Question

Identify four of the six reasons why the market mechanism may not result in Pareto Efficient allocation of resources resulting in market failure. Define briefly and provide one simple example for each.

Answer 1

In the real world there is problem of not attaining optimal welfare or Pareto optimality due to a number of factors and this results in market failure.Market failure is a situation in which the productive resources in the economy are not utilised efficiently.The four reasons are 1) presence of externalities-The existence of externalities in production and consumption cause market failure. Externalities refer to imperfections in the market which cause mal- allocation of resources.As a result production and consumption is not up to the level of pareto optimality .Externalities are also known external economies and diseconomies.External economies and diseconomies of both production and consumption influence the resources to be allocated in an adverse manner and does not lead to pareto optmality.As for eg when external diseconomies of production are more like a factory gives out smoke which affect the health of residents in that area,social marginal cost is more than social marginal benefit and firms will produce more than socially optimal level.

2) Public goods-The existence of public goods is another cause of market failure.The consumption of public goods is available to everyone and consumption by one does not reduce the consumption for another . Eg public park.The pareto condition for public good is Marginal social benefit should be equal to marginal social cost.Public goods create positive externalities.The externality begins when public cost of consuming a public good is zero but price more than zero is charged.Certain public goods are not consumed equally by all . For eg in certain bridges toll tax are taken and those who pay can only use it.

3)Indivisibilities- Complete divisibility of factors of factors used in production and consumption is a condition of pareto efficiency.But in reality factors are not divisible and they are indivisible.As for eg a road is used by many people in the locality.

4) Common property right-Common property right is a cause of market failure. For eg fish in a lake can be caught by anyone. So the use of the lake to catch fish leads to overuse of public property and reduction in social gains.