Market failure refers to a market that fails to provide efficient outcomes for the society. In other words, market works efficiently only when there exist perfect competition or when exclusion principle could be applied in the free market. Exclusion principle requires that, those who do not pay for as goods should be excluded from its consumption and those who derive any benefit from goods should bear its cost. In free market economy the main responsibility of the government is to prevent the market from failure.
Market failure can be summarized in two ways:
- Market failures due to incentive or incentive failure
- Market failures due to structure or structure failure
1. Market failure due to incentive or incentive failure
The market failure due to the presence of externalities is known as incentive failure. The free market mechanism does not function effectively when exclusion principle is not applicable. Exclusion principle requires that, those who do not pay for as goods should be excluded from its consumption and those who derive any benefit from goods should bear its cost.
But in the complex world there are many such goods and services where even people do not use goods and services are bearing cost in terms of loss of welfare, and even though people do not pay for the goods they are benefited by the goods and services. Such situations are called externalities.
The market mechanism does not compensate or charge those who are affected by externalities. Thus, collective action is needed by the government to charge those benefit from and compensate those who suffer from externalities. In order to prevent the market from failure, government response to incentive failure in two ways:
1.1 Consumption externalities
In traditional economics, consumption is supposed to be independent, but in reality, consumption of an individual is not independent. It is affected by external environment. For Example: those who smoke in a bus reduce the utility of those who do not smoke. Externalities may arise from either consumption or production.
Consumption externalities are of two kinds:
- Positive externality in Consumption: The consumption externality occurs if the welfare of the person is affected by the consumption pattern of other person. In other words, if an individual gets satisfaction with out incurring any cost. It is the case of positive externality. For example when individual paint his house, it increases the beauty of the whole society. Consumption decision of one, others receive value without paying compensation.
- Negative externality in Consumption: An external diseconomy of consumption arises when the purchase and consumption of goods or services results in disutility for people not involved in the transaction. For example, when an individual use loud speaker to listen the radio, it adversely affects the students who is planned to appear an examination.
In both cases, there is difference between social cost and private cost. In case of positive externality in consumption social value is grater than private values. In case of negative externality in consumption social cost is greater than private cost. The environment pollution is the glaring example of negative externality. If firm discharge polluted water in the river, swimming fishing comes to a halt. If the firm pulls water from the river is not available to others. People bear the cost in terms of social welfare without using the product or service. In this sense, government charges compensate made to firm.
1.2 Production externalities
Production externality is also of two kinds:
- Positive externality in Production: An external economy of production arises when an increase in the firm’s production results in some benefit to society or another firm. As for example construction of high way reduces the transportation cost of the firm, the research conducted by government benefit all the firms etc, are the positive externality in production.
- Negative externality in Production: Negative externality in production arises when expansion of the firm’s production results in adverse effects (social cost) that are not paid for by the firm and are therefore not reflected in the prices of its production. For example the water pollution created by leather industry and factory vehicles produces air pollution and imposes cost in the society
Government Responses in incentive failure
In order to prevent the market form failure, positive externalities should be increased. Market does not have any mechanism to encourage such activities. Government should take the following steps to prevent market failure:
1. Grant Patents
Patents are a government grant of exclusive right to produce, use or sell and inventions or ideas for a specified period of time. They are essentially a limited grant of legal monopoly power designed to encourage inventions and innovation. Patents arose response to the fact that a firm which develops an important technological breakthrough cannot begin to reap the full benefits of its efforts if other firms can freely begin making the new product or using the new production process without having to compensate the originator. Without patent rights and protection, few firms would devote resources to research, and the economy would obtain few of the benefits which flow from such research efforts.
Advantages of granting patents:
- Patent is necessary incentive to induce the business firms to work more and invest in new and creative projects.
- The inventions are disclosed soon due to the patent act. Consequently, since there is sooner dissemination of information, it facilitates other inventions.
Disadvantages of granting patents:
- There are some perversions of the patent law that directly effects competition. Controlling output, dividing markets, fixing prices are some perversions due to patent right.
- Since patent system enables the inventors to get a great part of the social benefit from their innovation although patent system is ineffective. Thus it encourages imitations.
Government also responds to external economies of production by providing subsidies to private business firms. These subsides can be indirect, as in the case of government construction and maintenance of highways used by the trucking industry. They can also take the form of such direct payments as special tax treatments and government—provided low-cost financing. Investments tax credits allowed for certain types of business investments and the depletion allowances provided to promote resources extraction industries are examples of tax subsides given in recognition of production externalities which provide benefits to society. The external economies associated with locating a major manufacturing facility in an industrial park have given rise to local government financing of such facilities. The low-cost financing is thought to provide compensation for the external benefits provided.
3. Tax Policies
Taxes are used to control the negative externalities created by market. Tax policies are designed to limit the undesirable activities of private firm. Pollution taxes, effluent charges, fines etc are common examples of tax policies. For example government fines to those who do not fallow the traffic rules such as wearing of helmet wearing of safety belt etc.
4. Operating Control
Just as government attempts to correct for the market failures associated with external economies, it also works to remedy problems associated with external diseconomies. One of the primary tools of government policy in this area is the imposition of operating controls that limit the activities of firms.
What kind of operating controls are imposed on business firms? Controls over environmental pollution immediately come to mind, but businesses are also subject to many other kinds of constraints. For example: Central Government sets limits for automobiles safety standards; and firms handling food products, drugs and other substances that could harm consumers are constrained under various labour laws and health regulations: Included are provisions related to noise levels, toxic gases and chemicals, and safety standards. Numerous other constraints have been imposed on firms. Rather than attempt to enumerate all of them, it will prove more useful to specify the value of economic analysis in determining the impact of direct controls over the activities of firms.