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Market Failure Essay

1706 words - 7 pages

Jordan Alexander February 14, 2012
Economics Essay – Market Failure

1. Markets fail when they under or over allocate resources of production or consumption, relative to the best interests of society. Market failure occurs due to four main factors: the existence of externalities, asymmetric information, the abuse of monopoly power, and inequalities and wealth and development. The existence of externalities means that the market mechanism does not always work efficiently. Markets run on a mechanism that only takes into account the private benefit and cost for a good. Besides the marginal private cost and marginal private benefit, there are the marginal social cost and marginal social ...view middle of the document...

Graph 3 demonstrating negative externalities, when the social cost is added to the private supply cost, giving a new supply curve, which raises the price and decreases the quantity.

3. Public goods are goods that are non-rivalrous and non-excludable. This means that the use of it by one person does not prevent the use of it by another, and also that people cannot be excluded from using the good. Public goods have very large positive externalities, but small private benefits, and this means that in a market system, they would barely be produced. This is defined as a market failure, and therefore, the government must find a solution to reallocate more resources of production to public goods.

4. To solve the market failure of lack of public goods, the government mainly uses one solution: the direct provision of public goods. This means that the government provides these services directly, paying for them using money from the taxation system. This is a way for everyone to receive the benefits of public goods. The problem with the method of direct provision is that it can be expensive, and also, there will always be the problem of ‘free-riders’, which benefit from the public good, yet do not pay a share of its cost. Another problem with this is that often, government is inefficient in its allocation of public goods, for example, between allocating too many resources to tanks than to police officers. Also, there might be inefficiency of government employees because the profit motive is not present.

5. Merit goods are private goods, which have large positive externalities. Due to the market system, the private optimum (equilibrium between private benefits and private costs) will be produced, instead of the social optimum. The government will want more produced because merit goods benefit other external people, despite it being a private good.

6. The government has three ways to allocate more resources towards merit goods. It can use positive advertising, direct provision of merit goods, or subsidising merit goods.
Graph 4. Advertising is used in order to increase demand for a merit good (shift the demand curve to the right). The increase in demand would mean that the price would increase, and therefore, the quantity supplied will increase.
Graph 5. If the good has very large positive externalities, the government might decide to provide the good directly for free, as with public goods. In most places, primary school education is made free for all, and is provided by the government. Another method is limiting its price to a certain amount, so that quantity supplied will be more than the market price. This occurs with medical care in some places. Also, making the good free and then rationing it is a common solution, which is often done with medical care for children or the elderly.
Graph 6. Another option is for the government to offer subsidies to private consumers. Therefore, the supply curve would shift to the right, lowering the...

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