Question

under perfectly competitive (free) markets, welfare is maximized and resource allocation is efficient. However, when there is a market failure, this result no longer holds. Choose an example of a market failure and provide a definition. Explain why the market failure you chose, will result in reduced welfare and/or a misallocation of resources. Use examples to support your argument.

Answer 1

MARKET FAILURES:

A market failure occurs when the supply of a good or service is unable to meet the demand of that particular good/service which thereby results in an inefficient distribution of resources in the market and reduces the overall welfare of the society. Market efficiency can be achieved if the value of goods produced is equal to the value of foregone production ( goods not produced). Therefore the other reason for a Market failure is when this efficiency condition is not achieved. Such failures can only be corrected by government intervention.

There are four types of market failures:

1. Public goods
2. Market control
3. Externalities
4. Imperfect information.

Considering the fact that we live in a perfectly competitive free market and so in that any competitive industry will produce goods in a way that an equilibrium is maintained that is Market Demand = Market supply. But if that industry is taken over by a Monopolist then the equilibrium cannot sustain. As the monopolist’s main agenda would be to earn profits rather than maintaining the market. They will have the power to increase the prices therefore leading to a decrease in the demand of that particular product. The monopoly price is assumed to be higher than both marginal and average costs leading to a loss of allocative efficiency which is that the firm is not making optimum use of the scarce resources and a failure of the market. The monopolist is charging a price from consumers that is above the cost of resources used in making the product and, consumer’s needs and wants are not being satisfied, as the product being under-consumed due to it’s high price.

One basic tenant of a competition policy is that Market control (Monopolies) affects the welfare badly which thereby says that Market Power is inversely proportionate to the welfare of the society. This happens because we see that in a monopoly, resource allocation is inefficient therefore leading to productivity inefficiency. As the main target is not to meet the demand of the society leading to a decrease in the production of the firm.

Monopoly will produce goods where Marginal revenue = Marginal cost. But the price it will charge for the same will be higher than what it should (more than marginal cost) and the production would be less than what it would be under competitive optimum conditions. Higher prices leads to lower consumer surplus lower than the pareto optimal levels also leading to some of their surplus being transferred to the producers. Producers will therefore sell less of their goods than they would in a competitive market. They do sell their products at a higher price which would eventually offset their gains resulting in a decline in producer surplus. This thereby guarantees the dead weight loss of welfare or the social cost of the monopoly as

Welfare = Consumer Surplus + Producer Surplus

In the following graph we see that a competitive firm would have an equilibrium at point C, at price Pc and quantity Qc. but a monopoly would produce goods at Qm and would charge a higher price that is Pm, making their equilibrium point at R. The dead weight loss of the society is GRC.