Question

What incentives such as taxes and subsidies among others, besides laws and regulations are useful to redress the failure of markets. Markets of information based products or services may or may not be contestable. What if they are in the context of market structure?

Answer 1

A pragmatic interpretation of market failures is where the economic participants aren’t properly incentivized for pushing the markets towards more acceptable results.

A market failure has a negative effect on the economy due to the non-optimal allocation of resources. In other words, the social cost to manufacture the goods or services i.e. all the opportunity costs of input resources used in the creation, are not minimized. This also leads to the wastage of resources.

Subsidies, tariffs, punitive or redistributive taxation, trade restrictions, disclosure mandates, price ceilings and several other economic distortions were mooted to correct inefficient outcomes.

1. Taxation: It is a way of controlling monopoly power during a market failure. Taxes could be levied lumpsum, irrespective of the output of the monopolist. The tax could also be proportional to the output i.e. the taxable amount rising with a rise in output. In both cases, the target is to bring down the monopoly to a competitive level.

Pigou suggested social control measures and using subsidies and taxes to achieve an optimal allocation of resources in the face of various externalities.

Pigou also suggested the government to encourage production of goods and services with positive externalities by granting subsidies on each unit of product or service by the manufacturer. This will also help buyers to maximize their satisfaction by tax concession so that they can buy more commodities. Negative externalities often discourage sellers from production, and buyers from consumption by levying taxes.

Contestable Markets: It is one with zero entry and exit costs. This means there are no barriers to entry and no barriers to exit, such as sunk costs and contractual agreements.

Asymmetric information is a key barrier to entry. Incumbents are likely to know much more about their industry than potential entrants, and are likely to be unwilling to share their knowledge or technology.

With no barriers to entry into a market, it can be argued that the threat of entry is enough to keep incumbents ‘on their toes’. This means that even if there are a few firms, or a single firm, as with oligopolistic and monopolistic markets, a market with no barriers will resemble a highly competitive one.

Potential entrants can operate a hit and run strategy, which means that they can 'hit' the market, given there are no or low barriers to entry, make profits, and then 'run', given there are no or low barriers to exit.