The market will not lead to social efficiency if the actions of producers or consumers affect people other than themselves. These effects on other people are know as externalities: they are the side effects, or 'third-party' effects, of production or consumption. Externalities can be either desirable or undesirable. There are four major types of externality.
1)External cost of production (MSC > MC)
The marginal social cost (MSC) of chemical production exceeds the marginal private cost (MC). For example, when a chemical firm dumps waste in a river or pollutes the air, the community bears cost additional to those borne by the firm. The problem of external costs arises in a free-market economy because no-one has legal ownership of the air or rivers and can therefore prevent or charge for their use as a dump for waste. Control must, therefore, be left to the government or local authorities.
2) External benefits of production (MSC < MC)
Marginal social cost is less than marginal private cost.
One of the example of external benefits in production is that of research and development. If other firms have access to the results of the research, then clearly the benefits extend beyond the firm which finances it. The firm only receives the private benefits, it will conduct a less than optimal amount of research.
3)External cost of consumption (MSB < MB)
The negative externalities make the marginal social benefit less than the marginal private benefit.
Example, the usage of cars would caused others to suffer from their exhaust, added with congestion and noise.
4)External benefits of consumption ( MSB>MB)
Marginal social benefit is greater than marginal private benefits.
For example, Some people prefer to travel by MRT trains than by car. They benefit by being less congestion and exhaust and also fewer accidents on the roads.
This is another source of market failure which is similar in nature to the problem posed by the commons. These category of goods of free market, whether perfect or imperfect will underproduce or may not produce at all. Public goods, such as national defence, are non-rival and non-excludable. Consequently, they give rise to the problem of free-riding: everyone wishes to free-ride on the efforts of others. This implies that the market cannot supply such goods, and a non-market mechanism has to be found.
Ignorance and Uncertainty
There is often a great deal of ignorance and uncertainty in the real world which result in market failure. Perfect competition assumes that consumers, firms and factor suppliers have perfect knowledge of costs and benefits. Thus people are unable to equate marginal benefit with marginal cost.
Immobility of Factors and Time-Lags in Response
Even under conditions of perfect competition, factors may be very slow to respond to changes in demand or supply. For example, Labour, maybe highly immobile both occupationally and geographically. This can lead to large price changes and hence to large supernormal profits and high wages for those in the sectors of rising demand or falling cost.
Protecting People's Interests
The government may feel that people need protecting from poor economic decisions that they make on their own behalf. It may feel...