[Business and Management] -> [General Theory]: Identify the four major sources of market failure
Submit date:17/11/2005
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Language: English
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Until now we all have seen how market acts as an invisible hand to maintain balance between suppliers and buyers when competition exists. We say that this type of market drives us to Pareto optimality where no one will be made better off without making the others worse off. This is a concept that will be discussed further in details. In general, where competition prevails, I believe that market works, that is, it takes us to Pareto optimality. However, when the pursuit of private interest does not lead to an efficient distribution of society's resources; situations where individual behaviour does not lead to Pareto efficiency, it is said that the market has "failed". Therefore, in this paper, I am going to identify the four major sources of market failure. To do so, I will start by explaining the conditions necessary for Pareto optimality and from which will bring to how each of the sources of market failure violates these requirements. One thing to note is that there are not only four sources of market failure. I will only focus on the four that were mentioned by Pindyck and Rubinfeld to keep it less complicated. As what I did in my previous assignments, I will derive my argument basing on several authors' publications, namely Estrin and Laidler, Pindyck and Rubinfeld, and the course materials.

Many times, company owners or regional regulators find themselves caught in the middle when making decisions of whether the current situation is at best or if a decision can make the whole situation better off. To ease them from this difficult state, an economist and sociologist called Vilfredo Pareto, postulated a benchmark criterion to help, namely the Pareto criterion. Later in the paper I will use Pareto optimality interchangeably.

A) The Pareto Criterion
When people are making decision with the aim of making the whole community better off in general, they first have to know how to tell when this is achieved. As a rule of thumb, the community becomes better off if one individual becomes better off and none worse off. If this is the case, the Pareto optimality is not yet reached as for any given state (e.g. a distribution of a given quantity of goods) is Pareto optimal, and thus efficient, if and only if there is no feasible alternative state achievable (e.g. no feasible alternative distribution of those goods) in which at least one person is better off and no one is worse off. This can be illustrated by Figure 3.1. It shows the contract curve which joins the two origins (OAOB). A contract curve shows all efficient allocations of goods between consumers A and B in the Edgeworth Box Diagram showing the possible allocations of clothing and food between A and B. The points of efficient allocations of goods between the two consumers are in fact where the indifferent curves of the two consumers are tangent to each other. Any points that are not on the contract curve (such as H and I) are not Pareto optimum since the two consumers can always move to a point on the contract curve where at least one of the consumers is better off without making the other worse off.

Figure 3.1

B) Conditions for Pareto Optimality
In order to achieve the Pareto optimality, the very first prerequisite is a competitive market. We will see how this is the case later but for the time being, we just take it for granted. Besides, there are several other conditions that need to be fulfilled.
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