Other Reasons why Markets Fail

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Other Reasons why Markets Fail

There are other ways in which markets fail.

Information problems. We said earlier that the only truly efficient market structure is perfect competition. One of the key assumptions with this market structure is that all buyers and sellers have perfect information. In the real world, this obviously does not happen. A given restaurant may be half empty one evening and then have queues down the street the next. Ideally, they would like to be able to adjust their prices to allow for this, but they do not have the information beforehand to be able to do this (of course, there would be menu costs as well).

General instability. We see this in stock markets, currency markets and, in particular, agricultural markets. The price of agricultural products can vary enormously depending on the size of the harvest. A good harvest can be bad for the farmer because the reduced price (caused by the shift to the right of the supply curve - see the 'supply and demand' topic) will reduce his revenues. A bad harvest will raise the price, but the farmer might have very little to sell. Governments often step-in to correct this market failure. They can buy excess stock when the harvest is plentiful and sell their excesses when harvests are poor so as to keep the price at a reasonable level at all times. This is called a Buffer stock scheme. The Common Agricultural Policy (CAP) does this to a certain extent.

Inequality. This one is a little bit obscure. 'Inequality' refers to inequality in the whole economy. For various reasons, some members of society have more money than they need, whereas other struggle to afford even basic necessities. Certainly the shift from direct taxation (e.g. income taxes) to indirect taxation (e.g. VAT) during the early Thatcher years caused the distribution of income in the UK to become more unequal. This inequality, which was caused in the first place by the market economy (great for those who succeed; a nightmare for those that don't), is an example of where the 'market' fails, and governments should intervene to correct this market failure. Labour governments are traditionally more likely to tax the rich and redistribute to the poor via benefits. This has happened to a certain extent with the Blair government, but not by as much as many 'Old' Labour activists would like.

Factor immobility. Factor here refers to factors of production. In particular, we mean the immobility of land, labour and capital. Obviously land is immobile, but in this context we mean whether it is easy or difficult to transfer the factor in question to another use.

'Capital' generally is fairly mobile nowadays, especially between countries as the old restrictions have been eliminated. But once money has been invested in a certain type of capital, like a nuclear reactor, how easy is it to transfer that capital to another use?

The biggest problem in most countries is that of labour immobility. Those of you doing Geography have probably heard of the terms occupational mobility and geographical mobility.

If someone loses their job, especially in one of the traditional industries like coal mining where there is not much prospect of regaining employment in the same field, then the worker has two options. He can retrain to gain different skills and become employable (becoming more occupationally mobile), or move to an area where one's current skills are still applicable (being geographically mobile).

With a coal miner, there are few areas to which he can move and continue mining. His only option might be to retrain, and governments again have a role in correcting this market failure by providing this training and then, perhaps, providing the jobs (as with the New Deal).

A well-qualified lawyer may have difficulty in finding a job in London and so looks to an alternative city. This is easy enough because house prices and rents are lower outside London than within. But those coming to London from outside to seek their fortune (like Dick Whittington!) find it almost impossible to find affordable accommodation, especially if they have a family. The government try to correct this market failure in the housing market through building new homes, housing associations and more recently, offering assistance with mortgages for those in respected, but relatively lowly paid, jobs such as teaching and nursing in London. A nurse has absolutely no chance of buying a house with a mortgage in London, and yet there is a huge demand for nurses in the capital.

These two mini topics are at the end of this section because they are slightly different in that the explanation is more descriptive rather than diagrammatical. They are also less 'traditional' examples of market failure, and yet are becoming more and more popular with examiners.

The extension of property rights

Your parents probably own a home. Legal ownership confers certain rights on that owner. If a drunk-driver flies over the pavement and in to your front garden wall, your parents would probably be able to claim some compensation from the person who ruined part of their property. In this example the case is clear because it is also clear who has the property rights.

Markets can fail if these property rights are not fully extended. An example that examiners like to use is that of the fishing industry. Nobody owns the sea. Fisherman go out to sea and catch as many fish as they can, considering short term profits rather than the long term viability of the industry. This over-fishing is an example of market failure. If all fisherman continue to over-fish, then the fish population will not be able to maintain its numbers through reproduction. The industry will eventually die.


The fisherman know of the problem, but there is no incentive to do anything about it. If one fisherman decides to have a week off to 'give the fish a chance', all the other fisherman will keep trying to catch as many fish as possible, so what's the point of thinking of the future?

The solution is to extend property rights. If certain fisherman owned certain areas of the sea, and therefore had legal rights over them, then they would each have control over a certain area and could stop people from fishing in their area (or fine them if they do). They could then think about the future and only fish at certain times of the year, perhaps.

This is another example of internalising the externality. The externality has been brought back into the framework of the market mechanism. The market price of fish should now reflect the true supply of fish in the sea rather that the exaggerated supply that occurred with over-fishing.

Or course, there are problems. How do governments extend these property rights fairly? How are they extended at all given that the things over which rights need to be extended, the sea and the atmosphere, cross international boundaries? International bodies such as the European Union do have the power to divide the seas around Europe amongst the various member states, but it is not an easy job. They often resort to the easier measure of fishing quotas.

Pollution permits

Another more recent solution to the international problem of pollution is to issue permits which only allow each country world-wide a certain amount of emissions of, say, greenhouse gases. The Kyoto Protocol, launched in 1997, was designed to force all countries to reduce their emissions of greenhouse gases. The sum of all the permits issued allows for a significant fall in world-wide emissions. Some countries will be better at reducing emissions than others. If the countries that are good at reducing emissions manage to keep their emissions below the level allowed by their permits, then they can sell their spare permits to countries that struggle to keep their emissions down.

The key point is that the total level of emissions allowed world-wide is fixed by the sum of the permits, so emissions should fall. But this system is better than simply having 'targets' for lower pollution because the 'cleaner' countries have an incentive to reduce their emissions by more than they need to so that they can sell their spare permits and make some money.

In addition, the countries that have to buy the spare permits because they struggle to keep their emissions down will probably also have lower costs. The cost of purchasing the expensive equipment required to reduce emissions is probably higher than the cost of simply buying the extra permits.

Since the Kyoto Protocol was launched, the country that has found it hardest to keep their emissions down has been the USA (surprise surprise!). By the summer of 2000, they were desperately trying to find a country who would sell them some spare permits!