Markets coordinate independent decisions by providing public signals to which producers react. Markets also give signals to consumers that allow them to respond to relative scarcities in the economy.
The major argument in favour of the market system is that “it provides a reasonably efficient and impersonal method of regulating the ever-changing pattern of the allocation of resources.”
The great virtue of the market is in providing automatic signals to producers. It coordinates, in the absence of a central planning authority, the decisions of millions of producers and consumers. A decentralised price system ensures efficiency, not chaos or disorder.
It is a communication device for pooling the knowledge and information of numerous buyers and sellers. True, decentralised decisions regarding resource allocation requires the existence of some form of market signal. This must be supported by a system of incentives to business firms and factor owners so that they can quickly respond to opportunities.
The alternative to this is government intervention. If the government holds price below equilibrium, alternative allocation system must be found. Rationing is the most commonly used method. But, it has certain drawbacks. Corruption is always present. And people always succumb to it.
There are certain areas of the economy where the market fails. This is the proximate reason why the government intervenes in the market.
The reasons for government intervention are as follows:
1. Social Cost:
Social costs are that which may or may not be borne by the firm. Social costs not borne by the firm are often ignored by business managers, but are considered important by economists, particularly those involved in questions of public policy.
Most business firms are interested in only those costs that are incurred by their own business. There are, however, costs that are incurred by those outside the firm. Consider, for example, the person who hangs laundry in the backyard to dry. A factory is built next door that emits smoke and dirt from its chimneys, dirtying the air in the backyard to the extent that no individual can hang laundry out to dry.
The cost is borne by persons outside the firm. Nowadays it is felt that the firm must bear the cost of cleaning its effluent, passing the costs on to the users of its products or its shareholders. So, there is need for government intervention if there is divergence between private and social cost.
2. Market Imperfection:
We do not live in the unreal world of perfect competition, but in the real world of imperfect competition. And a second source of market failure is market imperfection.
(a) Imperfections affecting factor behaviour:
The price system fails to operate in the labour market which is far from perfect. Trade unions often demand and succeed in getting higher wages even when there is no excess demand for labour (Rather there maybe excess supply or unemployment). Unions can put insurmountable barriers to labour mobility. They can limit membership and restrict the supply of labour in a particular sector or trade.
Markets are also poor allocators of labour among various uses if labour fails to receive the signals provided by the market. In reality, many people do not have any clear idea of their life-time earnings.
(b) Imperfections affecting firm behaviour:
K.J. Arrow first pointed out that when we depart from perfect competition and/or profit-maximising behaviour, firms achieve the power to interfere with the behaviour of the market. The monopolist can restrict output, raise price artificially and exploit the consumer. It is in this context that J.K. Galbraith introduced the term of ‘countervailing power’.
True, monopoly power prevents resources from moving in response to market signals. A rise in demand for a monopolist’s product will cause a rise in the monopolist’s profits. Resources will not be allocated from less profitable to more profitable uses as in perfect competition.
(c) Imperfections affecting consumer behaviour:
A market system is said to work if it responds quickly to changes in consumers’ tastes. But the market system will fail to work if consumers are misinformed about the products they buy. As H. A. Simon suggests, an individual will be satisfied once he has achieved a minimum (rather than maximum) level of utility from a set of purchases, and having reached that level he is unlikely to be motivated to devote further time and energy to make marginal improvements in his level of satisfaction. Lipsey argues that “lack of correct information can be an important cause of market failure.”
3. Collective Consumption Goods:
Certain goods or services, because of their nature, are to be provided by the government. Examples are roads, highways, street lighting, public parks, national defence, etc. Such goods, if they provide benefit to anyone, necessarily provide them to all other members of society. These are to be consumed by all members of society jointly.
This is why they are known as collective consumption goods. In such cases we cannot apply the exclusion principle (we cannot exclude anyone from enjoying such invaluable services if any one does not pay for them). These things are not made available through the markets and we do not pay prices for them. We pay for such valuable services through taxes. So, the market system fails to work in case of such goods.
4. The Optimal Correction of Market Failure:
The question of market failure or more specifically social cost has recently received a great deal of legislative attention. In today’s social environment, however, an effort is being made to internalise such costs. No longer will the public have to pay for the costs of clean air and water, for example, but the firm just bears such external costs.
True control of pollution and externalities is costly. From the economic point of view such control makes enormous good sense when stress is more on the quality of life than on material gains. So, less developed countries like India may, however, welcome new industries on employment and revenue grounds, but rich countries may seek to remove some of their existing industries in order to avoid unpleasant social costs they bring.