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 minimizedo Natural monopoly;
Natural monopoly under little pressure to lower cost high cost |
Market failure market inefficiencyGovernment 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 systemSecurities 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
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
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