MARKET FAILURE

1. MARKET FAILURE AND
FREE RIDER PROBLEM

2. INTRODUCTION
 In a perfect market resources used in the production of goods and
services would be allocated efficiently
 Producers trying to maximize their profit, will produce what
consumers want to buy and will do so at least cost.
 Competition will ensure that the mix of goods produced
corresponds to consumers preference.
These are the highly realized picture of the market system.
But in reality the market are imperfect. Because various
difficulties arises in the optimization of resource allocation.

3. MARKET FAILURE
 The first use of the term Market Failure by economists was in
1958.
 Market failure is a situation in which the allocation of goods and
services is not efficient.
 Market failures are often associated with time-inconsistent
preferences, information asymmetries, non-competitive markets,
principal-agent problem, externalities or public good
 Existence of market failure is often the reason that Self-
regulatory Organizations, Govt. or other national institutions
intervene in a particular market

4. Causes of Market Failure
 Incomplete Market
 Indivisibilities
 Common Property Resources
 Imperfect Market
 Asymmetric Information
 Externalities
 Public goods etc.,

5. Incomplete Market
 Market for certain things are incomplete or missing under perfect
competition.
 There is no way to equate the Social and Private Benefits and
Cost either in the present or in the future, because the markets are
incomplete or missing.

6. Indivisibilities
 In reality, goods and factors are not infinitely divisible. Rather
they are indivisible
 The problem of indivisibility arises in the production of those
goods and services that are used jointly by more than one person
Example:- A Road in a locality

7. Common Property Resources
 Common ownership when coupled with open access, would also
leads to wasteful exploitation in which a user ignores the effects
of his action on others.
 Open access to the commonly owned resources is a crucial
ingredient of waste and inefficiency.
Example:- Fish in a lake

8. Imperfect Market
 Pareto efficiency increases under perfect competition. But it
declines under market distortions or imperfections.
Example:- The case of monopoly

9. Asymmetric Information
 Pareto optimality assumes that producers and consumers have
perfect information regarding market behaviour
 In real world, there is asymmetric (incomplete) information due
to ignorance and uncertainty on the part of buyers and sellers
 Unable to equate social and private benefit and cost

10. Externalities
 Externalities are market imperfections where the markets offers
no price for service or disservice.
 It leads to malallocation of resources and cause consumption or
production to fall short of Pareto optimality.
Positive Externality:- An activity which create benefit
to the society.
Negative Externality:-Consumption of a good or
services by one will reduce
utility of others

11. Public Goods
 one whose consumption or use by one individual does not
reduce the amount available for others
Properties
 Joint consumption or non- rivalness in consumption by several
individuals.
 Non-excludability
 Indivisibilities and collective consumption
Example:- National Defence, Sun light, Air etc.,

12. Conti….
 Once the public good is produced and supplied a number of
people will collectively benefit from it, regardless of whether or
not they pay for it.
 The price system can be inefficient in public goods, but in the
case of private goods the price system can be efficient.
 Public goods creates the serious problem of free riders.

13. FREE RIDER PROBLEM
 Common among public good.
 When those who benefit from resources , good or services do not
pay for them , which results in an under provision of those goods
or services.
Eg: Mosquito abatement programme.

14. How free rider problem leads to market
failure
 The presence of free rider create problems for the market
to provide public goods efficiently.
 Market failure occurs when the act of free riders fail to
communicate appropriate signals to the allocators of
resources in the market.
 Allocative efficiency requires that all who benefit from the
consumption of goods signal those benefits to the providers
of goods.

15. Solution to free rider problem
Imposition of tax
Marketable pollution permits
Make public goods private
Appealing To People’s Altruism etc.,

16. 1. N . RADHAKRISHNAN (2013) “PUBLIC
FINANCE THEORY AND APPROACH”
VRINDA PUBLICATIONS (P)LTD. PP 32-39.
2. HTTP://WWW.ECONOMICSHELP.ORG/BLO
G/1626/ECONOMICS/FREE-RIDER-
PROBLEM/
REFERENCES