Imperfect market externality:

We will be able to obtain optimum welfare in competitive market conditions through economic reorganisation. But the real life conditions do not always exhibit the competitive features of the market owing to some constraints. Therefore, we are unable to attain optimum welfare. In this unit, we will examine these conditions, which lead to market failure and inability to obtain optimum welfare in the society. We shall also discuss the phenomenon of externality, which is peculiar to the consumption of public goods. The competitive market provides an efficient outcome. However, we face to imperfect markets, information asymmetry, externalities and presence of public goods, which contribute to non-attainment of such a position. In case imperfect competition, price and marginal cost equality required for Pareto optimality is violated. Again, between a pair of goods, the ratio of shadow price is not equal to their ratio of market price.

Externalities give rise to market inefficiencies whereby the consumption and production quantities do not match., Pollution is a common example of externality, where market fails to provide solution. It necessities collective solutions such as government intervention. When there is uncertainty about costs and benefits, shapes of marginal cost and marginal benefit may have to be taken into account for adopting one of the collective solutions.

Inefficiencies due to market failure may be tackled through bargaining among the affected parties. Coase theorem offers a solution to include clearly defined property rights, when transaction costs are zero. Public goods, because of their non-rival or non-exclusive features, are not produced efficiently by the market. To bring in efficiency to public goods provision, the vertical sum of the individual demands must be made equal to the marginal cost of their production.