Market failure is a market situation in which market equilibrium doesn’t work, meaning that the market regulation mechanism, the “invisible hand of the market”, does not work. Thus, “failures” usually imply the need for administrative regulation of the economy and economic relations in order to smooth out or eliminate the negative consequences of the market mechanism.
The reasons of market failures are:
- conditions of imperfect competition (monopoly, monopsony and oligopoly);
- lack and asymmetry of information;
- external factors;
- non-exclusion in the case of public goods.
In the case of monopoly, monopsony and oligopoly, equilibrium is established when marginal revenue and marginal cost are equal. With information asymmetry, the consumer cannot influence the manufacturer, there is no control over the quality of the products and services. The lack of information generates inefficiency, blocking the interaction between participants in the transaction. In the presence of external factors, some of the income received from any activity of production goes to unauthorized persons, which affects the individuals and the production functions of businesses.
Modern economic theory connects the need for government regulation with market failures.
For example, in the event of environmental pollution, the government can take the following steps, in order to solve the problem:
- adopt a law requiring the installation of equipment that controls the level of pollution;
- introduce a tax for the damage caused by pollution;
- carry out legislative clarification in order to protect entrepreneurs from pollution problems.
Any of these actions would lead to the change of the cost of pollution into an “internal cost”. As a result, costs of this type would be borne by the polluter and those involved in business relationships.
In cases where markets are unable to provide a supply of public goods, the state simply becomes the producer of public goods. In other cases, such as education, the government does not need to act as the sole producer. Here, the increase in the supply of educational services is decided by providing educational institutions with subsidies and tax benefits.
To prevent and predict market failures resulting from the lack of competition, one can use a variety of measures:
- adoption of antitrust laws;
- the requirement to publish prices and regulate pricing;
- the elimination of discriminatory prices for preferred customer groups;
- the provision of separate published bills (for the use of telephone lines, electric cables, gas pipelines), value added ones (profits derived from the consumption of electricity, gas);
- the supply of equipment (telephones, televisions);
- the separation of the process of sale of products, their delivery and their regulation.
Pure monopolies have the greatest power over the market. They are the industries with an infinite positive economies of scale: the larger the scale of the firm, the more efficient the production. This implies the undesirability and the impossibility of competition in such industries.
Given these considerations, the state must exercise regulation of the activities of monopolies, either taking them into its ownership or making them objects of economic regulation. In both cases, the state should set prices for the products of monopolies. Thus, it would become the competitive market, setting the price.
The competitive market sets a price in the long run, which provides an opportunity for competitive firms to cover all their economic costs, including normal profit. As the state seeks to replace the work of competitive market forces , it should take into account the economic interests of producers and consumers.
For this, it is necessary that the prices:
- are as close as possible to marginal (or at least average) costs;
- provide normal profit (not below the normal level);
- stimulate production efficiency (cost minimization).
Market failures happen within many other market models, which also does not go unnoticed by the state. It is the only entity which can predict and prevent market failures and strengthen the competition by pursuing antitrust policies and keep the prices at normal levels.
