First and foremost, one of the major reasons causes market failure would be externalities. It can be defined as an act of a person that causes impacts on the others, normally a bystander. When externalities exist, interest of the people in a society of a market outcome overwhelms the well being of consumers and suppliers who play a part in the market. This includes the welfare of bystanders who are affected indirectly. (N. Gregory Mankiw, 2007) Due to the fact that the external effects are ignored and causes externalities to exist, this results in market equilibrium to be not efficient which is equilibrium fails to maximize the total benefits as a whole. There are two types of externalities, negative externality and positive externality. When the effect on the bystander is undesirable, it is a negative externality; however if it brings benefits, than it is called a positive externality.
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Negative Externality Graph
The graph above shows a negative externality graph. Negative externality happens when the social cost of the good exceeds the private cost. Social cost simply means that the private cost add with the costs to the other affected negatively by an externalities. The graph above shows that the social cost is above the supply curve because external cost is taken into consideration. Difference between the two curves reflects the cost of the pollution emitted. (N. Gregory Mankiw, 2007). For example, producing plastic bag causes pollution in Malaysia. The supply and demand model shows that market will produce at equilibrium price (Q Market) before externalities are taken into consideration. However, external cost should be taken into consideration, thus the optimum level would be at (Q Optimum). To do this, government in Malaysia can apply Command-and-Control policies and Market-Based policies. Command-and-Control policies are a policy that regulates behavior directly; whereas market-based policies are policies that provide inducement so that the supplier will solve the problem themselves. Command-and-Control policies are normally actually Acts or regulation. For example, government can set the maximum plastic bags that are able to produce, any suppliers who go against the regulation will be fine or even launch campaign like â€œNo Plastic Bag Dayâ€ in Malaysia where every Saturday customers who persist to use plastic bags will have to give between 10 to 20 sen for every bag that used. In addition, government can use market-based policy like inducing taxes that would give suppliers an economic incentive to reduce pollution. Example is that if an factory emits pollution when producing plastic bags higher than the level set by government, they will paid a certain amount of money. Thus, the higher the pollution caused, the higher the tax, the more effective this policy is.
The graph above shows a positive externality graph. In a way, positive externalities are almost the opposite of negative externalities. It happens when social benefits consumption exceeds the private benefits. It was clearly shown on the graph that the quantity produced lower than the optimum quantity in the market, which results under consumption. This is because when there are positive externalities, social value of the good surpass the private value. Therefore, the optimum quantity (Q Optimum) is larger than the equilibrium, (Q Market). This also explains that why education is heavily subsidized through public schools and government scholarships, (N. Gregory Mankiw, 2007) when demand for education is much higher than the supply in market equilibrium. Subsidy, is another market-based policy to boost the consumption, and causes an increase in market supply.
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The following factors that cause market failure would be market governance by monopolies. Monopolies fail to allocate resources efficiently because the produce less than the socially desirable quantity of output and, as a result, charge prices above marginal cost. (N. Gregory Mankiw, 2007) For instance, TNB Sdn Bhd and PUAS Sdn Bnd is the sole provider for electricity and water in Malaysia. In this structure, the monopoly firm is the price maker. As a result of lack of competitors, the companies could have supply less to raise the price in the market since they are the sole provider for the service. As soon as the supple decrease, price will be raised because the supply curve had moved to the left. When this happens, resources available would not be able to allocate properly and causes market failure. Thus, consumer will have to suffer in the end. Thus, to solve this problem, government can apply antitrust laws and price regulations. When antitrust laws are put into practice, it allows government to break up large company into smaller companies, then the market will be more competitive. When competition exists, monopoly power will be reduced significantly. Another way is by regulating the behavior of the monopolies. One if it by regulating the price of the monopoly firm, whereby the price are not set by them, but the government. However, none of these ways are perfect where it will cause some problems to the market.
Lastly, oligopolies is almost the same with monopolistic, for example Air Asia and Malaysia Airline System. When both of the companies merge together, they would form a monopolistic firm or rather reducing competitiveness of the market. Like monopolistic firms, oligopolies would also lead to low production to charge a high price on goods or services. One of the strategies is also introducing antitrust laws. Like monopolistic market structure, government introduces this law to prevent the two big companies to merge, dominate the industry and also to earn monopolistic outcome. However, there are some laws that would cause controversy among the economist like the â€œprice-fixing agreementsâ€ and concern on behavior of predator pricing. Thus, government implements the correct policies so that there would not be any arguments arouse.
As a conclusion, there are many ways to counter market failure. It all depends of causes of market failure. Public policy towards externalities, monopolies, oligopolies have different kind of form of policies. Normally abusing the use of market power, whereby the supplier have an powerful influence over goods or services, will cause market failure. This happens when there are monopolies or oligopolies market structure. Externalities happen when the external effects on the bystander are not taken into consideration, which will cause market failure too. Thus, government introduces some policies to counter this problem where market failure causes from externalities can be solve by implementing Command-and-control policy and corrective taxes; monopolies would implement antitrust laws and price regulations and lastly oligopolies that add similarities with monopolies market structure should implement antitrust laws. Although all of these policies have its advantages and disadvantages, they are able to counter this market failure according to which factor that causes the problem.