Question

Usually, with a market failure or externality a government needs to step in to impose penalties?

Answer 1

The market is said to be the most efficient when it ensures all efficiencies. It guarantees all types of economic efficiencies like Productive efficiency, Allocative efficiency, Dynamic efficiency, Social efficiency and X efficiency.

A productive efficiency exists when the economy get maximum output from a given optimal combination of inputs. This can be achieved when the firms are operating at the lowest point of their average cost. This lowest point of average cost can be obtained when the firm is producing at its maximum productive capacity. Thus in an economy with productive efficiency, it will produce on its production possibility frontier where the Pareto optimality condition is satisfied.

The Allocative efficiency means all goods and services are distributed according to the consumer’s preference which they express through their willingness to pay for the goods or services.

A dynamic efficiency occurs when new technology and innovation reduce the production cost

The social efficiency is one where the marginal social cost of production is equal to social benefit.

X- Efficiency is purely internal to the firm. It occurs when the managers have incentive to produce maximum output.

The absence of these efficiencies results in market failures. The inefficiency in a market can occur due to several reasons. They are Positive externalities and negative externalities, lack of public goods, under production of public goods, over provision of demerit goods and the existence of monopoly power.

Positive externalities are the benefit availing to a third party from the production of particular goods. But a negative externality is the adverse effect on a third party from the production of particular goods. The existence of negative externality is considered to be a market failure.

The public goods are collectively consumed and their production cost does not increase with the number of consumers. The under production of public goods is considered as a market failure.

Merits goods like health care, education and sports etc increase the social benefit. A market with the lack of such goods is considered to be a failure.

The demerit goods are those whose consumption increases the social cost. For example the consumption of alcohol, cigarette, drugs etc increase the government expenditure on health care. If this goods are over produced and consumed the market is said to be in failure.

A monopoly market is usually restrict output and charges high prices. In such market the consumer’s choice and welfare is damaged. If the market is controlled by monopoly power it is considered as a failure.

For reducing the negative externalities the government imposes tax on the production of commodities to discourage their production and consumption. The imposition of tax increases the consumption cost which intern reduces its consumption. The imposition of tax on the production of commodities which created negative externalities reduces its consumption further. The penalities are imposed on the firms who pollute the environment and cause social cost of increase. The revenue from such taxes is used for the enhancement of production of those goods which increase the positive externalities.

The government can enhance the positive externalities by giving subsidies and tax concession on goods that create more externalities.

The public goods can be provided by the government. The government largely invests in infrastructure facilities so as to increase the provisions for public goods.

The merits goods are also increased by the government in investing in health care and educations etc.

The monopoly power can be controlled by the heavy taxation and taking over the monopoly industries which cause market failure by the government.