Market Failure Essay Example

Market Failure Essay A) Using appropriate theory, diagram and examples, analyse the way in which the market ‘fails’ with regards to the environment World market existed from the basic economics of supply and demand theory where demand is the amount or quantity of goods or services that buyers are willing to pay at certain price in exchange for its value or benefit while supply refers to the quantity of goods or services that suppliers are willing to produce at certain cost. Figure 1 and 2 below explain how demand and supply changes with price. Figure 1 shows an inversely proportional relationship of demand and the price. Demand increase from Q1 to Q2 when price drops from P1 to P2. This explains why post Christmas sales attracts huge crowd to the shopping mall. Figure 2 shows a direct proportional relationship of supply and the price. Supply quantity increase from Q3 to Q4 as the price of goods or services increase from P3 to P4. Supplier tends to produce more at higher selling price as it means higher profit for the supplier. This can be seen in agriculture industries where Malaysia and Indonesia where palm oil production increased significantly when the profit is high. However, supplier cannot keep producing without limit as price is determined by whether there is demand. When the supply is more than the demand, the price will drop. When demand is more than the supply, the price will increase. Due to the opposite nature of the demand and supply with respect to price, supply and demand will have to keep re-adjusting itself until a point where supply S is equal to demand D. This is the point where all the demand will be fulfilled by the supply at a optimum price (Peq). This is when market reaches its equilibrium (Fig 3). This is the state where market is most efficient in its resource allocation. We will write a custom essay sample on Market Failure specifically for you for only $16.38 $13.9/page Order now We will write a custom essay sample on Market Failure specifically for you FOR ONLY $16.38 $13.9/page Hire Writer We will write a custom essay sample on Market Failure specifically for you FOR ONLY $16.38 $13.9/page Hire Writer In the real world market, the basic supply and demand curve sometimes fails to allocate its scarce resources to the socially optimal outcome when externality exits. Externality is defined as the costs or benefits of activities that are indirectly imposed to the third parties at certain cost or benefit which is not been considered by the producers or the consumers. When there is a cost imposed on third parties, it is called negative externality. For example, when a pig farm is build next to a residential village, the villagers will have to bear the smell of pig farming. The pig farming activities may also pollute the river. This indirectly imposes higher cost to the villagers who drink the water from the river which causes higher health costs. Similarly, when third parties benefited from an activity in which they are not directly involved or paid for, it is called a positive externality. (A. C Pigou, 1932). Both negative and positive externality can cause market to fail. Figure 4 below illustrates the effect of external externality to the market equilibrium. When a firm produces a good and pollutes the air, the Marginal Private Cost (MPC) will represent the cost of producing the goods without taking into consideration any cost of polluting. This will produce QMKT quantity of goods at the cost of PMKT. Since the firm is polluting the air, there will be cost involved as there is 3rd party who suffers from the pollution. As such the true cost of producing will need to take into consideration of externality cost. It’s called Marginal External Cost (MEC). The true cost is reflected as Marginal Social Cost (MSC) which is the sum of MPC and MEC. A new supply demand equilibrium will occurs at MSC equal to D curve which gives the quantity of QMSC at price of PMSC. This shows how market fails in free unregulated market where it was producing too much goods / services (QMKT) at low price (PMKT). Positive externality exists when 3rd party enjoy the benefit from certain economic activities without paying for it. An example will be when a property developer builds a shopping mall nearby a housing estate, residents nearby will gain the convenience of shopping place as well as rise in property prices. The problem is that the developer will not spend to build more shopping mall simply because residents get to enjoy the convenience. This happen exactly the same in the market where market does not allocate enough resources to produce the socially optimal quantity at its own cost. This can be illustrated in Figure 5. Figure 5 shows that in free unregulated market where Marginal External Benefit (MEB) is omitted, equilibrium happens when supply curve (S) is equal to Marginal Private Benefit (MPB) curve and produces the QMKT quantity of goods or services. With the inclusion of MEB, the quantity of goods produced QMSB are more than QMKT at MPB. This underproduction due to positive externality is also a market failure. With proper subsidies and incentive, MEB will be taken into consideration, hence enable the supplier to produce more goods or services at quantity QMSB and sell at a higher price (PMSB). From the explanation above, we can conclude that market failure can occur when externality exists and causes misallocation of resources for most efficient use. These failures are especially obvious with regards to the environment. Factories decision to dispose waste into river, lake and greenhouse gases emission into the atmosphere has caused huge negative effect to the environment as well as to the people who utilise the natural supplies. It causes damage to health, infrastructure as well as the whole ecosystem. For the past 150 years, our world has gone through unprecedented economic growth as well as the population increase. This led to surge in demand for energy, land, transportation as well as agriculture product. At the same time, more waste and pollution was released to the environment all without proper control. Lots of forests which serve as natural way reducing carbon dioxide had been destroyed in order to provide land for new settlement and farming as well as for economic development. This further worsens the world’s carbon dioxide level of the greenhouse gases. Figure 7 shows the distribution of greenhouse gases emission from different industries (Stern Review, 2006). People today have experienced devastated effect of environmental damage. World is getting warmer, certain places are getting drier while other places are getting wetter and windier. People are also experiencing more powerful and destructive El Nino. Global warming has caused melting of ice and rise in sea level, together with unusual weather, it can cause tremendous damages to the people as well as country economy. According to Senate Minority Leader Harry Reid of Nevada, The hurricane Katrina would cost US at least $150 billion (San Francisco Chronicle, 2005). Recent snow storm in China will cost $21 billion to its economy and also directly affecting global supply chain (Singapore Straits Times, Feb 24, 2008). Figure 8 shows the global average temperature projection until 2100. It shows that global temperature will continue to rise by 2 to 3 degree and this will have serious impact to the world which may cause even worst disaster and much more disaster than what the world has experienced today. In view of the huge externality cost for the environment, different countries have come to realise the importance of reducing the greenhouse gases and pollution. This has brought to the agreement of Kyoto protocol in 1997. Legally binding greenhouse gases emission target was set for different member countries. Developed countries will provide financial aid to developing countries in the effort to curb pollution. Europe has adopted carbon trade permit in order to limit the amount of emission. Countries used Pigouvian tax method to levy taxes to the firm that pollutes according to the amount of pollution they produce. This forces the polluting firm to internalised the effect of externality as well as creating incentive for the firm to reduce pollution. However, this tax is based on estimate. Therefore with the inclusion of this tax, it may only get closer to marginal social cost. This tax method can also be applied to work with positive externality. Certain countries such as Malaysia will provide tax incentives for the re-plantation work after logging. Because of that, lots of land that were logged had gone through re-plantation process or had been converted into palm oil where palm oil has become a source of renewable energy source. Regulation for maximum emission was also enforced. Firms will be fined if they exceeded the emission limit. Regulation, however does not really gives incentive for firm to cut down pollution. Firms tend to pollute to the maximum pollution limit allowed. Some countries like Philippines also practices different policy on transportation. Only vehicle number plates end with certain number are allowed to be on the road on certain days of the week. This indirectly helps to cut down the transportation pollution. Introducing of new technology better efficiency and reduced emission has also gained steam. Singapore has introduced green vehicle such as hybrid car and Compact Natural Gas (CNG) car which are more fuel efficient and produce less carbon (Singapore News, Jan 13, 2008). Germany has introduced its hydrogen technology to the BMW cars which produces zero emission with the by product as water vapour (Singapore Straits Time, Feb 14, 2008). Australia is researching into injecting certain kangaroo bacteria into cattle and sheep stomach which scientists believe can reduce large quantities of harmful gases that were released by the animals (Green Diary, 2007). Use of renewable energy such as solar power has become increasing popular. International Energy Inc of USA is developing technology to convert carbon dioxide into bio fuels using algae (International Energy Inc). The technological breakthrough can lead to substantial emission reduction. Other policies such as subsidies are also introduced. Singapore has been giving huge subsidy for firms involved in renewable energy as well as water recycling research. This has made some of the water treatment companies to successfully bring down the cost in converting waste water into drinking water. In conclusion, externalities cause market to fail with regards to environments which have serious implication to the world economy. Each country will have to contribute their fair share and effort towards a feasible solution and collaborate with each other in the effort of reducing emission although there are still lots of argument by developing countries that current environmental problem was mainly the result of the past emission by the developed countries. References A. C Pigou, 1932. The Economics of Welfare. Air Transport Bureau (ATB). 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German Gas (Technology) To Save The World? Singapore Straits Times, Feb 19, 2008. Record Year For Spore Aerospace Industry In 2007 Output Hit $7b Singapore Straits Times, Feb 20, 2008. Asian Airlines To Order 3000 Planes in 20 Years : Boeing Singapore Straits Times, Feb 24, 2008. Death Toll From China Snow Storms Hits 129 Nicholas Stern, 2006. Stern Review : The Economics of Climate Change U. S. Environmental Protection Agency, 2007. Inventory of US Greenhouse Gas Emission and Sinks : 1990 – 2005