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Market failure refers to a situation where the market forces fail to ensure efficient allocation of resources. There are different forms of market failures which require different form of intervention (Pindyck, 2005).

Situation 1

Negative Externality

In the production of cement sifters, the producer also pollutes the river and affects the plants and hence human beings. As such, the producers do not account for the cost caused to the society but rather consider just the cost of production in the pricing criteria. The solution to such problem is to make the producers account for the marginal external costs as indicated below.

From the above diagram, the market forces give equilibrium at P1 and Q1. At this point the producer does not account for the Marginal External Cost (MEC). This leads to overproduction of the pollutant. To collect it, the producers are forced to account for the externality and hence the supply curve shifts from PMC to SMC. Prices increase to P* from P1 and quantity reduces from Q1 to Q*. The reduction of the quantity reduces pollution and hence socially optimal equilibrium. 

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Situation 2

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Positive Externality

Positive externality occurs in a place where a consumer or the state benefits from provision of a particular good or services and yet they don’t pay for it. In this case, by state providing tuition free university studies for state residents, production increases and hence society benefits from such a program. However, there is a tendency of under-provision of such services due to the public failing to account for the benefits derived from educated students in the labor market.

The authorities may force the society to pay for such benefits by such things as taxation. That way, the authorities get more money that enables them to provide even more free tuition studies. This way, the equilibrium shifts from the market determined equilibrium (P1, Q1) to a socially optimal equilibrium (P*, Q*).  

Situation 3

Public Good

Public goods are goods that are generally provided by the government. The reason for government provision is because provision of goods is expensive, non-excludable and non-rivalry. It is non-excludable by the fact that it is impossible or highly expensive to prevent people from using the goods, such as the road that was paved at Bob’s expense. They are non-rival by the fact that marginal cost from usage by an extra person is equal to zero (Arnold, 2001).

For this reason Bob cannot limit the usage of the road to only those who have paid, no matter if there is the willingness by the residents to make such payment. This leads to market failure in the sense that, though the residents are unwilling to contribute due to the free-rider’s problem, the road would help improve their welfare. Such goods should therefore be provided by the government which may be able to indirectly tax the user of such road through fuel tax among other taxes to raise funds for road constructions.                                     

Situation 4:

As noted in the situation 3, the public will not be willing to contribute for provision of the public good and if anything, the amount that they would be willing to contribute would be less than required due to the free-riders’ problem. Therefore, the advisor who says that the public good may not be provided through the proposal made by the president is right. For the good to be provided, the government must not depend on the voluntary contribution but rather come up with the tax policy that will be perceived fair by the citizens to avoid avoidance and evasion and also to be efficient. The diagram below indicates that size of the national defense will be optimally provided when the society is forced to pay for the benefits derived through indirect taxation.Public Good

Therefore, such tax helps to reduce the cost of the national defense to the government in the current budget. 

 

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