6 Major Instances of Market Failure | Public Finance

This article throws light upon the various instances of market failure which calls for government intervention for correction. The instances are: 1. Externalities 2. Provision of Public Goods 3. Decreasing Cost  4. Uncertainty as a Source of Market Failure 5. The Distribution Function 6. Market Efficiency and Income Distribution.

Market Failure: Instance # 1. Externalities:

Externalities refer to spillover or neighborhood effects. Externalities are pervasive and significant phenomena in the modern world.


An external economy is said to me emitted when an act   ivity undertaken by individual or firm yields benefits to other individuals or firms in addition to the benefits accruing to the emitting party.

The benefits so generated are typically non-excludable and these are un-priced, ‘that is they are external to the pricing system. The emitting party is not reimbursed for the external benefit generated.

An externality is said to be present when the utility of an indi­vidual depends not only on the goods and services the individual purchases and consumes but also on the activity of some other individual.

According to Buchanan and stubblebine, externalities exist whenever the utility function of an individual (or the producer function of a firm) includes a variable which is under the control of a second individual (or firm) We can state the case in terms of a utility func­tion.

An externality is present, when:

UA =UA(XvX2……………. XnY1)


The utility of an individual A’ is a function not only of activities under his own control, X1 X2…Xn; but also of another activity Y, which is under the control of a second individual, ‘B’.

Buchanan and Stubblebine defines activities to include any distinguishable human action that may be measured such as eating bread, drinking milk, spewing smoke into the air, dumping litter on the highways, giving to the poor etc. This definition is broad and comprehensive.

Therefore the term externally means the economic effects which occur from the production or use of goods to other parties or economic units. It can arise between producers, between consumers, between con­sumers and producers. Externalities will be negative or positive.

There­fore we will have to categories them to understand which type is more important for our study. For example, externalities which may affect consumers or firms. We categorize them as consumption and production externality.


Secondly distinction may be made between initiating agent (a producer or consumer) and the affected party (a producer or consumer).

Thirdly we can differentiate between exter­nalities which benefit the affected party (positive externality) and those which harm him (negative externality) let us have a brief ex­planation of the same with some examples.

Immunization against a contagious disease is an example of a consumption activity involving external benefits, when a person is vaccinated, that individual benefits directly because his chance of contracting the disease is reduced.

However this benefit is not the external benefit. But the decision to be vaccinated, also confers benefits indirectly on others because, they are less likely to catch the disease from the vaccinated person. This is the external benefit.


The fact that other people benefit from the individuals action, how­ever, will not influence that persons decision as to whether being immunized is worth the cost. The person is concerned only with the effect on his or her own health. Therefore the benefit the vaccination generates for others is external to the person’s decision.

Maintenance of a beautiful lawn and flowers by my neighbor may also produce external benefits for neighbors. Here the con­sumption activity of my neighbor generates enjoyment to me and the surrounding residents. If the well-being of myself and neighbours is improved by living in a more attractive neighborhood then there is an external benefit associated with home lawn maintenance.

Edu­cation creates several types of benefits. Education is considered as a consumption activity, since the student directly benefit from it. At the same time it creates a positive production externality for the firm intending to hire and employ literate and educated persons.

On a broader scale education also involve external benefits such as re­duction in Juvenile delinquency, an improvement in the functioning of the political process or greater social stability.

Likewise innovation of a new technology helps a firm to adopt a process which reduces the pollution caused to a nearby stream resulting from the produc­tive activity of the firm. However the market does not provide a pro­cess by which the firm can charge the swimmers for the benefit they receive in the form of clean water.

External costs are also quite common. The best example can be found in the area of pollution. For example driving an automobile or operating a factory with a smoking chimney pollutes the atmo­sphere that other people breathe. Thus operation of a car or factory imposes costs on people not directly involved in the activity.

Litera­ture on ecology is full of examples of production activities which harm various types of consumption. The consumption of air by city dwellers is affected by smoke from factories and the vacationer is confronted with polluted streams and omnipresent billboards (winfrey).

Consumption activity may also create negative production external­ity. For example a change in consumers taste and preference may decrease the demand for a firm’s product. Of course the market mecha­nism would readily respond to such changes.

But the market is in capable of accommodating all externality suffered by the owner of a fishing pier whose product is harmed by motor boats and water ski­ers are another striking example. Congestion is also an external cost. When a person drives during rush hour, the road becomes more congested not only for the drivers but for the other commuters as well.

Externalities generally lead to an inefficient allocation of resources or market failure. As externalities are not reflected in market prices, it can be a source of economic inefficiency. As such it affects the efficiency of market allocation.

The essence of externalities- in con­sumption as well as in production- is that their costs or benefits are not reflected in the market price. Therefor the decision of consumers or producers does not take into account the effect of externalities. The externalities make it impossible for the market to reach a Pareto optimum.

Market Failure: Instance # 2. Provision of Public Goods:

A pure public good may be defined as one whose consumption by one individual does not reduce the benefit received by another. A public good was defined by Samuelsson as one “which all enjoy in common in the sense that each individuals consumption of such a good leads to no subtraction from any other individual’s consump­tion of that good.”

It was emphasized that public goods differ mark­edly from private goods, which can be parceled out among different individuals.

The analysis of efficiency of market mechanism assumes that each individuals utility depend upon the quantity of commodity pur­chased by that individual. Likewise each producer’s production of output was determined by those factors of production purchased by the producer.

However in practice there are some commodities which exhibit the property that they simultaneously provide benefits to more than one individual, e the same time. In a sense they are jointly consumed.

Typical examples of such goods jointly consumed by a particular population are the services of defense; law enforcement, light house beams, radio and television transmission and flood con­trol. Such goods are called public goods.

These goods possess certain properties which render the market mechanism an inefficient device for allocating resources to them.

The important properties of such public goods are:

(a) Property of joint consumption or non-rivalness in consumption by several individuals.

(b) The property of non-excludability.

(c) The property of indivisibility and collective con­sumption (refer public goods, concept and theory).

A. Public Goods and Market Failure:

In the case of a public good the non-rivalry and non-exclusion prop­erties go together. National defense is the best appropriate example for this. The existence of public goods creates problem for a price system.

Once a public good is produced and supplied a number of people will collectively benefit from it, regardless of whether or not they pay for it. This is because of the fact that they cannot be ex­cluded from its consumption.

Therefore it is difficult for a private pro­ducer to produce and supply a public good. In the case of a private good consumption is rival. Those who are not ready to pay for the commodity will be excluded from its consumption.

Consumption of one person becomes rival with that of another. Therefore in the case of private goods provision the price system can function effectively. However in the case of public goods voluntary cooperation of indi­viduals to market system creates the serious problems of free rider.

Therefore the basic questions in the provision of public good are whether the voluntary cooperation through the price system will find a solution to the efficient allocation of public goods.

There is a natu­ral tendency among individuals to pay nothing for the public good they consume. Since lack of exclusion characterizes many public goods, an individual many well choose to be free rider.

Free ridership means literary that one or more individuals choose to let others pay for goods that they themselves plan to consume. Thus they get to ride free, while others pay. Even though it is impossible to exclude all free riders from the benefits of public goods, supplied in the pri­vate market. It is to be noted that one or more individuals do tend to pay for public goods.

Consider a locality where a cluster of 100 households are resid­ing. Further suppose that 10 households in that community think of considering a mosquito abatement programme involving a cost of Rs. 5000/-.

The mosquito abatement programme is public goods for the entire 100 households in that community. However the cost is shared only by 10 out of a number of 100 households. Here we must remember that the problem is mosquito abatement, is non-exclusive.

There is no way to provide the service without benefiting every­one. Therefore the households do not have the incentive to pay what the programme really is worth to them. Here people act as a free rider understanding the value of the programme, so that they can enjoy its benefits without paying for it.

Therefore the presence of free riders, create problems for the market to provide public goods efficiently. Market failures occurs when the act of free riders fail to communicate appropriate signals to the allocators of resources in the market.

Allocative efficiency re­quires that MSC = MSB. Allocative efficiency requires that all who benefit from the consumption of goods signal those benefits to the providers of goods. However the benefits enjoyed by free riders are invisible to the providers of goods, in our particular example, the households who pay for mosquito abatement programme, consider only their own benefits, and not of free riders.

The providers of the programme bear a higher cost, when compared to the zero cost involved for free riders. This depends upon the prevalent behavior of the free riders, the larger the groups the more potential is the free rider problem.

Hence the more likely is that public goods could not be financed by voluntary contributions. As the group size increases, more households will take the chance to behave as a free rider, and public Good will not be provided.

Goods that lack exclusion will not be produced or rather under produced in the private sector. Therefore public sector will produce optimal quantities of public goods, pro­vided there are some means of excluding free riders.

B. Efficient Output Level of Public Good:

Determination of the efficient output level of a public good involves a comparison between marginal costs and marginal benefits associate with different levels of output. The marginal cost of a public good includes the cost of resources used to produce the good, just as the case with a private good. But the marginal benefit of a public good differs from a private good because of the non-rival character of a public good.

In the case of a public good like defense, the marginal benefit of producing an additional unit is not the value that an indi­vidual alone place on it.

A large number of people also benefit simul­taneously from the same unit. Therefore we must add the marginal benefit of every person who values the additional unit of defence. The resulting sum indicate the marginal benefit from that particular unit of the commodity this is called the social marginal benefit.

Efficiency in the Provision of Public Good

Figure No.2.6 shows the efficient level of production of public good. Assume that only two persons A and B benefit from the production of public good under consideration.

The demand curves of the two consumers are shown as DA and DB. To determine the marginal benefit in society, we must add the demand curves of both individu­als. Geometrically this involves a vertical summation of the demand curves of consumers.

Each demand curve shows the marginal ben­efit that the consumers receive from consuming every level of output. For example when there are two units of the public good, the first consumer is willing to pay Rs. 41- for the good so that his marginal benefit is Rs. 41- (DA). Similarly the second consumer (DB) has a marginal benefit of Rs. 12/-.

To arrive at the total marginal benefit to both consumers, we add together the demand curve vertically. For example at 2 unit output level, the marginal social benefit is Rs. 16/ – (Rs. 4 + Rs. 12/-). When this is calculated for every level of public goods outputs we get the aggregate demand curve for the public good ‘D’.

In this way we can arrive at the efficient level of output for the public good. The efficient output of a public good is that level of output at which MSB, obtained by vertically summing the demand curves of all consumers equals the marginal cost of production.

In the figure the most efficient rate of output is at 2, where A marginal benefit of Rs. 41- plus B’s marginal benefit of Rs. 12/-, just equals the marginal cost of Rs. 16/-. This is the level of output at which the relevant marginal benefit and marginal cost are equal. This is really the equilibrium level of output.

Market Failure: Instance # 3. Decreasing Cost Condition:

The production of a public good is subject to the law of decreasing cost. Decreasing cost occurs when there are high overhead or fixed costs. For example the provision of transportation, hospitals, postal service, power generation etc. involve huge overhead cost.

The mar­ket determined process is likely to result in underproduction of com­modities in these sectors. Since productions in these sectors are sub­ject to decreasing cost condition, the producer will find it profitable to produce less and charge a high price.

Moreover being lumpy, production in these sectors would be subject to economies of scale. A firm producing under decreasing cost condition cannot be expected to equalize marginal cost with price.

This will incur heavy losses, since cost per unit and hence price goes on declining as the scale of production increases.

This can be illustrates with the help of the following diagram:

Production Under Decreasing Cost Condition

Figure No. 2.7 shows that the firm will produce OQ quantity of output, and change PQ price. Whereas under marginal cost pricing the optimum allocation of output will be at QQ1, correspondingly the price level is P1 Q1 At this scale of production the firm will incur a loss of RTP1K.

Therefore if optimum allocation is to be achieved, the loss to the firm must be met by government, through a subsidy programme of tax-transfer mechanism. Therefore in view of the gen­eral welfare of the entire, a pure public good which is subject to decreasing cost condition should be produced and provided by the public sector.

Anyhow if it is partly produced under market condi­tion, government must use the corrective measures under Budgetory allocation to compensate the loss.

Allocative Efficiency and Monopoly:

Private competitive market maximizes total net benefits by setting prices at marginal cost of production (P = MC). Monopolist being the sole seller of goods is capable of setting prices above marginal costs.

Therefore resources will not be allocated efficiently, when monopolist control prices. When compared to competitive markets, monopolists charge higher prices, produce fever goods and allocate resources inefficiently. The welfare loss under monopoly condition relate to the extent to which inefficient resource allocation exist under monopoly market.

Similarly consumer surplus is lower under inefficient resources allocation under monopoly. This welfare loss associated with monopoly condition can be overcome by corrective measures on the part of the government. These measures include antitrust laws, which break up large monopolies into smaller com­petitive firms and regulations.

Market Imperfections:

Adam smith and other classical economists believed that market mechanism can efficiently solve the country’s economic problems associated with resource adjustment. Therefore he strongly advo­cated non-intervention of government in economic activities of the country.

“But in reality the efficiency of market mechanism is conditioned by a number of factor operating within the systems. In a private market system the consumers do not always possess the informa­tion necessary to make appropriate decisions regarding the type of goods to be produced in the economy.

Imperfect information very often results in consumer behavior which are irrational. Imperfection in the competitive market may also arise due to: economic instabil­ity.

Problems of cyclical unemployment, poverty, economic fluctua­tions, wastage of resource which prevents automatic optimal utilization of resources, unhealthy competition and sluggish functioning of the price mechanism.

All these factors contribute towards an irrational allocation of resources. Therefore a paternalistic role of the govern­ment is inevitable to regulate various symptoms of market imperfec­tions and to ensure optimal allocation of resources.

Market Failure: Instance # 4. Uncertainty as a Source of Market Failure:

The efficiency of the competitive market system is fundamentally based on perfect certainty in market process; both consumers and producers were assumed to know with certainty the prices of all goods and factor of production prevailing now and in the future. But in the real world future events are of course uncertain.

There are several chances on uncertainty in business. The probabilities of out­come resulting from specific actions are not known and cannot be predicted, because of subjective nature of events.

As a result future price subject to the vagaries of changing taste, preference, popula­tion, technology etc. Business expectations are determined by MEC, which is quite uncertain. The concept of MEC is a fluctuating factor in a market oriented economy.

Therefore due to fluctuating invest­ment activity in the private sector, the market economy is subjected to trade cycles. In such a situation government intervention is needed for introducing anti-cyclical measures and economic stabilization. Prof. J. M. Keynes believes that monetary and fiscal policies can increases economic stability in a market oriented economy.

Market Failure: Instance # 5. The Distribution Function:

The concept of economic efficiency requires that in all economic systems, the factor price should equal with the value of its marginal product. That is, in the case of labour for example, the way in which it is paid should be governed by the value added to output by the last laborer employed.

In socialist countries this method of factor pric­ing is solely done for accounting purposes, as a means of planning the employment of resources in the most productive activity. How­ever actual wages may differ.

Moreover return to capital and land will be retained by the state, in the capacity of owner of factor of produc­tion. In market economies depending upon the degree of perfect competition, the actual returns to factor will be regulated by their marginal net productivity. Labour in heterogeneous.

The return in different occupation will therefore reflect the differ­ence in education, training and skill. There will be variation in wages and salary income.

The distribution of capital income is governed by the existing properly ownership relations, including inherited wealth.

In nut shell, several factors determine distribution of income and wealth in a market economy. Thus the nature of the market struc­ture, law of inheritance, differentials in productive capacity, qualita­tive differences in labour productively and efficiency, generate a par­ticular pattern of income distribution. This income distribution may seem to be proper to some, whereas others may visualize a more equitable distribution of wealth.

The net result is that in regulated market economies we will find substantial inequalities in income distribution. The general opinion of the society may be for an egali­tarian sharing of income and wealth.

Therefore the major objective of the distribution branch of budget is to use the fiscal instruments to bring about a fair distribution of income and wealth in the society. There are some basic norms which have to be satisfied by the pattern of income distribution, to achieve the level of the acceptance in a democratic society.

If the existing state of distribution is considered to be less than proper, then gov­ernmental interference is necessary to provide corrections and to bring about an ideal distribution of income. The tax transfer mecha­nism of the distribution branch of budget secures this objective.

Criteria for Optimum Distribution:

It is necessary that public policy should achieve some mea­sures of redistribution, now the question arises as to what consti­tute a fair or just state of distribution. Modern welfare economics sheds no light in this matter.

It proceeds on the assumption that economic efficiency is improved, if ‘A’ is made better off, without that of any one else including ‘B’ and ‘C’ being worsened. Of course this approach is useful in evaluating the functioning of the market. How­ever it cannot help in establishing justifiable criteria for an optimum distribution.

The market process cannot find an answer to this question. The decision in a democratic society should be left to the political pro­cess of voting the legislature of the country can decide what the ideal distribution should be.

The ideal distribution should reflect so­cial values and political pressure which have been conditioned by the existing state of income distribution. The principle of ideal distri­bution also implies equality among individuals.

The concept of equality is inteprected in different ways. Like equality of economic welfare, equality of opportunity, and equality of income. The choice among these equality criteria is not simple.

It is also not easy to translate any one criterion into the corresponding ‘correct’ pattern of distribu­tion. For example if equality of economic welfare is to be achieved, income distribution should be in accordance with capacity to enjoy income.

Since the capacity differs from individual to individual, the distribution of income should be unequal, leading to more incomes to those who have larger capacity to enjoy income and less to those who have lesser capacity.

This goes against the socially accepted meaning of equality. In modern times it appear that the emphasis on equality is shifting from the traditional concern with relative income positions, to the overall state of equality; and with excessive income at the top of the social layer to adequacy of income at the lower end.

Therefore current discussion on principles of equality emphasis pre­vention of poverty, setting a tolerable cut of line or floor at the lower end rather than putting a ceiling at the top. This has important bear­ing on the design of tax structure. Thus the-tax-transfer mechanism, intend to bring an ideal distribution of income, should be designed in such a way as to achieve vertical as well as horizontal equity.

Fiscal Instruments of Distribution Policy:

As stated realization of vertical and horizontal equity involves un­equal treatment of unquails and equal treatment of equals. Taxes should be imposed based on ability to pay.

Musgrave observes “the proper state of distribution as determined by the distribution branch will be defined inn terms of income earned minus such taxes or plus such transfer as the distribution branch choose to impose. Taxes and transfers of the stabilization branch will be distributionality neu­tral and the distribution branch will disregard taxes collected by the allocation branch.”

Among the various fiscal devices, redistribution is implemented most directly by:

(1) A tax-transfer scheme, combining progressive taxation of high income with a subsidy to low income households. Alternatively re­distribution may be implemented by;

(2) Progressive taxes used to finance public services, especially those such as public housing which particularly benefit low income households. Finally redistribu­tion may be achieved by;

(3) A combination of taxes on goods purchased largely by high income consumers with subsides to other goods which are used chiefly by low income consumers (Musgrave, 1989).

The tax transfer mechanism of income redistribution, is as­sumed that it will not interfere with particular consumption or produc­tion choice. But the extent and nature of fiscal adjustment in the distribution pattern through tax transfer mechanism depends on dis­tribution of factor income as determined by market forces and poli­cies of the allocation branch.

Market Failure: Instance # 6. Market Efficiency and Income Distribution:

Efficiency and equity objectives conflict with each other in a private market system. The market oriented system, because of its basic features always favours the rich, who possess the ownership of the productive resources.

The economic activities in a market oriented system perpetuate income inequality and lead to the deprival of the poor.

There is no fair sharing of the cake of national product in the market process of distribution. The unfair income distribution in a market economy lead to economic inefficiency. Therefore equity goals are live topics of public policy.

The tools of welfare economics are vital instruments to affect fairness in income distribution. It is there­fore necessary for the government to correct income distribution through appropriate budgetary policy.

Developing economies are always characterized by low income, low capital formation, underutilization of resources, higher level of under employments etc. Economic growth is a primary objective of these economies.

The private sector in these economies did not care to provide for the necessary infrastructure and basic facilities required for a rapid economic growth. Therefore in a developing economy because of its peculiar characteristics the public sector investment and increased participation of government in regulating economic activities are imperative.

Under various ideal conditions related to competition, perfect information, absence of externality or public good the private com­petitive market can allocate resources optimally. However in reality the ideal condition is far from practical situation, Very often competi­tive market system fail to obtain rational allocation of resources ow­ing to the factors analyzed above.

Monopolies externalities, provi­sion of public good, policies relating to issue of distribution and sta­bilization are the problems which prevent the market based alloca­tion to obtain efficiently.

We call it as instance of market failure in a market oriented economy. Therefore it is argued that public sector may be able to correct various Allocative inefficiencies, instabilities or inequalities that result from private market resource allocation.

But economists doubt the possibility that may exist, when the poli­cies aimed at correcting market failures may also misallocate re­sources, leading to a situation of government failure.

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