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Market Failure and Government Intervention

                                   Figure 17-6d COBWEB MODEL

NOTE:  In response to high prices at Ao Chemical companies would expand capacity to produce A1.  However, with excess capacity prices fall to A2 and capacity exits to A3.  The shortage in capacity raises prices up to Bo.  The cycle starts all over, but the swings are more dramatic leading to dynamic market failure.

(2)  Overuse of Replenishable Resources:  Many populations of plants and animals replenish themselves to produce a sustained yield for industry.  However, if the rate of utilization reaches past a certain critical level, the density of the resource population may be reduced to a point where the population can no longer sustain itself.  If firms do not know the critical level for a resource population or experience a lag in being able to measure the use of a resource, they may inadvertently reach past the critical point and send the resource into extinction.  In this case lack of information or a lag in monitoring information is the source of the problem.

Even with knowledge about sustaining the yield of a population, market incentives may lead to the demise of the population.  A prisoner's dilemma faces the firms using the population.  If everyone cooperates, sustained yield can be achieved.  If they don't cooperate the population will become extinct.  However, if some individuals cooperate while others do not, the resource population will not only become extinct but the cooperating individuals will lose out to those who do not cooperate as the resource disappears.

(3)  Non-replenishable resources.  Even when resources are not replenishable there may be an optimum rate of exploitation based on the speed with which they can be replaced with substitutes.  However, invention, innovation, and diffusion must work smoothly to produce the new substitutes.  Otherwise society faces a crisis of market failure.

While market failure provides a basis for government intervention, such intervention has its own costs.  When governments provide buffer stocks in the form of stockpiles, such stockpiles are costly and often are not released when they should be.  This results in an overhang on the market and weakening of prices.  Frequent articles about organizations like OPEC concern the problems of dynamic market failure.  The benefits of government intervention must be weighed against the costs of that intervention.

A manager must understand how all of these market failures work, the likely government failures, and the studies that are used to figure out whether government failures are worse than the market failures they attempt to cure.


Ideally markets should be left to perform without government intervention unless there is an overriding market failure exists that must be corrected.  Even if such a market failure exists

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