Market Failure and Its Types

Market Failures
The normative theory of market-failure predicts that regulation will be instituted to improve economic efficiency and protect social values by correction market imperfections. Six types of market-failures are explained here: Natural monopoly, Externalities, Public Goods, Asymmetric information, Moral hazard, Transaction cots. Anyone of these six failures legitimates regulation.

1.Natural Monopoly
A monopoly is natural if one firm can produce a given set of goods or services at lower cost than can any other number of firms. A natural monopoly results when costs are decreasing in the scale of a firm (economy of scale) or in the scope of its products or services (economy of scope). In natural monopoly situations the monopolists will raise his costs and tariffs because he lakes incentives for efficiency and is interested in the maximization of profit.
Before concluding that regulation is warranted under the natural monopoly rationale, two questions must be answered. The first is whether there are any natural monopolies, and if there are, whether significant economic efficiency or social welfare would be gained by regulation. Economies of scale and scope certainly exist over some sets of goods and services, but these economies can be exhausted at output levels that allow more than one supplier to persist in the market. Empirical studies indicate, for example, that the large electric power plants in the United States have exhausted the achievable economies of scale. A natural monopoly can also result if having more than one supplier would result in an uneconomical duplication of facilities. Local electricity distribution systems within cities may remain a monopoly to avoid duplicate sets of distribution wires. This rationale does not necessarily apply in the telecommunications industry, since cable television and wireless communications systems provide alternatives to the local wire connections.
If there is a natural monopoly, it does not necessarily follow that there is substantial economic inefficiency. First, if entry into the industry is easy, the threat of potential competition may limit the extent to which an incumbent monopolist can restrict output (and raise prices). Second a monopolist may choose to use a pricing policy, involving fixed charges and a low unit price, which can both increase profits and benefits consumers. Third, if there are a number of possible suppliers of a monopoly service, competitive bidding for the right to be the monopolist can be used to lower the supply price and increase economic efficiency. Similarly, an alternative to the regulation of the electric power industry is for communities to own the local distribution system and bargain with power companies for the supply of electricity.

2.Externalities

Private market activities create so-called spillovers or externalities. They include any cost or benefit not accounted for in the price of goods or services. A positive externality exists when a producer cannot appropriate all the benefits of the activities it has undertaken. An example would be research and development that yields benefits to society (e.g., employment in industry) that the producer cannot capture. Thus, the producer's incentive is to under-invest in the activity unless government subsidized or protect it. With positive externalities, too little of the good in question is produced. With negative ones too much is made. Negative externalities such as air pollution occur when the producer cannot be charged all the costs. Since the external costs do not enter the calculations the producer makes, the producer manufactures more of the good than is socially beneficial. With both positive and negative externalities, market outcomes need some kind of regulation to be more efficient.

3.Public Goods

A pure public good is one whose consumption by one person does not reduce its availability for others. When a person consumes a private good such as an apple, it is not available for consumption by others. When a person consumes a good such as national defense or a radio broadcast, however, the amount of the good available for consumption by others is not diminished.
For some public goods, such as national defense, bridges, and roads, government provision is customary. Public provision, however, does not imply that a good has the characteristics of a public good. Many goods, such as public housing, food stamps, and solid-bank programs, are provided by government for redistributive purposes rather than because they are public goods. Also, public goods can be supplied by the private sector. Radio and television broadcasts are provided by private enterprises subject only to non-economic regulation.
A fundamental problem with either private or public provision centers on the "revelation of preferences" for public goods. If those who benefit from a public good are asked to contribute an amount reflecting their valuations, an individual may decide to free ride on the payments of others. Because of the free-rider problem, public provision may be warranted. This, however, does not resolve the problem of determining the public's aggregate valuation of the good and thus whether it should be supplied. If individuals could be excluded from consuming the public good the revelation and free-rider problem could be resolved - at least in principle. For example, not allowing satellite-dish ownership free reception of cable television induces customers to pay for the service.
Fire protection has the properties of a local public good is typically supplied by municipalities and paid for by the taxes of the beneficiaries. It can be provided privately, though, if exclusion can be practiced. Tim Emerson of Illinois learned this the hard way when his nearly completed house caught fire from a space heater. He called the Taylorville firefighters. They responded to his call. When they got to the house, they asked if the house were covered by the fire protection plan. Emerson, who had not paid the $25 fee, said, "No". The firefighters asked if there were anyone inside. When Emerson replied "No", they drove away, letting the house burn to the grounds.

4.Asymmetric Information
If people have different (private) information at the time they act, markets may not perform efficiently, even when there are advantageous trades that could be made. Akerlof presents an example of a sued car market in which each seller knows the value of the car she/he wants to sell but the buyers known only the probability distribution of the values of the cars that might be offered for sale. There is a potential buyer who is willing to buy each used car, but the buyer cannot through causal inspection determine the value of any particular used car offered for sale. All he knows is that the car might be a lemon or might be of high quality.
Because of this asymmetry of information, the maximum amount the buyer is willing to pay is the average of the values of the cars believed to be offered for sale. Because buyers will only pay the average value, those potential sellers who have high-quality car then find that the amount buyers are willing to pay is less than the values of their cars. They thus will not offer their cars for sale. … This is clearly inefficient, because for every used car there is a buyer who wishes to buy it if he only knew the true value.
This phenomenon also occurs when sellers have incomplete information about customers. Insurance is, in principle, to provide coverage for individuals with similar risk characteristics. When those characteristics cannot be readily assessed, however, people with quite different risks are placed in the same pool. The higher risk individuals then have an incentive to buy insurance, which can drive up the price of insurance a cause some low-risk individuals not to buy insurance. Insurance companies respond to this adverse reaction by requiring a physical examination for life insurance and basing auto insurance rates on accident and traffic citation records and on the number of years of driving experience.
When market participation havincomplete information and acquiring information is co, markets may not function efficiently. The mandated provision of information through regulation may then be warranted. Regulation may not be warranted in all situations involving asymmetric information, however. Information has value, so there is a demand for it. In the used car example, a potential buyer may take the car to a mechanic for inspection. More generally, individuals may invest in information acquisition or hire agents who are more knowledgeable than they are.
Information, however, can remain under-supplied because it is the self-interest of its possessor not to supply it. Manufacturers are understandably reluctant to release negative information about potential hazards associated with their products because doing so may reduce demand. Consequently, consumers may be poorly informed about hazards. Similarly, an employee may be incompletely informed about possible health and safety hazards in the workplace. In such situations, the liability system may serve as partial alternative to regulation.

5.Moral Hazard
Moral hazard refers to the presence of incentives for individuals to act in ways that incur costs that they do not have to bear. For example, in medical care, a fully insured individual has an effectively unlimited demand for medical care, since she/he doesn't bear the cost of the care they receive. In addition, the individual may not have the proper incentive to take socially efficient preventive measures, since she/he knows that the cost of any illness or accident will be covered by insurance. Similarly, the provision of federally funded flood insurance encourages people to live in areas prone to flooding and can lead to socially inefficient local decision.
Regulation is one response to moral hazard problems, but regulation can also cause moral hazard making regulation itself less effective. In a controversial article Peltzman argued that the automobile safety regulation induced drivers to take more risks, thus reducing the effectiveness of mandatory safety standards.
The principal means of dealing with moral hazards is to structure incentives so that the induced behavior is taken into account. In the case of medical insurance, co-payments can be required and reimbursement limits imposed. Moral hazard can also be addressed by monitoring the behavior of individuals to increase the likelihood that they take proper care. Fine for not wearing a set belt is an example of monitoring.

6.Transactions Costs
Market failures can also result from costs associated with making market transactions. To the extent consumers and producers incur costs in becoming informed about market opportunities and completing market transactions, markets will not perform efficiently. Regulation to reduce those transactions costs then can improve efficiency. For example, in the auto industry global auto emissions standards can enhance efficiency, as auto producers would not have to produce different models for different states.
As an example, a common problem in markets is the incentive for sellers to shirk on the quality of the goods or services they sell. When quality can only be observed through use, a seller may have an incentive to shirk. As long as a high quality good is more costly to produce than a low-quality good and a consumer cannot tell the difference until after it is purchased, the seller's strategy can be to cut back on quality.
Markets however can resolve some of these problems. For example, If consumers can sully the reputation of the firm by informing other consumers that the firm shirked on quality, consumers will not purchase from that firm.