ArtsAutosBooksBusinessEducationEntertainmentFamilyFashionFoodGamesGenderHealthHolidaysHomeHubPagesPersonal FinancePetsPoliticsReligionSportsTechnologyTravel


Updated on May 1, 2012

Market Imperfections and Failures of market Mechanism

Market failure is the inability of an unregulated market to achieve, in all circumstances, allocative efficiency. The classical economists were of the view that in a free enterprise economy, price mechanism operates, smoothly and efficiently in solving economic problems of the society. According to them, price mechanism is the only automatic regular' which can achieve maximum satisfaction of peoples wants, with a minimum use of resources. Here, they say, each individual is motivated by self interest. The consumer spends his money on those things which gives him maximum satisfaction. Likewise, the producer employs the methods of productions which involve the least cost per unit of output. The fundamental economic decisions of what is to be produced, how much is to be produced, how the output is to be produced and the decision for whom to produce (distribution of national product) are solved through the competitive market system. There is freedom of enterprise and choice.

Role of government in market economy

The classical economists firmly believed that the system of market in a competitive economy promotes high degree of efficiency in the use of its resources. Therefore, the government should not interfere in the freely market system. The role of the government should only be confined to (i) the maintenance of law and order in the country (ii) provision of justice and (iii) protecting the frontiers of the country. in case, the government exercises its authority and market system is not allowed to function by an 'invisible hand', it will not promote the efficient use of resource.

Market imperfections: in a capitalistic economy, the market system determines which types and quantities of goods are to be produced. The consumers, here, are free to buy what they choose. The goods are produced with least cost combination, Profit is the guiding force in making production decisions. The supporters of free enterprise economy claim that market mechanism works so efficiently and effectively that it ensures the maximum welfare for the society as a whole.

In the capitalistic world, however, we find that producers are not really free to produce what they wish. The consumers are also not sovereign. The decisions rendered by buyers and sellers of product and resources are also not very effective through the market system. When the forces of demand and supply do not play their due role in the market, the market becomes imperfect. Market imperfections, thus, are the failures or flaws or defects which interrupt the smooth working of price mechanism in promoting the efficient use of resources. The main market imperfections in brief are as under.

  • Inefficient use of resources: The virtue of market system, as claimed by the classical economists, is that it promotes the efficient use of resources. It guides resources into production of those goods and services which are most wanted by the society, Practically, we find that in developed and more in developing countries, the functioning of market mechanism in the resource allocation is not perfect. There are basic obstacles in the free working of price mechanism. For instance ignorance about prices of goods and services, illiteracy, customs, traditions poverty etc. stand in the way of forces of competition. The society, thus, is deprived of attaining the efficient use of resources for production.
  • Externalities: Another serious shortcoming of market mechanism is that it does not take into consideration the externalities or spill overs associated with the production or consumption of any good or service. Externalities are the activities that effect others for better or worse without those other paying or being compensated for the activity. For example, the installation of a chemical plant or a coal burning steel mill in a residential colony creates pollution and leads to economic inefficiency. The firms no doubt may be producing the maximum output with least cost combination and earning maximum profit but they are not considering the side effects of pollution on the residents of that area. In the same way, the setting up a park, construction of road, provision of electricity etc in a area spreads to that locality. The market mechanism fails to consider the economic effects of externalities on resource allocation.
  • Consumer's sovereignty no longer valid: The classical economists are of the view that in a free enterprise economy, the producers and resource suppliers work to the dictates of consumers. The consumers are said to be king or sovereign in a free market economy. In the real capitalistic world, however, the position is now changed. Consumer's sovereignty is considered a smith. The growth of multi national corporations and other big businesses have greatly weakened the forces of competition. The position of the consumer is now that of a chained king.
  • Price distortion: In a competitive market system, the forces of demand and supply determine the prices of goods and services. The prices are the signals on which the consumers, resource owners and entrepreneurs make their free choices in the selection production and distribution of commodities.

In the real capitalistic world, another cause of market failure is the weakening of competition. Prices of consumer goods and factors of production mostly do not represent the competitive prices. The monopolists and the oligopolists are controlling the prices of goods and factors and are charging higher than they could get under competitive conditions. As a result of price distortions, the prices are no longer, the guide posts of the preferences of the consumers and the real value of factors of production.

  • Economic instability: Another flaw of competitive market system is that it causes fluctuations in the levels of economic activity and employment. The periodic ups and downs in the level of prices, output and employment cause instability in the economy and lead to inefficient use of resources.
  • Bias against the production of capital goods: In the free market mechanism, individuals are led by self interest in the pursuit of economic activities. The entrepreneurs, prefer to produce consumer goods which have a wide market and are easily saleable at attractive prices. The production of capital goods requiring heavy funds is ignored. The resources are divested in meeting the immediate consumption demand rather than making investments in the production of capital goods. The entrepreneurs are also not interested in spending money on the construction of roads, dams, bridges, canals, provision of electricity etc. as these do not promote their self interest.
  • Maximum social satisfaction of wants is not a reality: The advocates of free market system claim that freedom of enterprise, ensures maximum social satisfaction of society at the minimum of social cost. The fact, however, is that under free market mechanism only those goods are produced for which people have willingness and ability to pay. For example, if a class of the people are interested in the purchase of cars, television, cosmetics etc., then the resources will be diverted to the production of these goods. The production of necessaries will be curtailed. We, thus, conclude that free market system does not increase the satisfaction of the society as a whole.
  • Inequalities of money income: Another shortcoming of the free market economy is that it does not provide equal opportunities of acquiring wealth, property, skill, education to the people, As a result, thereof, there is unequal income distribution which creates hatred, dissatisfaction between the 'have' and 'have notes.

Keeping in view the market failures in achieving greater efficiency in resource allocation, provision of goods etc the economic functions of the government both in the developed and developing countries of the world have considerably increased. Government is now providing legal framework and the necessary services for a market economy to operate efficiently. The role of planning in the capitalistic countries, have considerably increased.


    0 of 8192 characters used
    Post Comment

    No comments yet.