Explain how market dominance and imperfect information can lead to market failure.


Market failure occurs when the operation of the market fails to achieve economic efficiency in the allocation of scarce resources i.e. it is possible to change the existing resource allocation to make someone better off without making someone else worse off. There are a few causes of market failure including market dominance and imperfect information.


In the imperfect market structure, firms can enjoy market dominance. Such firms are price setters and thus, their demand curve is downward sloping. At the profit-maximising level of output, the price charged is greater than marginal cost. With the supernormal profits earned by such dominant firms, other producers will be enticed to enter the industry. But entry barriers are so high that the dominant firms shut out all competition and continue to produce the output level where his price is greater than the marginal cost of production.

The socially ideal price and output are 0Pc and 0Qc respectively where P=MC. This means that the value the society places on last unit of output produced is exactly equal to the opportunity cost incurred by the society in having that last unit. For that output level, the  total net benefit to society is area AEcX. Given his profit-maximising motive, the monopolist will produce where MC = MR and MC is rising. At output, 0Qm, the price charged by the firm is greater than his marginal cost of production (P>MC). Hence the total net benefit to society falls to area ABEmX.

A particular case of imperfect information is that of asymmetric information whereby one party has significantly more information about a good or service than the other side of the economic transaction. This gives rise to sub-optimal outcomes in resource allocation.

For example, in the healthcare market, patients often know much less about their medical conditions or treatments available compared to doctors who generally have better information regarding medical procedures and treatment. On the other hand, buyers of

health insurance may not accurately declare their own state of health to insurance companies. Asymmetric information presents an opportunity for the party with more information to exploit the information gap, resulting in sub-optimal outcomes.

Conclusion Given these sources of market failure, the government may need to step in and intervene to bring about a better outcome to society.

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