High School economics — Market Faikure

Understanding what is Market failure

[Memorize the definition. The ideas will become clear as you see the examples and their explanation.]

Understanding Demand Supply Equilibrium… From time immemorial, buying and selling of goods and services have followed a familiar pattern. Let us consider a cluster of 50 villages having a population of nearly a lakh of people. Among this population, there are, say, 20 families whose profession is to rear cattle and sell the milk. A situation arises when the demand for milk goes up and the traditional cattle farmers can not supply so much milk. Inevitably, the prices soar as buyers scramble to procure their needs. Costly milk is not a desirable option. Seeing the scarcity, the traditional milk producing families buy more cows to meet the shortfall. Some young men from other professions such as fishing, washer men etc. buy cows and start their own diary business. As a result, milk supply improves and rates fall. It may so happen that the supply continues to go up and the rates continue to fall. At one point, the diary business becomes unprofitable. Many families will sell off their cows and will exit the milk supply business. As a result, the price of milk will rise again luring the families who exited the profession to re-enter the business. Milk supply will increase and price of milk will fall.

Such cycle of rise and fall of milk production and price of milk will continue till an equilibrium is reached. This is the interplay of market forces.

Competition between the producers of goods and services to offer high quality products at less prices leads to a healthy demand supply match. This equilibrium is highly desirable as the market becomes transparent, stable and predictable.

In a capitalist economy, great value is attached to the free play of market forces and the attainment of a healthy match between supply and demand of any commodity. Generally, it has been observed that a free play of market forces and free competition between producer of goods and services is very beneficial to the consumers and the suppliers.
In capitalist economy, allowing free competition and free interplay of market forces is considered sacrosanct. Governments seldom interfere in the market.

However, a free market can lead to undesirable consequences too. A situation may arise when either too much or too less of a certain product or service is being produced jeopardizing the interest of either the individual customer or the society as a whole. Such a situation is attributed to ‘Market Failure’.

The factors behind such distortion in market can be many, like – greed of industrialists, shortsightedness of an over-bearing government, callous indifference towards society’s needs, ineptitude of individuals taking decisions etc.

So, we can safely conclude that free-market mechanism is a fail-safe route to ensure optimum utilization and distribution of a country’s resources / assets. ‘Resources’ can include a very broad range of things like land, river, forests, ocean, cattle, transportation networks, education infrastructure, farm produce, minerals etc. It can also include man power resources like students, teachers, young skilled and unskilled workers, nurses, doctors, scientists, engineers, administrators, army men, police etc. etc.


Private cost, private gain, social cost and social gain –How to strike a balance .. Let us examine a case where an industrialist establishes a tannery and a shoe manufacturing unit near a village. As a result, he employs dozens of young men and women from the village, starts a leather technology polytechnic  near the village, repairs the village road to let loaded trucks come and go, offers to buy raw hide from local people, establishes a canteen where local people can buy food stuffs at reasonable rates. All these are meant to ensure smooth working of his business and, more importantly, to keep the local people in good humour.
All these cost him money. If we analyze these items of expenditure, we will see some of them are directly linked to his production, such as, cost of hide, chemicals, power bill, wages paid to staff, freight etc. The total of all these constitute what we term as ‘Private cost’.  Rest of the items such as widening of road, setting up a polytechnic, putting up a canteen etc. constitute ‘Social; cost’ to the entrepreneur. But, as we will see a little later, this is not the complete list of ‘Social Cost’.


For the villagers, the factory brought benefits such as employment, higher buying power, access to cheaper food items, access to a skill building education through the polytechnic etc. For the hide suppliers, it brought new business and new income.
For the shoe selling shops, it ensured steady supply of shoes, and so, ease of business. All these are classified as ‘Private gains’.


Un-accounted Social Cost … The tannery discharged its chemicals to nearby river, polluting it dangerously, and rendering it unsuitable for human use. The fishes died. Additionally, the factory’s chimney spewed toxic fumes rendering the air dangerous for inhaling. Thus, the tranquil, un-spoilt village lost its two life lines — water and air for ever. This is the additional ‘Social Cost’ generally ignored when all decisions are left to free- market forces. This cost must be added to the ‘Private Cost’ of the industrialist and recovered from him. He must be forced to treat the effluent and the fumes to render them harmless before being released to the environment.
When these costs are added, the cost of the finished shoes go up. It inconveniences the shoe buyer, but then it forces him to buy shoes only when necessary and try to conserve his shoes to reduce his buying. On the whole, although a little painful, due monitoring and imposition of environmental controls lead to  long term preservation of environment and optimum consumption of shoes.
Thus the government has responsibilities, and powers to regulate the free market forces from straying to a situation where the society suffers.


Definition of Market Failure

a. Market failure is a broad term. It happens when the price mechanism fails to allocate scarce resources efficiently or when the operation of market forces lead to a net social welfare loss.
b. A market failure occurs when the supply of a good or service is insufficient to meet demand. This results in an inefficient distribution of resources among market participants.

Market failure exists when the competitive outcome of markets is not satisfactory from the point of view of society. What is satisfactory nearly always involves value judgments.

Market failures happen in all societies, in all ages, and in all fields, be it industry, real estate, education, armed forces, healthcare, stock market operations, labour market, infrastructure development etc. NGOs, alert environment activists, economists, and media highlight these aberrations and force the government to step in correct the situation through legislative measures. These can be imposition of new taxes on goods being over produced, subsidies for goods and services being under- produced, imposition of partial bans, imposition of punitive penalties etc.


Some typical examples of ‘Market failure’…

1. Partly to gain popularity and partly out of concern for young children, pregnant mothers and the sick, government fixes the price of milk at Rs.25 a litre. The thousands of small rural milk producers are hit hard as the rate at which the large diaries buy milk from them falls. On the other hand, the urban middle and lower class consumers are elated as they can buy more milk at less cost.
Their joy is however short-lived. The resentful milk producers give up rearing cattle, sell off the cows and switch to some other profession. In a few months time milk availability falls sharply making it very scarce. The urban consumers vent their anger on the government.

2. During the World War 1, the British colonial administration forcibly recruited all available young men in villages to army. As a result, the farming activities in rural areas came to a standstill. Paddy, wheat and sugarcane production fell to near-zero level causing a famine in the countryside. The army got its soldiers, but the population went hungry.

3. The industrialist’s young son had got a gift of Rs. One Crore from his father. On the advice of a few of his ill-informed friends, he invested the money in the shares of an automobile company. In doing so, he disregarded the advice of his father to deposit the amount in a bank as fixed deposit. Sadly for the son, the company did not do well and was able to give just 2% dividend to its shareholders. The son got just 2 lakh in place of nearly 8 lakh which the bank could have given him for his fixed deposit.

4. Whenever a hydroelectric power plant is built, hundreds of villages are inundated driving lakhs of poor people out of their ancestral homes. Vast swathes of agricultural land are lost. Orchards drown, ponds are lost and places of worship are immersed. The environmental cost becomes painfully enormous. In return we get power for nearly six months a year.
The social cost of the hydroelectric project exceeds the benefit it brings to the society. This situation arises when the government assesses the impact of the proposed project too hastily.

5. The oil spill in the Gulf of Mexico in July 2010 is a case of the oil company British Petroleum’s (BP) efforts to maximize its profits at the cost of safety. The sub-contractor – Deepwater Horizon – was doing the drilling job deep under the sea when the accident happened causing a ruptured pipe to spew out huge quantities of crude oil into the water of the ocean. It took BP engineers a couple of days to plug the leak by which time the black oil had spread far and wide endangering aquatic life, damaging beaches and throwing the local fishing community out of their jobs.
It was a case of corporate greed and a reluctance to weigh the risks involved before undertaking a project. The oil industry is highly competitive and regulated by government. Yet, this colossal accident happened.
So, competition and government regulation do not necessarily guarantee due diligence on the part of large business houses. At the end, the society was the loser.

6. In India, the government encouraged starting of computer training institutions to meet the soaring demand for IT professionals. This yielded the desired results, but the time came when the best and brightest students shied away from science courses, and opted for IT education. This trend is not getting reversed, and the country’s leading science colleges, universities and labs are starved of brilliant students. Thus, due to inept planning and wrong policy implementation, the society loses.

Complete and partial market failure

• Complete market failure occurs when the market simply does not supply products at all – we see “missing markets”. Example .. The United States does no longer manufacture low value-added products like cast iron products, garments, toys, and imports them from China and other countries.
• Partial market failure occurs when the market does actually function but it produces either the wrong quantity of a product or at the wrong price. Example .. Take the case of dairy products like butter, cheese etc. India produces these items, no doubt, but the prices are way too high compared to those in New Zealand, EU countries etc.

Markets can fail for lots of reasons …..

1. Negative externalities (e.g. the effects of environmental pollution) causing the social cost of production to exceed the private cost. Example .. Factories situated in the banks of the Yangtze River in China. Their effluents have spiked the pollution level so much that traditional fishing folks do not get enough fishes to catch.

2. Positive externalities (e.g. the provision of education and health care) causing the social benefit of consumption to exceed the private benefit. Example … In France, the government provides very generous post retirement benefits to its population. This has burdened the budget and forced the government to increase taxes. As a result, net individual incomes have shrunk, and French goods have become uncompetitive in the export market. The economy as a whole has taken a hit.

3. Imperfect information or information failure means that merit goods are under-produced while demerit goods are over-produced or over-consumed. Example … India needs cheap basic drugs, vaccines and simple medical equipments to cater to the needs of the rural masses. India does not as much need sophisticated drugs needed for treating rare diseases like Dementia etc. So, government must promote ventures that cater to the needs of the poor rural folks suffering from malnutrition-related diseases, pre and post natal complications, Dengue, Malaria etc. Sadly, this emphasis is lacking.

4. The private sector in a free-markets cannot profitably supply to consumers pure public goods and quasi-public goods that are needed to meet people’s needs and wants. Example … Students need inexpensive, but high quality text books, nutritious, but simple mid-day meals, low-cost water purifiers and inexpensive computers. Obviously, few companies in India would like to enter this arena. So, the students suffer and the society loses.

5. Market dominance by monopolies can lead to under-production and higher prices than would exist under conditions of competition, causing consumer welfare to be damaged. Example … MNC automobile companies in India do not manufacture low-cost cars like Nano. Instead they produce high-value luxury SUVs. India needs these cars, but it needs more of Nano type cars.

6. Factor immobility causes unemployment and a loss of productive efficiency. Example .. America has clamped restrictions on the entry of Indian IT workers under H1B visa. This has adversely affected the efficiency and competitiveness of American IT firms.

7. Equity (fairness) issues. Markets can generate an ‘unacceptable’ distribution of income and consequent social exclusion which the government may choose to change. Example … In India, in the last few years we have witnessed some huge scams relating to coal mining, iron ore mining, real estate transactions, telecom licensing etc. Corruption angle apart, such cornering of the nation’s assets by a few companies and individuals has resulted in huge amounting of money landing in the pockets of a few crooked individuals. The miners who toil in the mines braving the hazards have seen no increase in their earnings. This is a clear case of unequal distribution of income leading to the social exclusion of the labourers who work in mines, construction sites etc.