Market Failure in Free Market and Externalities

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Table of Contents

Definition of market failure
Free Markets and Market Failure
Externalities
Reference List

Definition of market failure

Market failure is an economic theory where the allocation of goods and services in a free market mechanism is inefficient. That is in the inefficient allocation, there are some players whose gains outweigh their losses while for other participants, their losses outweigh their gains. Market failure can be termed as a situation where the individual market players pursuit for self-interest results into inefficient outcomes. Keynesian economists believe that inefficiencies can be corrected by government intervention in trade and have advocated for government intervention in the market (Arrow, 2001).

There are various factors that have been linked to market failure, they include: monopolies, externalities, public goods, and merit and demerit goods. Economists and more so micro economists have always raised concerns over the causes and the solutions that can be developed to solve market failures. Such analyses have been critical in shaping public policy decisions and studies. Nonetheless, some of the policy interventions that have been advanced by governments such as: subsidies, taxes, price and wage controls, bailouts, and regulations among other corrective measures have often resulted in inefficient allocations (Arrow, 2001).

Monopolies in the allocation of resources, monopolies do not often pass the benefits of the economies of scale to the final consumer and this leads to inefficiencies and market failure.
Public goods these are goods and services that are non rivalry and non excludable; that is the consumption of the good by one person does not limit the availability of the good to other persons and that there is no effective way that can be used to limit the consumption of the good by the other persons.
Merit and demerit goods merit goods are goods that are often undervalued by the society and result in under consumption under a free market; often, the goods have a positive externality. On the other hand, demerit goods are goods that the general public ignore their costs and thus a free market situation may result in the over consumption of the good. The goods often have negative externalities.
Externalities these are spill over gains or costs that arise from the consumption or production of certain goods and services; these costs and gains are often not transmitted through prices.
Immobility of factors of production these occurs when there are barriers to the transfer of the factors of production from one industry to another or between different occupations. Often, this results to factors of productions being used in an economically inefficient manner.
Imperfect information in order to make efficient choices, all the players in the market requires complete information. Imperfect information results in a misallocation of resources and the likelihood of market failure.

Free Markets and Market Failure

In free markets, market failure occurs when the markets functioning without any form of government intervention, are unable to allocate resources in an efficient manner. The competitive forces are unable to deliver an efficient outcome from the general view of the society. The free market presents some benefits to individuals and business for undertaking certain business activities; market failure occurs when these benefits diverge from the individuals and businesses to the entire society. Paul Krugman, a Keynesian economist describes it as the situation where an individuals pursuit of self interest results in effects that are harmful to the general society.

In a perfect market, market failure occurs because all the essential assumptions are not achievable in the real market situation (Arrow, 2001). The free market may over produce or under produce a good because of the existence of externalities and rivalry among other features. This implies that the goods have the capacity to be used by more than one person without increasing the costs; this makes the production of the good undesirable for business reasons. Therefore, the demand for these products is reduced resulting in the failure of the market. Other factors that have been attributed to market failure include: inadequate provision of public goods by the government, under provision and over provision of merit and demerit goods respectively, and the abuse of monopoly powers.

Externalities

Externalities refer to the spill over gains or costs to persons who did not originally consent to the production or consumption of the product that caused the costs or benefits (Varian, 2003). The benefits and costs can either be positive externalities and negative externalities respectively. Thus, the existence of an externality in a competitive market implies that prices do not depict the full costs and benefits that are incurred in the production or consumption of the goods with externalities. Therefore, the producers or consumers do not incur total costs or derive the maximum benefits of producing or consuming the product. This often results in under production or under consumption of the good.

There are four major solutions that are provided to eliminate the problem of externalities:

Criminalization- this has been implemented in various cases such as in the prohibition of unlawful drugs and criminalization of commercial scams.
Civil Tort Law
Government Provision- the government may provide facilities that are not commercially viable such as national defense and education.
Pigouvian Taxes or Subsidies- these are taxes that are imposed to eliminate negative externalities; the taxes are equivalent in value to the externality.

Reference List

Arrow, K. (2001) Economic Welfare and the Allocation of Resources for Innovations. New York, Princeton University Press.

Varian, Hal R. (2003) Intermediate Microeconomics: A Modern Approach. 3rd edition. New Delhi, East-West Press.

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Market Failure in Free Market and Externalities

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