Markets are composed of different businesses. The goods are produced or services are provided by a business using factors of production – land, labor, capital and enterprise. Then the final price is paid by the customer. However, sometimes markets do not operate in this way and then market failure occurs.
What is market failure?
Market failure is when markets fail to achieve the most efficient allocation of scarce resources to meet the demand. So, there is underproduction or overproduction of certain goods or services. And the needs and wants of customers are not met.
What instances are there of market failure? Why should businesses be concerned about it? What decisions should the government do to correct market failure?
Examples of market failure
The three examples of market failure illustrate how the market should work, why the market does not work the way it should, the most affected stakeholders by failing markets and how to correct market failure.
(!!!) Market failure 1: Incorrect allocation of resources -> Monopoly producers
How the market should work?
The world demand for rice is rising. This leads to a doubling in the world price of rice. Farmers in rice-growing countries are encouraged by this high price to plant more rice and produce less of other crops which prices are not growing as fast as the price of rice. More resources are not allocated to the product with the increased price – the rice.
Why the market does not work the way it should?
When a market is dominated by one firm, a monopoly is said to exist. The business will be interested in making profits as high as possible. The easiest way of achieving this will be to restrict output and raise prices. As the monopolist is able to prevent competitors from entering the market, this strategy will lead to under-provision of goods and services compared with what consumers would really like.
The most affected stakeholders by failing markets?
Stakeholder groups most affected include consumers, who will be concerned about lack of choice, restricted supplies and high prices. There may be a reluctance by monopolies to develop new goods as there is limited competition. There will be high prices and lack of competitiveness of important industries.
How to correct market failure?
The corrective policy action could include the government using competition policies. Government can also investigate and act against monopoly practices. Privatization has led to the break-up of many state run monopolies. Consumers can purchase from other suppliers where at all possible. The increasing use of the Internet for consumer goods is allowing consumers to choose from a wider range of suppliers and this will break down some monopoly situations.
(!!!) Market failure 2: Poor labor training -> Workers follow the money elsewhere
How the market should work?
High salaries offered in the Singaporean financial sector are attracting staff into the financial industries away from other sectors which do not pay as much as working in finance. Labor resources are being allocated to one industry and away from others as a result of wage differences. More skilled workers earn more money, while less skilled workers earn less money
Why the market does not work the way it should?
Will firms pay for the training of staff when there is a real danger that, once qualified, they could be poached by other businesses that have not paid for the training? The answer is that many firms will not make sufficient provisions for training. This means that the country has a shortage of skilled workers and professional staff which will reduce economic growth. In this case, there is under-provision of training.
The most affected stakeholders by failing markets?
Stakeholder groups most affected will include consumers as scarcity of qualified staff may reduce consumer service or lead to higher prices as output is restricted. Also the government as lack of skilled staff will limit the international competitiveness of industry. And, shareholders whose potential profits will be lost as output will be below potential.
How to correct market failure?
To solve this market failure, industry-wide organizations, such as Engineering Employers Federation in the UK, could levy members to pay for industry-wide training which would benefit all firms in the industry. The government could pay for more training courses at colleges funded from general TAXation.
(!!!) Market failure 3: Companies do not clean up the mess -> External costs for the country
How the market should work?
In order to produce products, manufacturing businesses pay for private costs of production such as the land, capital, labor and materials. During the production process, in addition to products, the side effect is produced as well in the form of pollution: air pollution, water pollution, soil pollution, noise pollution, etc. However, this external cost of cleaning up after the production of chemicals or plastics is not included in the price charged to consumers, but left for the society to bear and the government to handle.
Why the market does not work the way it should?
Pollution resulting from manufacturing is a good example. When a business makes a product, it has to pay for the costs of the land, capital, labor and materials. These are called the private costs of production. We are all aware, however, of the consequences of production other than those from the use of these factors. Air pollution, noise pollution and the dumping of waste products are all side effects of most manufacturing processes. Who pays the costs of cleaning up after the production of chemicals or plastics? Unless the business is forced to pay, the costs will be borne by the rest of society. The government or local authority will have to raise TAXes to clean the buildings dirtied by smoke, pay for medical provision for those affected by air pollution and make provision for waste disposal.
What are the external costs?
External costs are the costs of an economic activity that are not paid for by the producer or consumer, but by the rest of the society.
In this example, the market has failed to reflect the true and total cost of production in the price of the product. If the price charged to consumers included all of the costs of production – private as well as external – then less would be demanded and produced. As the price charged does not include the external costs, too much of the product will be demanded and too much produced.
The most affected stakeholders by failing markets?
Stakeholder groups most affected will include consumers as there may be few alternatives, so they may be forced to buy environmentally damaging goods. The government and local authorities will be forced to take the issue seriously by voters and pressure groups. And workers, who may be concerned about their own health and job security if bad publicity leads to a decline in sales.
How to correct market failure?
Corrective policy action could include the government imposing fines on polluting businesses or impose strict limits on pollution levels. Businesses may act to reduce externalities, if bad publicity leads to lasting damage to reputation and sales.
