act 1974. The strategy of the Act is to list the sorts of activities that the legislators wished to stop and to ban some activities outright, that is, make them illegal. You can check this out on the ACCCs website (www.accc.gov.au) Also take a look at the ACCC's Annual Report for 2005-6 pages 3-11, 14-19, 76-83, 121-129 to get a broad appreciation of the breadth and depth of work done by the ACCC. You will find this report at:
http://www.accc.gov.au/content/index.phtml/itemId/764868

Also it will pay you to take a look on the website for news releases - for example,
http://www.accc.gov.au/content/index.phtml/tag/NewsReleasesByTopicByYear/fromIt emId/621556/endYear/2006/startYear/2004/topicItemId/621556 gives you the last

two or three years' releases on price -fixing cases. InequalityThe distributive function of the government entails the redistribution of income and wealth to reduce the degree of inequality which would otherwise be arrived at via the market mechanism. The market mechanism can lead to cruel or socially unacceptable results, such as poverty, unemployment and even malnutrition. Some people may exist outside the market system because of illness, old age or illiteracy. Government involvement largely means progressively taxing those with higher property incomes and salaries and making transfer payments and providing welfare services to the disadvantaged who would otherwise have little or no income through the operation of the market mechanism. Transfer payments take such forms as aged and invalid pensions, family allowances and unemployment benefits. Rural price support schemes can also have a redistributive effect in favour of farmers. Retraining and relocation schemes can help those unable to find work in their current position or location. Affirmative action and anti discrimination legislation help those in society unable to succeed because of discrimination. Thus society, through its elected representatives, makes a judgement as to what

52

is a socially acceptable degree of equity and effects a redistribution of income and wealth accordingly. Imperfect informationThe government mainly responds to this market failure by legislating to ensure that as much information as possible is provided to consumers in most instances. InstabilityThe stabilisation function of government entails influencing the level of economic activity by using macroeconomic policy tools. The community regards the government as being responsible for the state of the economy, and there is a public expectation that they will act to solve these problems. The purpose of stabilisation policy is to iron out fluctuations in the level of economic activity, achieve strong economic growth, and to hold down the levels of unemployment and inflation while achieving a stable exchange rate and 'balanced' international trade.

Economic instability
The advocates of the market system under capitalism looked to it to automatically ensure full employment and price stability right up to the Great Depression of the 1930s. Instead, national economies and the international economy were wracked by cyclical economic fluctuations known as the business cycle. The business cycle is the periodic but irregular and unpredictable upward and downward movements in economic activity, measured by fluctuations in real GDP and other macroeconomic variables. Since the 1930s it has been generally recognised that the market economy is unable by itself to deliver stability of output, employment and prices.

CONCLUSION AND THE BIG PICTURE

In spite of the shortcomings of the market mechanism, it remains a useful and much used mechanism for economic decision-making in capitalist countries because it affords the maximum degree of freedom of choice and enterprise. However, its limitations also give rise to social intervention by government via non-market (or planning) mechanisms.

53