Topic 3: Market Failure
When competitive markets fail
 When a competitive market is left to operate freely the
result will be an optimal level of output and the most
efficient allocations of resources.
 That is, the point of “equilibrium” will also be the
point at which the greatest number of people achieves
the highest level of living standards possible.
 Sometimes markets fail and as a result unregulated
markets are unable to allocate resources efficiently or
resources are allocated in such a way that national
living standards or welfare is not maximised.
Government Intervention
 In Australia’s economy, the market generally makes
good decisions about how resources are used.
 However, as we have seen, sometimes the free
operation of the market system creates problems that
reduce efficiency and undermine our living standards.
 When this occurs, the Australian government
intervenes in the market.
 Typically there are several justifications for
government intervention, influence or regulation of our
market system.
Reasons for Government Intervention
1. The correction of various types of market failure.
 Markets do not always make good decisions when, for
example, there is market power, asymmetric information,
negative externalities, and the requirement to have affordable
socially desirable goods and services for the community.
 The government attempts to correct these market failures by
passing laws, and using particular indirect taxes and specific
government outlays in budgets to reallocate resources more
efficiently.
 In so doing, society’s needs and wants are better satisfied and
our living standards are improved.
Reasons for Government Intervention
2. Stabilisation of the level of economic activity.
 We know that most markets are quite unstable.
 At the microeconomic level, prices and output vary
greatly over a period of time.
 This contributes to macroeconomic instability where the
Australian market economy experiences economic
booms and recessions.
 These reduce our living standards. As a result, the
government attempts to moderate the severity of these
fluctuations using special stabilisation policies to
regulate the level of economic activity
Reasons for Government Intervention
3. Redistributing income more equitably.
 The price system (involving the forces of demand and
supply) not only determines the price of particular
commodities, goods and services, it also greatly affects
the level of people’s wages (the price of labour) and
contributes to income inequality where there are high and
low income earners.
 As we shall see, governments reduce the level of income
inequality generated by the free operation of the labour
market.
 This involves using particular policies to redistribute
some income from the rich to the poor
Government Intervention
 Unit 4 focuses of government intervention to improve
economic stability and achieve a more equitable
distribution of income.
 In unit 3 we will just focus on government intervention
to deal with market failures.
Definition – Market Failure
 Market Failure: is a situation where, because of
imperfections in the working of the market
mechanism, competitive markets do not achieve an
efficient allocation of resources. It occurs when
consumers or producers pursuit of self interest leads
to a situation where resources are allocated in ways
that do not maximize the economic welfare of all
members of society and national living standards.
 (Consumer sovereignty, price system, profitability
unsuccessful or inefficient at allocating resources into
areas that increase the nations living standards)
Types of Market Failure
 There are four types of market failure we will
examine:
 Public Goods
 Asymmetric Information
 Externalities
 Market Power
Public Goods
 Public goods: are both non-excludable and non-rival
(non-depletable) in consumption. A person who does
not pay for the good cannot be excluded from
consuming it and one person’s consumption does not
lesson another’s ability to consume.
Public Goods
 Public goods: are both non-excludable and non-rival
(non-depletable) in consumption. A person who does
not pay for the good cannot be excluded from
consuming it and one person’s consumption does not
lesson another’s ability to consume.
Non-payers cannot
not be excluded
from consuming
Public Goods
 Public goods: are both non-excludable and non-rival
(non-depletable) in consumption. A person who does
not pay for the good cannot be excluded from
consuming it and one person’s
consumption
The consumption
of does not
lesson another’s abilitythe
to good
consume.
by one person
does not reduce the
benefits received by
another
Public Goods
 Public goods: are both non-excludable and non-rival
(non-depletable) in consumption. A person who does
not pay for the good cannot be excluded from
consuming it and one person’s consumption does not
lesson another’s ability to consume.
 The existence of a public goods leads to the free rider
problem, where a free rider is a person who receives
the benefit from a public good but does not pay for it.
 The existence of free riders means the market will tend
to under-allocate resources to those goods where the
producer cannot charge all end users.
Examples of Public Goods
Government Intervention - Public Goods
 The government will intervene in those markets where
it deems the provision of public goods to be important.
 The main method the government uses to put more
resources into socially desirable production is through
outlays or spending on health, education and so on.
 This change to resource allocation is done mostly
through the annual budgets announced by federal, state
and local governments.
 Outlays for desirable public sector production are paid
largely from tax revenues.
Market Failure – Asymmetric Information
 If a market is perfectly competitive then economic
agents are assumed to be making fully informed rational
decision based upon full information about factors such
as prices, quantities, conditions and technologies.
 In certain circumstances consumers will not be able to
ascertain all information about the good or service they
are purchasing.
 In certain circumstances the seller will not have enough
information to charge the correct price of offer the right
service.
Definition – Asymmetric Information
 Asymmetric information exists then there is an
imbalance of knowledge between the buyer and
seller. For example. the seller has more information
than the buyer in a transaction, so rational choices
and efficient decisions about resource allocation
cannot be made.
 The market fails to work well.
Asymmetric Information and adverse selection
 Adverse selection is a problem that may arise in a
market where the seller knows more about the
product than the buyer does. The uninformed buyer
may therefore purchase adversely.
 Example:
Asymmetric Information and moral hazard
 In some markets buyers have more information than
the seller.
 Example:
Asymmetric Information and moral hazard
 Moral hazard occurs when economic agents adjust
their behaviour to one that is less efficient or
favourable from society’s point of view.
 As a result they become less risk averse in their
actions.
Asymmetric Information and government intervention
1. Government legislation and laws
 One approach is that the government could require full
product disclosure by sellers of all relevant information
needed for effective decision making by potential buyers
through appropriate legislation, such as useful labelling on
products like food).
 The government could make it illegal for sellers to withhold
certain information; for example, laws about the
responsibilities of company directors to accurately inform and
update investors about business conditions and prospects that
affect decision making, or product labelling requirements that
warn users of potential hazards or dangers.
 The government has a range of consumer protection laws
through the Trade Practices Act (1974) that prohibit a number
of unfair practices, cover conditions and warranties and sets
product safety standards and information.
Asymmetric Information and government intervention
2. Advertising and educational campaign
 The government could conduct an advertising campaign
to educate and inform consumers of potential dangers of
products so that effective choices can be made and
resources allocated efficiently to maximise society’s
wellbeing.
 In addition, improving the speed and level of public
access to the internet can help facilitate effective
research, and better knowledge and understanding of the
consequences of decisions made by consumers.
Asymmetric Information and government intervention
3. Private organisations and associations
 These provide useful information for potential
consumers.
 Independent reviews by consumer groups such as Choice
and an RACV car inspection can help the consumer to
increase their level of information about a particular good
or service.
 The internet has also provided consumers with a wealth
of information to ascertain whether a product offered by
suppliers meets their needs and is priced competitively.
Definition; Market Power
 Market power occurs when there are not enough
buyers and sellers in the market and there is a lack of
competition. As a result sellers can attempt to obtain
higher profits by charging higher prices or forcing
prices up by limiting supplies to the market.
 Generally in these markets the market price is not a
competitive price.
Recall – Market Structure
 Perfectly competitive Market
 Competition produces an equilibrium price in the
market and this can lead to more products being shared
 There tends to be an efficient and effective allocation
of resources and higher levels of production
 Due to consumer sovereignty wants are satisfied and
living standards maximised.
Recall – Market Structure
 Monopolistic Competition
 Prices tend to be higher as businesses try to gain an
advantage in the market
 There can be wastage in resource allocation due to
businesses trying to differentiate similar products
 Some firms can dominate leading to larger profits and
wealth causing income inequality and lower living
standards
Recall – Market Structure
 Oligopoly/Duopoly
 There can be competition and cheaper prices but there
can also be agreements to share the market, restrict
production and fix similar prices.
 Can make agreements to engage in restrictive trade
practices and reduce efficiency in the interests of more
profit.
 Living standards can be reduced by the actions of selfinterest exercised by these firms.
Recall – Market Structure
 Monopoly
 Have economic power to act in their own interest and
to set their prices in the market or restrict production
so that they can charge higher prices
 They can set quotas, restrict production, discourage
invention and innovation. Acting in their own interests
tends to lead to inefficiencies and even to wasteful use
of resources.
 Since acting in self interest can reduce living standards
of other.
Market Power
 While highly concentrated markets are not always
associated with inefficient outcomes, it is more likely to
occur than in more competitive market structures.
 Monopolies and oligopolies have an incentive to restrict
competition and output, lift prices (since firms are price
makers rather than price takers), reduce efficiency in
resource allocation and lower customer service.
 In some cases this can lead to greater profitability,
especially if the demand for the product is inelastic.
 As a result there is an under-allocation of resources to the
production of the product and some consumers will miss
out.
Market Power
 Lack of competition in a market can also reduce the
incentive for firms to innovate or increase their
productivity.
 As a result firms with market power may become
complacent as they can generate high profits without
needing to modify current work practices.
Market Power – Government Intervention
Government deregulation of key markets
 Deregulation involves the removal or reduction of unnecessary
government restrictions or rules that prevent competition.
 Over the past two decades there has been partial deregulation of
some important markets including the labour, capital,
waterfront, primary produce, telecommunications, electricity,
water, milk and aviation markets.
 The hope is that the level of competition between sellers will be
greater, creating increased efficiency and better living
standards.
 Microeconomic reforms like these expose industries and
workers to greater competition by removing unnecessary
government restrictions and by breaking up both public- and
private sector monopolies and oligopolies.
Market Power – Government Intervention
Trade Liberalisation
 Trade liberalisation involves removing restriction on international
trade which give firms protection from international rivals.
 Trade liberalisation involves:
 By exposing businesses to greater competition the specific
markets become bigger increasing consumer choice.
 As a result, local firms have had to improve product quality and
cut production costs in an effort to lift their efficiency in resource
allocation.
 Increasingly, our resources are allocated into areas where
Australian industry has a comparative cost advantage.
 Living standards should rise as a result.
Market Power – Government Intervention
Laws designed to increase competition
 The main law designed to promote competition is the Trade
Practices Act (1974).
 It gives the Government power to prevent anti-competitive
behaviour.
 The competition policy is monitored and policed by the
ACCC.
 The primary objectives of the ACCC are to improve
competition and efficiency in markets and to foster
adherence to fair trading practices and to provide participants
full information
Market Power – Government Intervention
Laws designed to increase competition
 Aspects of the TPA that promote competition:
 The Act allows the Government to prevent mergers or
acquisitions that will substantially lesson competition.
 The Act makes it illegal to fix, control or maintain prices
 The Act prevents the use of resale price maintenance contracts
that specify a minimum price below which goods or services
may not be resold.
 The Act prohibits predatory pricing which involves charging
low prices in order to drive the competitor out of the market
which then allows the business to increase their prices.
Market Failure - Externalities
 An externality arises when a person is engaged in a
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transaction (or activity) that affects the wellbeing of a third
party who is not involved in the transaction (or activity).
Externalities can be positive of negative.
Externality is a cost or benefit borne by a third party, not
involved in the transaction, as a result of the
consumption or production of a good or service.
A positive externality occurs when the third party receives a
benefit as a result of the production or consumption of a
good or service.
A negative externality occurs when the third party is
imposed a cost as a result of the production or consumption
of a good or service.
Market Failure - Externalities
 Buyers and sellers tend to neglect the impact of the
externality on their decision making which means the market
outcome is not efficient.
 The market will tend to over-allocate resources to the
production of those goods of services that create a negative
externality.
 Whilst the market will tend to under-allocate resources to
the production of those goods and services that create a
positive externality.
Market Failure - Externalities
 Positive externalities of production:
 Positive Externalities of consumption:
Market Failure - Externalities
 Negative externalities of production:
 Negative Externalities of consumption:
Externalities – Government Intervention
 When the existence of an externality causes an inefficient
outcome the government can use its regulatory powers to
regulate a market or use taxation system to influence the
structure of relative prices.
Externalities – Government Intervention
1.
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Legislative powers
The government can use their powers to mandate certain
activities or forbid certain activities
For example in 1987, the Government banned
Chloroflurocarbons (CFCs) because their use
contributed to the hole in the ozone layer.
Most state Governments have also banned smoking in
enclosed areas such as pubs, restaurants and shopping
centres.
Externalities – Government Intervention
2. Use of Taxation System
 The government may choose to influence market
outcome by indirectly the incentives of the consumer or
producer via the market system.
 In the case of a negative externality the aim would be to
force the producer or consumer to internalise the
external cost that has been imposed on a third party.
 This can be done by imposing a tax on producers who
cause a negative externality.
Externalities – Government Intervention
2. Use of Taxation System
 The tax shifts the supply curve to the left for the good or
service that is causing the negative externality.
 This will lead to a higher price for that good or service.
 The higher price will generally lead to a decrease in
demand as the good or service now has a higher price
relative to other substitutes which doe not cause the
same external cost.
 The firm will notice the drop in demand and look at
ways of reducing their external cost which may involve
a change in the production process.
 As a result the market will move to a more efficient
outcome.
Externalities – Government Intervention
2. Use of Taxation System
 In the case of positive externalities the Government
could subsidise activities that create external benefits in
order to provide or encourage either greater production
and/or consumption.
 Governments will generally subsidise education because
an educated person gains private benefits and will also
contribute to productivity growth and add to the
productive capacity of the economy.
Externalities – Government Intervention
Use of Taxation System
3. The government also provides funding and offers
research grants for basic research in medicine,
mathematics, other sciences and economics
 Without government support, there would be an underallocation of human resources to the production of
research and development because not all the gains can
be appropriated by the producer of the R&D.
2.