Market Failure

Market  failure refers to the circumstances under which market fails to allocate resources efficiently. 

This can occur due to externalities and public goods.

They are explained as under:-

1) EXTERNALITIES:- The presence of externalities in production and consumption lead to market failure. Externalities are market imperfections where the market offers no price for service or disservice. These externalities led to malallocation of resources and cause consumption or production to fall short of an optimum level. They do not lead to maximum social welfare. Externalities, also lead to the divergence of social cost from private cost, and of social benefits from private benefits. When social and private costs and social and private benefits diverge, perfect competition will not achieve maximum social welfare. This is because under perfect competition Private Marginal Cost (PMC) is equated to Private Marginal Benefit (PMB), i.e. PMC=PMB. 

Lets discuss how external economies and diseconomies of consumption and production affect adversely the allocation of resources and lead to market failure.

A) External Economies of Production:- These economies accrue to other firms in the industry with the expansion of a firm. Whenever external economies exist, Social Marginal Benefit (SMB) will exceed Private Marginal Benefit (PMB), SMB>PMB and Private Marginal Cost (PMC) will exceed Social Marginal Cost (SMC), PMC>SMC. So, when under perfect competition, PMC is equated to price which is also PMB, SMB will be higher than SMC because of external economies of production. The firms will produce less than the socially optimum level of output.

#Diagram

B) External Diseconomies of Production:- When there are external diseconomies of production, SMC is higher than SMB. SMC>SMB. Firms will produce more than the socially optimal level of output. A factory situated in a residential area emits smoke which affects adversely health and household articles of the residents. In this case, the factory benefits at the expense of residents who have to incur extra expenses to keep themselves healthy and their household clean. These are SMC because of harmful externalities which are higher than PMC and also SMB.

#Diagram

C) Externalities in Consumption:- They lead to non-attainment of  maximum social welfare. In the case of external economies in consumption, the consumption of a good or service leads to increase in utility of other consumers. When an individual installs a TV set, the satisfaction of his neighbours increase because they can watch TV programmes free at his place. Here SMB is larger and SMC is lower than PMB and PMC. But the TV owner is likely to use his TV set to a smaller extent than the interest of society require because of the inconvenience and nuisance caused by his neighbours to him.

D) External Diseconomies Of Consumption:- They arise when the consumption of a good or service by one consumer leads to reduced utility of other consumers. Consumption Diseconomies arise in the case of dress, fashions and articles of conspicuous consumption which reduce their utility to some consumers. Smokers cause disutility to non-smokers, and noise nuisance from stereo systems to neighbours are other examples. Such diseconomies of consumption prevent the attainment of maximum social welfare.


2) PUBLIC GOODS:- Another cause of market failure is the existence of Public Goods. A public good is one whose consumption or use by one individual does not reduce the amount available for others. Examples are city parks, defence, police, ocean or lake fishing, etc.

Public Goods have two characteristics: non-excludable and non-rivalrous. A good is non-excludable if it can be consumed by any one. It is non-rivalrous if no one has an exclusive right over its consumption. Its benefit can be provided to an additional consumer at zero marginal cost. Thus public goods being both non-excludable and non-rivalrous are not sold in a free market like private goods. 

They lead to market failure in the following ways:-

A) The consumption of a public good is always joint and equal. The maximum social welfare condition for a public good is that its Marginal Social Benefit should equal its Marginal Social Cost(MSB=MSC). But the characteristics of a public good are such that the economy will not reach an optimum point in a perfectly competitive market. Public goods create externalities. The externality starts when the marginal cost of consuming or producing an additional unit of a public good is zero, but a price above zero is being charged. This violates social welfare maximisation criterion of equating MSC and MSB. This is because the benefits of a public good must be provided at a zero MSC.

B) Public goods are not subject to the "exclusion principle" which means that their benefits are available to everybody, whether a person pays for them or not. But in the case of some public goods, exclusion is practised. Take the example of a bridge as the public good whose use is restricted to those who pay a toll tax. This does not lead to maximisation of social welfare because the toll tax restricts the service of the bridge to only those who pay the toll tax. For social welfare maximisation , its services should be available to every consumer at a zero price.

C) In the case of some public goods where exclusion cannot be practised, all payments for their services are purely voluntary. In such a situation, many users have the tendency to avoid paying for their services when they know their benefits can be obtained free. All such users are known as "free riders". Therefore, when such a public good is produced, much less than the optimum quantity would be available to its users. 

#Diagrammatic explanation

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