Term Paper on "Market Failure"

Term Paper 10 pages (2840 words) Sources: 4 Style: APA

[EXCERPT] . . . .

Market Failure

Running Page: GOVERNMENT REGULATION, BOON OR BANE?

Weimer and Vining (2004) perceive a perfectly competitive economy as the rational setting for public policy. Public policy is the creation of both positive and negative incentives by the government in order to encourage collective choices. An economic theory assumes that many profit-driven firms and utility-maximizing exist in that perfectly competitive economy. Their interplay leads to efficient patterns of production and consumption. It is described as efficient in that the players' behavior pattern cannot be changed without putting some persons at an advantage over others. They make private choices, which create circumstances, which in turn justify public policy. These circumstances are called market failures or MF, which interfere with efficiency in production or consumption. Social values -- such as human dignity, distributional equity, economic opportunity and political participation -- also justify public policy (Weimer & Vining).

Utility refers to a person's perception of his well-being. Economists view a utility function as serving two key assumptions (Weimer & Vining, 2004). The first says that the more a person has of a good, the greater its utility. The second says that more and more of the same good progressively decreases its utility. This latter function is also called declining marginal utility. Economists believe that people in a society maximize their well-being by using their income to buy goods with the greatest utility. A General Equilibrium Model applies to explain the situation earlier mentioned. It states that prices arise and distribute factor inputs to firms and goods to people in a way that put some at an advantage and others at a disadvantage. Economics refer to this as Pareto efficient. The Pareto efficiency justifies government intervention or public policy in making some persons better without making someone else worse. Pareto efficiency occurs when it is no longer possible to raise the sum of compensating variation and rents by re-allocating factor inputs or final production (Weimer & Vining).

Market Failures

Public Goods

A Pareto-efficient allocation of goods and services occurs as a result of utility maximization by individuals and profit maximization of firms (Weimer & Vining, 2004). Violations, however, occur, which contravenes Pareto efficiency. These are market failures, which in turn, justify government intervention into private affairs. These violations are a pure public good, externalities, natural monopoly and information asymmetry. A private good is completely consumable by one person and, thus, described as non-rivalrous and excludable. There are also toll goods, which are under-consumed because are inefficiently priced and under-supplied. This happens when the consumer does not use the good if the price is greater than the marginal benefit as priced by producers at marginal cost. In contrast, a pure public good is non-rivalrous and non-excludable. Everyone benefits from it regardless of the amount paid for it As a result, users do not reveal their true demand for it (Weimer & Vining).

Externalities

An externality is a positive or negative impact on non-participants or unwilling participants in a voluntary exchange (Weimer & Vining, 2004). Attenuated property rights cause an externality. An externality is positive and affects externalities when the under-supply or under-consumption of a good benefits society. It is negative when there is over-consumption and over-supply, which exact a cost to society. The solution is the reallocation of goods to increase social surplus (Weimer & Vining).

Natural Monopoly

This occurs when the fixed costs involved in producing a good are higher than the variable cost (Weimer & Vining, 2004). The average cost, thus, declines through a range of demand. Natural monopoly includes both declining average cost and relevant range of demand for a firm to produce the good at a lower cost than at another market scheme. Price elasticity of demands determines the impact of natural monopoly on public policy. The demand is inelastic when he absolute value of price elasticity is less than one. This increases price and total revenue rather than efficiency. Inelasticity leads firms to choose outputs that will maximize their profit at the expense of social surplus. This leads to market failure. Natural monopolies have no incentive to produce at minimum cost and this creates inefficiency.

Information Asymmetry

Information about a good and its distribution between an external supplier and consumer influence social surplus (Weimen & Vining, 2004). Consumers or buyers who over-estimate the value of a good will under-consume it. They estimate the value of a good by the information provided by its producer. The three categories of goods are search goods, experience goods and post-experience goods. A search good is determined after purchase and, thus, seldom produce information asymmetry, affect efficient distribution or justify public policy. An experience good can lead to information asymmetry, as it is determined by or limited to the information provided by the producer. Its value is revealed only in secondary markets. And a post-experience good has strong inefficiency potential because the buyer is uncertain about its value. The uncertainty proceeds from the unexpected effects of the good's use. The buyer is unable to connect the use of the good to its quality (Weimer & Vining).

Planning and Rational Choice

Planning is the process used in attaining ends (Banfield, 1959). Planning is good if it is likely to attain those ends or maximize their chances of attainment. And the attainment of ends is likeliest through the process of rational choice. The process consists of an analysis of the situation, an end reduction and elaboration, a design of the courses of action, and a comparative evaluation of consequences. In analyzing the situation, every possible course of action must be considered in order to attain the stated ends. The courses of action must be viewed within the conditions fixed by the situation, such as available resources and the obstacles the situation presents. The plan must include courses of action, which are really open. End reduction and elaboration mean specifying terms in the concrete circumstances of the plan. The goal must be set in a future context as well as the current and active components of the goal. The design of the courses of action describes the major actions or steps taken to achieve the goal. These are premises on which a general course of action is based. A more defined course of action can proceed from this while considering alternatives and consequences. And a rational plan must take all intended and imagined consequences into account. Good planning, as a matter of fact, give space and proactively addresses unintended consequences or developments (Banfield).

Lack of Planning in Organizations

Organizations are disinclined to plan for a number of reasons. The future is highly uncertain (Banfield, 1959). Reliable predictions cannot be made for more than the next five years. Demographic predictions cannot be trusted. The ends set by the plan are as subject to rapid change as the conditions. Organizations also find it imprudent to announce a plan publicly in that it attracts opposition and gives opponents the advantage.

Organizations likewise do not consider major alternatives, as required by rational planning. They are unlikely to deviate from something quite different from what they have been doing or producing. They have established preference for present more than future effects or ends. Unlike individuals, organizations are less willing to postpone satisfactions for some future time. They do not give great stress on the future as they must continually concentrate on present necessity to maintain the "economy of incentives." Their heads are constantly devising incentives to elicit contributing activity to keep the organization going. A program of incentives is unstable, as it must continue to adjust to the needs of the moment. An expert planner said that incentives scheme is seldom determined in advance of application (Barnfield).

Organizations seek to maintain their existence more than pursue a substantive end (Branfield, 1959). This preference leads them towards opportunistic decision-making much more than planning. Towards this end, they make as few long-term commitments as possible, viewing flexibility as an advantage. Organizations are hardly led by a clear and coherent picture of some desirable future towards which a plan is aimed. At best, they draw upon some vague perspective, whose task is to justify the existence of the organization to members and outsiders. Stated ends are mere propaganda, not concrete criteria for action. It becomes logical, then, that stating ends in more ways than general or vague would be destructive. Ends must be vague and high-sounding in order to motivate members. They lose their magic or make the organization controversial when reduced to specifics and concrete forms. It also follows that organizations do not maximize the chances of attaining ends but only their survival. Storing large reserves will still be for the maintenance of the structure for some future time or in advance of need. What is being maximized is utility. According to an expert, organizations seek out satisfactory courses of action more than maximize these (Branfield).

Organizations view courses of action, clarifying ends and evaluating alternatives as costly and time-consuming procedures and requiring the active participation of their executives (Branfield, 1959). These organizations fix their… READ MORE

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