Market Failure and Perfect Competition Essay

Market failure occurs when goods or services are not allocated in an efficient manner, or when the quantity of a good or service in demand is unequal to the quantity supplied (“Market Failure,” 2008).  In other words, failure of the market is the absence of perfect competition in which prices automatically move to economic equilibrium and the quantity demanded equals the quantity supplied (“Perfect Competition,” 2008).  Hence, market failure typically calls for public ownership or regulation to move the market toward efficiency (“Market Failure,” 2006).  Experts are agreed, however, that the best solution to reverse market failure is pure or perfect competition.

            The imperfect market is a market failure in which some of the producers and/or buyers are dominant enough to influence the price and quantity of the product or service by their actions alone (“Imperfect Market,” 2008).  Oligopolies, monopsonies, cartels, monopolistic competition, the oligopsony, price skimming and price discrimination are all examples of imperfect markets or market failures because they allow for mechanisms other than the supply and demand of a product or service to control prices (“Market Failure,” 2008).  A monopoly is an expensive kind of market failure, seeing that it often results in antitrust lawsuits.  Regulators are usually concerned about the effects of a monopoly.  This is the reason why the European Union antitrust chief continues to press for “open markets” as some European countries remain adamant about the necessity of establishing gigantic energy enterprises (“Competition Test,” 2007).  The EU anti-trust chief wants European energy sectors to be open to foreign competition (“Competition Test”).  For the same reason, the United States Justice Department had presented an antitrust case against Microsoft with the argument that the company had used its near monopoly position in the operating system market in order to gain an unfair advantage in the browser market (“Microsoft”).

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            In a perfectly competitive market there are many firms supplying a good or service.  A monopoly, on the other hand, is the only firm in a particular market.  The market price in the industry is determined by the supply and demand for the product or service in question.  As the market supply is decreased, the price of the product must increase (“Microsoft”).  Hence, a monopoly is in a perfect position to decrease supply and thereby increase the price that it charges for the product or service that it supplies.  Since it has no competitors, there is no compulsion to decrease the price in order to beat competition.  All the same, the monopolist faces a loss because now there are fewer buyers for its products or services, given that the price has increased.  So as to offset the decrease in profits, the monopolist would decide on a price that is higher than its marginal cost.  If the marginal cost is represented by the supply curve, the monopolist would decide to produce a quantity that is less than the quantity at the intersection of the demand and supply curves, that is, the quantity produced in a state of perfect competition (“Microsoft”).

            According to economists, the Dead Weight Loss of a monopoly must be borne by the entire economy seeing as the monopoly is charging a price that is higher than the price at the intersection of the demand and supply curves in a state of perfect competition, and also producing a quantity that is lower than the quantity produced in a state of perfect competition.  The monopolist may decide to continue increasing the price by reducing the quantity that it supplies, and thereby increase the Dead Weight Loss to society (“Microsoft”).  This is exactly why the U.S. Justice Department or the EU anti-trust chief must intervene to put an end to monopolistic practices or market failure in favor of pure or perfect competition.

            There are other characteristics of the perfectly competitive market that tend to oppose market failure when they are combined.  Homogeneity of goods or services, complete and perfect information, equal availability of technologies for the producers, mobility of resources, free entry, and the individual actions of producers and buyers (as opposed to group behavior) are some of the defining characteristics of perfect competition.  Moreover, in a perfectly competitive market, the consumers’ goal is to “maximize utility,” while the maximization of profits is the goal of producers (“Perfect Competition”).  These factors, in combination, may lead to productive efficiency in addition to allocative or Pareto efficiency.  Productive efficiency is attained by producing a product or service at minimum cost so as to maintain a price that is reasonable for both the producer and the buyer.  Pareto efficiency, on the contrary, refers to the condition where price is equal to the marginal cost of producing a good or service, and the producer is unable to make a profit (“Perfect Competition;” “The Market Economy”).

            A firm that operates in a perfectly competitive market may choose to allow buyers to benefit from the allocative efficiency of the perfectly competitive system for a while.  Nevertheless, it is not expected to produce public goods, seeing that these goods are not considered profitable to produce in either the short- or the long-run.  The benefits of public goods or services cannot easily be restricted to those that pay for them.  A good example of a public service is national defense that all people in the nation are permitted to enjoy.  The benefit that an individual gains from national defense is not reduced by the benefits available to others.  Furthermore, there is no way of excluding people from availing the benefits of a public good or service once it has come into existence.  This creates the free-rider problem.  Because the private firm in a perfectly competitive market sells for profit, it is not feasible for it to produce a public good or service that individuals other than direct consumers would also be able to enjoy without payment.  Therefore, the production of a public good or service, which usually happens to be the responsibility of the government, is a market failure that opposes perfect competition (“Market Failure,” 2008).

            Other sources of market failure include transaction costs as well as organizational failures that a producer may expectedly or unexpectedly confront.  If a private firm in a perfectly competitive market must face significant litigation, regulation, contract or decision-making costs, for example, it may not be able to sell its products or services at prices that allow for allocative or productive efficiency.  Similarly, if a firm is slow at organizational learning or enforces rules that are not truly conducive to the maximization of profits, organizational failures would translate into market failure (“Market Failure,” 2008).

            Externalities are another form of market failure or threat to the perfectly competitive market.  Defined as spill-over or third-party effects, externalities arise from the consumption and/or production of goods or services for which nobody pays.  If a private firm in a perfectly competitive market were to produce a public good or service, there would be a positive externality where the marginal social cost (that is, the cost paid by all those who enjoy the public good or service) is less than the private marginal cost, which is the cost of production faced by the firm.  On the other hand, if a chemical plant pollutes the environment, a negative externality would result with the marginal social cost or the cost paid by society exceeding the private marginal cost (“What are Externalities”).  Since perfect competition is meant to maximize the benefits of society as well as producers, externalities are considered a form of market failure.

            As mentioned previously, perfectly competitive markets are also reliant on perfect information, that is, all of the agents are perfectly informed about the availability of the goods or services, in addition to prices that are charged by the suppliers.  Consumers find it easy to make purchasing decisions with free and complete information about goods and services that they are interested in paying for.  Market failure occurs when the information available to suppliers and consumers is imperfect.  There may be misunderstandings or uncertainty about the actual benefits or costs of a good or service; or there may be complex, misleading or inaccurate information that disrupts the process of buying and selling in a purely competitive system (“Imperfect Information”).

            Regardless of the nature of imperfect information, or whether externalities are positive or negative, market failure results when the perfectly competitive market is unable to operate at levels of efficiency that allow all agents to benefit.  Public goods, transaction costs, failures of the organization, and imperfect markets are additional examples of market failure.  The government generally assumes responsibility for correcting these failures.  The best method available to the government for the reversal of market failure is the establishment of a perfectly competitive market.

References

Competition Test. (2007, Sep. 5). The Wall Street Journal Online.

Imperfect Information. Tutor2u. Retrieved Oct 16, 2008, from

http://www.tutor2u.net/economics/revision-notes/as-marketfailure-imperfect-

information.html.

Imperfect Market. (2008). Answers. Retrieved Oct 16, 2008, from

http://www.answers.com/topic/imperfect-market?cat=biz-fin.

Market Failure. (2006). OECD. Retrieved Oct 16, 2008, from

http://stats.oecd.org/glossary/detail.asp?ID=3254.

Market Failure. (2008). Answers. Retrieved Oct 16, 2008, from

http://www.answers.com/topic/market-failure?cat=biz-fin.

Microsoft: Is The Company Too Big? Retrieved Oct 16, 2008, from

http://www.humboldt.edu/~ee3/econ104/topics/monopoly.

Perfect Competition. (2008). Answers. Retrieved Oct 16, 2008, from

http://www.answers.com/topic/perfect-competition?cat=biz-fin.

The Market Economy. Blacks Academy. Retrieved Oct 16, 2008, from

http://www.blacks.veriovps.co.uk/content/3352.html.

What are Externalities? Tutor2u. Retrieved Oct 16, 2008, from

http://www.tutor2u.net/economics/content/topics/externalities/what_are_externalities.htm.

 

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