Over the course of an average day, our life is touched by literally thousands of regulations. They are at work from utility services, telecom services, oil and petrol, to public transport,banking, housing and other government services. Ever wondered why these regulations exist at the first place??? What is the economics behind these Regulations?
What is free in free market??
Economics explains lot of real life scenarios such as public welfare and regulations which are entwined with complex set of cause and effect phenomenas. Few such interesting concepts which explains why regulations are in existence are 'Free Market Failures and Externalities'. You will appreciate their true meaning and contribution in explaining the esoteric workings of an economic system when you see them at work in real life.
These seemingly arcane terms, work on the fundamental premises of ecomomics i.e. forces of demand/supply and efficient allocation of resources. A free market is a market where there is no intervention of a controlling authority (Government) and market is left to the forces of demand and supply. The prices of the services or products exchanged in such markets are agreed solely by mutual consent of buyers and sellers in the market. In such a market the allocation of products i.e. who gets what, is decided by purely the purchasing power of consumers and forces of supply/demand. Adam Smith, one of the influential economist of 19th century, coined the term 'invisible hand' to describe the self regulating structure of market due to invisible forces of
- Self interest i.e. doing what maximizes my profit or doing what is good for 'me';
- competition between the market participants and;
- demand and supply
Now, free market premise is based on ideal conditions in the market such as markets are perfectly competitive and no market power exists with any player eg. Monopoly, market participants are perfectly informed about choices and interchangeability exists between goods and services. The necessary components for the functioning of an idealized free market include the complete absence of artificial price pressures from any form of government intervention(other than protection from coercion and theft, and no government-granted monopolies which eventually makes it "pareto efficient'(Named after italian economist). So we see the cause and effect chain as:
Free Market - causes - Competitive forces, prices decided by market forces with no government intervention (idealized conditions)- leads to - efficient allocation of resources- leads to - Pareto Efficient market
Why Markets Fail?
In reality, we dont see a idealized scenario of a free market at work. What we see is a deviation from the equillibrium where there are lot of other factors influencing the market forces and competition which leads to an inefficient allocation of goods and services to producers and consumers. Economists have identified following scenarios when a market can fail(i.e. where individual self intretest leads to inefficient the resource allocation). Now this is the exact reason why government steps in to ensure that allocation happenes in a way that ensures equitable distribution of benefits to all participants and therefore economic and social welfare can be maximized. Market Failure eventually lead to inefficient and hence said to be 'Pareto inefficient'. Economists have defined following causes of market failures:
- Externalities: When consumers and producers come together in the market, the products/services are exchanged in return for money or the price of the goods/services. However, there could be costs/benefits associated with this transaction which is not transmitted through prices but through any other means and borne by the thrid parties not involved in this transaction.A live Eg. is Posco, steel maker,is alleged to have violated the forest act while acquiring land for a steel project near Paradip and where as Vedanta, mining company, is battling criticism from environmental groups over plans to extract bauxite in Niyamgiri hills in the state's Kalahandi district. Both firms are engaged in capacity enhancement activities which is linked to profit maximization. however, these actions have negative externalities in terms of social cost(effect on tribes and wild life in orissa) being greater then the private cost of the firms.
- Monopolies or market dominance: these occur due to imperfect competition in the market. It can happen due to various reasons. A firm gains a monopoly over market resource, Government gives exclusive right to one firm to produce or provide services or cost of production (gained from economies or scale or strategic investments)makes a single produce more efficient then others in the market.An example is BSNL as it was given exclusive rights to sell telecom service to users and entry barriers were high till the time the market was opened to private players.
- Information Asymmetry: This happenes when both buyers and sellers will have different information about the product’s attribute or one party has more or better information about the product than the other.A classic example is Financial services and Financial intermediaries.Imagine for a moment that Banks do not exist and people have no other options to search for the right lender who can lend the fund to them. Similerly lenders search for the right investors. That would be a difficult scenario. So the primary reason why people give/deposite their money to Banks/financial intermidiaries instead of lending or investing the money directly is because of the risk that is present from the information asymmetry between the provider of funds and the receiver of those funds.A seller knows more about the sale item than the buyer.Likewise, a borrower knows more about his financial condition and his future prospects than the lender.
How Government intervenes to correct Market Failure?
In a market failure scenario, an economic rationale behind government intervention is:
1) Ensuring equitable distribution of economic benefits/income/wealth to the participants as a whole.
2) Correcting the losses suffered by market failure thereby making market efficient.
A government achieves this by several means such as taxes, subsidies, bailouts, public policies etc. One of the means is Regulations also called Command and Control technique.However, government regulation does not necessarily ensure equity and efficiency and may result in what is called Regulatoy Failure which could be a negative externality of regulations.
Market Inefficiency- causes -Market Failures - Government intervenes by means of Regulations, subsidies, taxes etc - which may (or may not) lead to - efficient allocation of resources and equitable distribution of income and wealth- leads to - Pareto Efficient market
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