Theory of market failure:
Market failure is a technical expression for certain situations where market is found to produce outcomes inefficiently. It may produce more than or less than what is socially desirable or not at all. It means that market allocates resources inefficiently in those situations. For Example, market is likely not to produce national defence at all, produce less primary health than is socially desirable or more pollution that could be willingly tolerated by the society.
Why markets fail in certain cases? It is suggested that when microeconomic decision- making in market fails to adequately capture costs and/or benefits in prices the market outcome is likely to diverge from socially desired outcome. It may also happen when market structures are sub-optimal.
Existence of externalities is the basic reason for market failure, which we shall be concerned with in this unit. Bee-keeping activity of a private honey-maker may help pollination in neighbour's orchard and may make passers-by a sting. Both are externalities as both are unintended fallouts of the activity undertaken by the beekeeper. While the former is a case of positive externalities as the third party gets some benefit without making any payment, the latter is a case of negative externalities, as the third party gets hurt for none of his fault. The extreme example of externalities is existence of public goods (or public bad), which have twin characteristics of non- rivalry in consumption and non-excludability from consumption.
Public, private and merit goods are interlinked in the economy. They satisfy the consumer in different ways. Due to competition for resources question arises as to what should be produced in the economy. In the course of production/consumption of some goods, externalities a rise in the market, which leads to inefficiencies whereby the consumption and production quantities do not match. An example of externality is pollution, where market fails to provide solutions. The government in many ways can tackle inefficiencies due to market failure. Because of non-rival and non- excludability features of Public Goods, they are not produced efficiently in the market.
Prisoner's Dilemma and Lindahl pricing techniques have helped us to understand how the consumer behaves in the society and also an action of one person affects the action of another person. Public good theory is widely applied in the day to day market where it can be converted into a private good. It thus states that a good at one time can be public and the same good at another time can be converted into private good.