MARKET FAILURE AND NEED FOR GOVERNMENT INTERVENTION

MARKET FAILURE AND NEED FOR GOVERNMENT INTERVENTION

Market failure can be divided into two types;

i)                    Which has impact on efficiency

ii)                  Which has impact on stability

Government intervention is necessary to promote efficiency and maintain stability

1.   Efficiency:

·         A situation in which the sum of all gains from lending, payments and trade in risk are as large as possible

·         Major conditions for efficiency are;

o   Competitive pricing

o   Minimum transaction cost

o   Integration of market services

Competitive pricing

o   First condition for efficiency

o   Pricing that covers the cost of all resources used to produce a good or service but no more

Minimum transaction cost

o   Transaction cost absorbs the resources that could be put to better use

o   One way to attract more business and to increase profit is to find a way arranging transaction cost lower

o   Search for lower cost and for higher profit is driven by competition

Integration of market services

o   Operation of financial system such that similar loans are made on similar terms everywhere

o   Lack of integration may be the cause for inefficiency

Reasons for inefficiency

o   Economies of scale;

High economies of scale                low cost of production               small firms out of financial market

 

Inefficiency in financial system                                  competition minimized

o   Natural monopoly;

Natural monopoly              under little pressure to lower cost                    high cost

 

Market failure                          market inefficiency

Government intervention to promote efficiency:

i)                    Intervention to promote competition

-                Bring policies to prohibit anticompetitive practices such as curtailing (agreement not to compete)

-                Regulate monopoly; e.g. price is regulated

-                Nationalization; Government takeover of a firm or industry

ii)                  Intervention to lower cost and make trade feasible

2.   Stability:

·         Three types of instability observed so far in the financial system; panics, crashes and price level instability

Banking Panics

o   Financial intermediation create liquidity through pooling and nettang

o   For successful adoption of pooling and netting requires

• dIversification and


• confidence

and lack of any one breakdown pooling

o   Breakdown in poodijg leads to bank run and banking panics

Example;

De0ositors’ confidence erodes                  withdrawal of deposits             bank closedown or run           

 

Close down of all banks or banking panics                 chain effect in banking system

Securities market crisis

o   Secondary markets provide liquidity for holders of direct securities

o   A pool of investors holds claims to illiquid underlying assets

o   Secondary markets nets the claim on sells against purchase

o   If everyone wishes to liquidate, pooling becomes weak, which results to the sharp fall of prices that lead to market crash

o   Example; 1929 market crash in USA

Price level instability

o   Two types of price level instability;

• Inflation: continuous rise in price


• Deflation: continuous fall in price

o   Impact on lending

o   Example of hyper inflation: Germany, 1921-23; price doubled every two weeks; inflation at such rate is called hyper inflation.

Reason for financial system subject to instability:

o   Composition Problem:

• Problem that arise out of behavior that is sensible for a single individual but harmful if pursued by all individuals


• Example:


• Banks: withdrawal


• Securities market: tendency to sell


• Price level instability: when single bank increases or decreases lending and creates or destroys money- little effect; if all do so- may lead to price instability

o   Excessive risk taking:

Government intervention to promote stability:

i)                    Regulation:

§  Regulation of excessive risk taking

§  Put limitations on lending and borrowing

ii)                  Creation of institutions:

§  To regularly monitor the activities of specific institutions

§  E.g., Central bank looks after the working of banks and financial institutions; Insurance Board looks after the insurance companies; Securities Regulator monitors the activities in the stock market

iii)                Other types of government intervention:

§  Consumer protection: for example; provision for deposit insurance to protect the credit of depositors

§  Social policy:

• Equal credit opportunity policy


• Community re-investment policy

Failure of government intervention:

o   Intervention often serves special interest

§  Example; legislators may have interest in bringing specific laws

o   Intervention is costly

o   Intervention often does not work

§  Example; mechanism of deposit insurance may not work when there is crises in financial system as a whole