Market Economy

and
Market Failure
An overview

By Prof. Dr. Balram Paudel

 Four major questions
• What is market economy ?
• How does market economy function ?
• What is market failure and why does market
fail?
• How can market economy be improved ?
 What Economics is all about
• Economics is a social science ,concerned with production ,
distribution , consumption and exchange
• Economics is a dynamic subject and its focus has changed
along with time
• It was born as science of wealth in 1776
• By 1890 , it was develop as a science of human welfare
• By 1932 , It was defined as science of scarcity and choice
• By 1930s, economics was classified into two Branches
Microeconomics and Macroeconomics
• By 1969, Economies was honored by Nobel Prize
• By the late 1990s, knowledge revolution caused to produce
knowledge economy
 What is an Economy?
• The word economy has two meaning:
• 1.Economy = Money saving 2.Economy= System :an entire net work of
producers, ,consumers, and distributors in local , regional or national
level
orAn economy is an economic system of a particular country. It is the sum of
all economic activities
Two main functions of economy
• ( a)provide livelihood to the people and (b) Makes efficient allocation of
resources .

• An economic system is said to be efficient if it is not possible to produce

more of one good without producing less of other good through the
reallocation of resources

• When maximum possible output is produced with given level of input , it

is called technical efficiency

• When the same output is produced at the possible lowest cost or by

using fewer amount of resources, it is called economic efficiency
 Global Economy: An overview
• The Global GDP in2016was $76.32 trillion (1trillion=1
followed by12 Zeros, 10,000 billion or 10kharb)
• 1st Economy, US economy $18.6 trillion ( around24.49percent
of the total )
• 2nd Economy , China $12.25 trillion(16.06 percent )
• 3rd Economy Japan $4.17 trillion (5.46 percent )
• 7th Economy , India $2.38 trillion (3.12percent )
• 39th Economy Pakistan $232 billion
• 44th Economy Bangladesh $ 218 billion
• 104th Economy Nepal $24.06 billion (0.03 percent ) and Per
capita income $730 and 17th poorest country of the world
• Source :IMF,2016
 Major issues
• Global growth is projected at 3.1 percent in 2015, 3.4 percent in 2016 and
3.6 percent in 2017.
• Major global issues are :
• In 2015, global economic activity remained subdued( passive) because of
the sluggish investment , slowing trade, and falling commodity prices

• According to IMF there are three key transitions which are influencing the
economy:
• (1) the gradual slowdown and rebalancing of economic activity in China
away from investment and manufacturing toward consumption and
services
• (2) lower prices for energy and other commodities, and
• (3) a gradual tightening in monetary policy in the United States in the
context of a resilient( flexible) U.S. recovery
• other major advanced economy central banks continue to ease monetary
 Market Economy
Market :A market is an exchange mechanism thorough which buyers and
sellers interact to determine price and output
• Markets are broadly classified into perfect competition and imperfect
competition

• Monopoly , Monopolistic competition and oligopoly are 3 forms of

imperfect competition
Economy :
• An economy is an organization of economic activities which constitutes
consumption , investment ,government expenditure and international
trade
• It can also be viewed as primary sector , secondary sector and tertiary
sector
Market Economy :
• An economic system which allocates resources based on market
mechanism or market price is called market economy
 How does market economy function ?

• There are two main functions of price mechanism

• Rationing function: Rationing is the process of distributing a given amount of
goods or services among competing users. Markets allocate commodities through
price rationing. If the quantity of a given commodity becomes increasingly limited,
then the price rises. Only the buyers most willing and able to buy the commodity,
and pay the higher price, obtain the good.
• There are two kinds of rationing ( a) price rationing ( only the highest bidder
obtain the product (b) Regulatory rationing ( government distributes limited
amount)
.
• Signaling function :
• Price changes send contrasting messages to consumers and producers about
whether to enter or leave a market.
• Rising prices give a signal to consumers to reduce demand or withdraw from a
market completely, and they give a signal to potential producers to enter a market
 Three Forms of Economic System
(Market ,Mixed and Command Economy )
• When the following three basic economic questions are
answered by the market ,it is called market economy ( allocative
efficiency P=MC and productive efficiency P= Minimum AC can be obtained only
in competitive economy or market economy)
• What to produce ( types of goods and amount )
• How to produce ( technique of production modern
technology or traditional one )
• To whom to produce (distribution )
• When these basic economic questions are partly answered by
market and partly by the state, it is called mixed economy
• When these basic questions are entirely answered not by
the market but by the state , it is called command economy
or communism
 Origin of Market Economy
• Adam Smith , the father of economics ,was the pioneer of
market economy
• Smith was the promoter of laissez- faire economy
• According to him an invisible hand operates the economy i.e.
the free play of demand and supply caused to smooth
operation of an economy
• It is not from the benevolence of the butcher, the brewer and
the baker that we expect our dinner rather they regard it
from their own interest .
• Laissez- faire economic doctrine of Classical economists
collapsed during the great depression of 1930s.
• This was the first major historical evidence of market failure
 Great depression of 1930s
( Historical market failure )
• First share price declined by 13 percent in 1929
• Sale of automobile stopped by 1930
• Agriculture price fell down by 40- 60percent
• Unemployment rate increased from 2.5 percent to
nearly 25 percent in 1933
• More than 15 million people were jobless
• Around 5,000 banks failed
• Around 85,000 business failed
 Government intervention
• New deal policy was declared and $4.88billion
was injected to the economy
• Work Program Administration ( WPA) and
• Civil Conservation Crops (CCC) were declared
in which jobs were provided to around 3
million youths slightly below than prevailing
wage rate
• This was the first effective government
intervention in the market economy
 What is market failure ?
• The inability of market to make efficient
allocation of resources in the production
system is called market failure
• The result of market failure is under and over
allocation of resources in the economy
 Why market fails
Four Main Reasons are Responsible for Market Failure

1.Market imperfection or growth of monopoly power

2.Incomplete information
3.Existence of Public goods
4.Externalities
 Growth of Monopoly power
Patent right :
• It is an exclusive official right granted to an inventor to
control the use of an invention for 17-20 years. It creates
monopoly power
• Historically, Xerox had monopoly power on photocopy
machine ,DuPont on Instant camera, poil raid on Cellophane

Control over Strategic material

• Aluminum Corporation of America ( Alcoa) controlled entire
input of Bauxite until second world war

Government Franchise( permission)

• Certain Public entities are established by special Act
 Growth of Monopoly power…
Natural monopoly
• A form of market organization whose per unit cost sharply
falls over an entire range of output . A single form is
considered efficient than multiple form for the supply of
certain goods e.g. local electricity distribution, drinking
water and so on

Brand loyalty
• goods of certain brands are strongly preferred by the
consumer
 Incomplete information
• Consumers do not receive full information about the
market price of products, available products, quality
of products in the market.
• Supplier also do not receive full information about
demand , size of market ,input price and
productivity of inputs
• Retailers , friends , relatives and medias are the
sources of information, Which produce incomplete
information
• Due to the lack of full information, some goods are
produced more some goods are produced less
 Existence of public goods
• Private goods are (1) rivalry in nature (2) Non payers are excluded
Ex ample: food, clothing ,housing and other commodities.

• A public good is defined as one which is consumed jointly by all the

members of society even if produced by a single firm .
Characteristics
• 1.Non rival in consumption ( it does not reduce while consuming by all
the members of a society )

• 2.Non excludability ( No one can be excluded to consume public good ) for

example , every one gets benefit from national defense , environmental
protection , global positioning system and prevention of particular disease
in a a particular society

• Private firm do not sufficiently produce public good

 Externalities
• Externalities are the costs or benefits of a transaction to parties who do
not directly participate in it.
Externalities are discrepancies between social cost and private cost and
social benefit and private benefit
When some of the costs or benefits of a good are passed onto or “spill over”
to some one other than immediate sellers and buyers , it is called
externalities

Examples
Irrigation facility , flood control , dieses control, environmental
protection( positive externalities )
Pollution created by the firms, noise created by vehicles, over crowded
vehicles of a firm , deforestation and so on ( negative)
Externalities lead to under and over
allocation of resources
 Private cost
• From the policy perspective, total production
cost of the firm is classified into (a) paid out
cost (explicit+ implicit cost ) and (b) Unpaid
cost (use of freely available resources, e.g.
throwing of waste material into a river )
• Paid out cost which is reflected in the cost of
production is called private cost. It is
internalized cost which firms actually bear
• Unpaid cost is external cost
 External cost or Social cost
• Unpaid cost which is born by the society as whole is
called Social cost . Social cost includes both private
cost and external cost
• The cost of freely available resources for which
firms are not compelled to pay e.g. ( atmosphere,
road, drainage etc) are called External cost from
the view point of firm and Social cost from the
view point of society.
• External or Social cost are not reflected in the cost
of production
Free rider problem ( get something
paying nothing )
• Non rivalry and non excludability are two main characteristics of public
goods
• These two characteristics of public good creates free rider problem
• Free riding means the willingness to pay of the free ridder is not
expressed in the market
• People are not willing to pay for a product which they get it free of cost
( environmental protection, diseases control, plantation of tree ,flood
control public fire display etc are some example of free riding )
• When all people want to free ride , the demand of such goods is zero
from the view point of producer
• Private firm therefore , do not want to produce such goods and market
fails
 Six Major functions of government for
effective operation of market economy
• Legal and social framework
• Maintain competition
• Provisions of public goods
• Manage Negative externalities
• Redistribution of Income
• Stabilize economy
 Three types of learner
• Empty (who dos not know and even does not
know that he dos not know )
• Filled up (Who does not know but believes
that he has a perfection )
• Filled Half ( Who knows a little and knows that
he does not know )
• Only the third category of learner is interested
to learn
 Four Methods of Knowing
• Tenacity ( firmness)
• Authority
• A priori
• Research
 Objectives of BBA
• To develop communicative skill among
students
• To develop analytical capability
• Make innovation

The end , thank You.