Problem Areas for the Market

The sources of market failure can be grouped into tour major categories: (a) externalities, (b) public goods, (c) poor information, and (d) monopoly.

When externalities are present, the market may fail to confront decision-makers with the proper incentives. Since decision-makers are not forced to consider external cost, they may find it personally advantageous to undertake an economic activity even though it generates a net loss to the community. In contrast, when external benefits are present, decision-makers may fail to undertake economic action that would generate a net social gain.

When external costs originate from the activities of a business firm, the firm's cost curve will understate the social cost of producing the good. If production of the good generates external costs, the price of the product under competitive conditions will be too low and the output too large to meet the ideal requirements of economic efficiency.

External costs result from the failure or inability of a society to establish private property rights. Clearly established private property rights enable owners to prohibit others from using or abusing their property. In contrast, communal property rights normally result in overutilization, since most of the cost of overutilization (and misuse) is imposed on others.

When external benefits are present, the market demand curve will understate the social gains of conducting the activity. The consumption and production of goods that generate external benefits will tend to be lower than the socially ideal levels.

The efficient use of air and water resources is particularly troublesome for the market because it is often impossible to apportion these re sources and determine ownership rights. A system of emission charges (a pollution tax) is capable of inducing individuals to make wiser use of these resources. Emission charges (a) increase the cost of producing pollution-intensive goods, (b) grant firms an incentive to use methods of production that create less pollution, and (c) provide producers with an incentive to adopt control devices when it is economical to do so.

When the marginal benefits (for example, cleaner air) derived from pollution control are less than the social gains associated with a pollution-generating activity, prohibition of the activity that results in pollution (or other external cost) is not an ideal solution.

When the control costs of firms vary, the emission charge (pollution tax) approach will permit society to reduce pollution by a given amount at a lower cost than will the maximum emission standard method. which is currently widely used. The marginal cost of attaining a cleaner environment will rise as the pollution level is reduced. At some point, the economic benefits of a still cleaner environment will be less than the costs.

In evaluating the case for government intervention in situations involving externalities, one must consider the following factors: (a) the magnitude of the external effects relative to the cost of government action; (b) the ability of the market to devise means of dealing with the problem without intervention; and (c) the possibility that the political majority may carry the government intervention too far if the external costs imposed on the minority are not fully considered.

When it is costly or impossible to withhold a public good from persons who do not or will not help pay for it, the market system breaks down because everyone has an incentive to become a free rider. When everyone attempts to ride for free, production of the public good will be lower than the socially ideal level.

The market provides an incentive for consumers to acquire information. When a business is dependent on repeat customers, it has a strong incentive to promote customer satisfaction. However, when goods are either (a) difficult to evaluate on inspection and seldom purchased repeatedly from the same producer or (b) have potentially serious and lasting harmful effects, consumer trial and error may be an unsatisfactory means of determining quality. Franchising and brand names often communicate reliable information on product quality to consumers and thereby reduce the likelihood that consumers will be cheated or misled, even in cases when the specific item is not purchased regularly.