Market Failures

• Most markets are imperfectly characterized by monopoly,

monopolistic competition and oligopolies.
• Therefore, markets fail to ensure optimum allocation of
goods between the consumers, optimum allocation of factor
inputs between various productive activities and optimum
distribution of incomes.
• Due to imperfectness of the market system, markets fail to
ensure optimal allocation of resources, called as market
failures.
 Factors of Market Failure

• The major factors responsible for market failures are

following:
I. Growth of monopoly powers;
II. Incomplete information;
III. Existence of public goods and
IV. Externalities.
 (i) Growth of Monopoly Power and Market Failure
• Monopoly powers in product markets grow over time for reasons, such
as:
 patent rights,
 legal restrictions on the entry of new firms,
 production efficiency and
 mergers and acquisition.
• In input markets, especially in the labour market, monopoly powers grow
due to politicization of labour force and formation of labour unions.
• Growth of monopoly powers distorts the competitive structure of the
markets.
• Market distortion results in inefficient allocation of resources among the
industries and of consumer goods among the consumers.
 (ii) Incomplete Information
• One of the basic conditions for the market system to work efficiently
is ‘perfect knowledge’.
• For efficient allocation of resources, the consumers require:
• complete information about market price of the products and their quality,
• And the producers need to have full information about:
• market size,
• demand for the product,
• availability of inputs,
• input prices and their productivity,
• the cost conditions and so on.
Contd..
• In the absence of complete and reliable information about the
market, neither consumers nor producers can optimize the
allocation of resources.
• For lack of complete and correct information, consumers may
spend more on some goods and less on others than required
to maximize their utility;
• Producers may produce some goods in excess of demand and
some goods much less than the prevailing demand; and
workers may not be able to find right wages and right place
for their employment.
 (iii) Existence of Public Goods
• A pure public good is defined as one whose benefits are consumed by
all members of a community as soon as it is produced for, or by, any
one member.’
• More appropriately, a pure public good can be defined as one which is
consumed jointly by all the members of a society even if it is produced
by an individual, and no one can be excluded from its consumption
even if one does not pay for the good.
• Production of a pure public good generates external benefits and costs
which go to all the members of a society whether intended or not.
• National defense, law and order system, flood control, control of
epidemics and pollution-free atmosphere are some of the classic
examples of pure public goods.
Characteristics of Pure Public Goods
• It is easier to identify a pure public good by its
characteristics rather than to define it in specific terms.
• There are three basic characteristics of public goods,
viz.
 collective consumption,
 non-rival consumption and
 non-exclusion.
• These three characteristics stem from the other features
of pure public goods, i.e. its indivisibility forcing their
joint consumption.
a) Collective or Joint Consumption
• A pure private good is consumed individually, e.g., a shirt cannot be put on by two
or more persons simultaneously.
• In contrast, a pure public good (air) is consumed jointly by all the members of a
society because of its indivisibility.
• In simple words, a pure public good cannot be divided into parts or apportioned in
accordance with the consumer’s need, e.g., national defense and pollution-free air
cannot be divided into parts and made available to the people in accordance with
their need.
• Because of their indivisibility, pure public goods have to be consumed jointly and
simultaneously by all members of a society.
• An important property of pure public goods is that the demand for a public good
cannot be determined on the basis of choices and preference function of an
individual.
• Demand for a public good is determined by collective choice of all the consumers.
b) Non-Rival Consumption
• There is rivalry in the consumption of private goods in the
sense that, given the supply of a product, if one consumer
consumes more of a commodity, it reduced the share of
others.
• For example, if you occupy larger number of houses, the
number of houses available (given the supply) to other
residents of the city is reduced, and if you consume larger
quantity of petrol, my share is reduced.
Contd..

• In contrast, consumption of a pure public good is non-

rival.
• This is a unique feature of pure public goods.
• Non-rivalry in consumption means that consumption
by one does not prevent consumption by others and a
larger consumption by one does not reduce the share of
others and increase in the number of consumers does
not reduce the amount available to other consumers.
Contd..
• For example, if some persons of the society benefit more from a
pollution-free atmosphere, it does not reduce the share of others.
• This is called non-rivalry in consumption of pure public goods.
• It is equally important to note that marginal cost of distribution
of a pure public good to additional consumers is zero, though
marginal cost of production may be positive.
• For example, if population of a city increases, the cost of
pollution control may increase but not the marginal cost of
distribution.
c) Non-Excludability
• In case of pure private goods, a person who does not
pay for the commodity can be excluded from the use
of that commodity.
• For example, if you do not pay taxi fare, you may be
excluded from using the taxi service and if you do not
pay for a laptop, you may be excluded from its use.
• In contrast, in case of a pure public good it is not
technically feasible to exclude a consumer from its
consumption, if he or she is unwilling to pay for it.
Contd..
• For example, it is technically not feasible to exclude an
individual from the benefits of expenditure on national defense
and control of air pollution if he or she does not or cannot pay
for defense services.
• This characteristic along with others, assumes a special
significance with regard to the provision of pure public goods
through market system.
• Because of non-excludability of consumers, the exclusion
principle of market system does not apply to pure public goods.
• Therefore, market system fails to provide for pure public goods.
 (iv) Externalities and Market Failure
• Externalities refer to the costs people have to pay and the
benefits they enjoy due to production and consumption by
others.
• For example, air pollution caused by industrial units located
inside the city of Delhi and about 5 million cars running on
Delhi roads cause health problems like breathing problem,
asthma, bronchitis and lung infection; industrial units
polluting Yamuna River are all the cases of negative
externalities.
• This is called external cost to the society.
Contd..
• There are positive externalities also.
• For example, private cost of immunization against
contagious diseases and car owners getting their cars
regularly checked for pollution, benefit the people who
do not pay it.
• Such benefits are called external benefits.
• External costs and benefits are together called
externalities or spillovers.
Contd..
• Market system fails to work efficiently where externalities
exist because private entrepreneurs take into account only
their private explicit cost, and there is no way to compensate
the losers and to charge the gainers.
• Externalities lead in non-optimal allocation of resources
from social welfare point of view: they create divergence
between social and private costs and between private and
social benefits.
• The market system does not provide a mechanism to
account for such social costs and benefits.
Thank You