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Please explain why and how demand and supply may not lead to the allocation of some...

Please explain why and how demand and supply may not lead to the allocation of some resources to their best uses.

What are the roles that government might play in attempting to correct the misallocation of resources in the market economy.

business   economics   
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Answer #1

Market can fail to allocate resources when there are factors affecting demand and supply that prevent the market from reaching an equilibrium. Some of them are externalities, public goods, informational asymmetries, etc. Government can interfere and correct them using subsidies, taxes, etc

For most of the goods and services, the market determines the quantity and the price which appears to be adjusted by invisible hands. This outcome is the result of self-interested economic agents who are guided by their own utility maximizing choices given the constraints. Competition in the market ensures that the market quantity is produced with least possible cost. Simultaneously, it attempts to allocate the resources most efficiently. However, when resource allocation becomes inefficient market failure occurs. One of the reasons why market fails is externality. The invisible hand theory works for the market outcome but not for socially efficient outcome where a third party is affected by the market. In a sense, externality is the cost or benefit of any action that affects other groups besides those involved directly in an economic transaction. These externalities have external cost or benefit on other people who are not involve directly. Because they impose an external cost or benefit on the ociety which the invisible hand theory fails to recognize, it causes markets to fail in resource allocation. Negative extemalities are treated by taxes, imposing a cap or limit and a license to produce that product which causes extemality. This discourage their production. For positive externalities, to encourage their production, subsidies are provided Possible reasons for failure in the market also include the presence of public goods. Public goods are different from any other goods that consumers usually consume. Non-rivalrous and non-exclusion therefore becomes the characteristics of public good where people cannot be excluded from the consumption of a public good. Another market failure is asymmetric information where one party engaged in transaction has hidden information unavailable to the other party. This distorts the market outcome. Possible examples are market for lemons insurance market etc For public goods, the efficient provision is done by the government by charging taxes from people for the provision. Private provision suffers from free riding problem and so government intervention is required. For informational asymmetry, potential sufferers use signals such as insurance companies set minimum standards for health, or of the product being insured, firms use education as signal of quality of workers, used car owners use certificates of verification etc

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