Apparently is seems that for the operation of an economic system, price mechanism or market model is plausible. But in real life, perhaps, it is not so, particularly when we see the role of externalizes, lack of information, monopolies and misallocation of resources etc. Such like events are given the name of market imperfections which obstruct the smooth working of price-mechanism. Before observing such all, we introduce what market imperfections are: If at any time the forces of demand and supply could not play their dues role the market becomes imperfect.
Thus, “by market imperfections we mean those defects which interrupt the smooth functioning of price mechanism.” It is reminded that if the market is perfect, the factors will get the payments equal to their marginal product; consumers will maximize their satisfaction; price of a good will remain same throughout the market; the wages of a labor will remain same in the labor market, national income will be distributed fairly, and equitably, and resources will be allocated optimally. All this phenomenon coincides with “Pareto’s Optimality”.
The market imperfections will be analyzed with reference to those defects which rise with in the capitalistic system and those defects which are out of the system.
- Misallocation of resources
Under market mechanism the resources will be allocated in those uses which maximize owner/producer’s profits. This means that market will minimize both the efficiency and output. This was identified by Smith in the form of motivate of self-interest, while following Pareto, it was given the name of ‘ Pareto’s Optimality’. In such state of affairs, resources prices will be settled by the forces of demand and supply and output will be produced with the least cost. The resources will be allocated in such a way that there will be no divergence between private benefit and social benefit. But practically, it does not happen and we find a long range of misallocation of resources. They are discussed as:
- The maximization of efficiency and output is furnished with a lot of restrictive assumptions like existence of perfect competition both in goods and factors markets, perfect information regarding presents and future prices, independence of consumer tastes from another, divisibility of capital, no increasing returns to scale and no external economics. In real life, all above assumptions are not available.
- When above mentioned restrictive assumptions are not met, there will be irrational decisions on the part of owner / producers regarding allocation and utilization of resources. As results, the resources will be utilized below the maximum point.
- The optimum allocation of resources is also subject to the availability of perfect information. But in capitalistic economies, particularly in developing countries laborers are hardly aware of with the employment opportunities. This checks the labor mobility. Hence, on the one side more people get higher wages (more than market determined wages), some other work on subsistence wages (less than market determined wages). In addition to labor, people are ignorant about investment opportunities. Hence, the savings assume the form of hoarding or diverted in purchasing the jewelry or land. Because of ignorance or lack of information some people reap abnormal profits while some others have to face fall in purchasing power of their hoarded money and return foregone. Thus, in the presence of reduced or limited information about goods, factors and capital markets, the consumer or producer is unable to make rational choice -what he is doing and what he is foregoing. In such situation, the market equilibrium will hardly be attained at optimal situation.
- Accordingly, to H. G Johnson, ‘Ignorance, illiteracy, traditions and poverty’ are basic obstacle in the perfect markets. Due to rigid social set-up (in UDCs), the inventions and innovations are not encouraged. Private units (firms etc) are very much secretive in their actions. This irrationality in decisions is further compounded in UDC’s by decisions which are influenced by traditions. As a result, not only production but the level of efficiency also remains at the lowest level. The specialization and division of labor is obstructed and least cost combinations are not met.
In market economies, the externalities or external effects also distort the situation of efficient allocation of resources and maximization of output when we find the divergences between private and social benefits. The externalities may be concerned with production activities which are carried-on without considering their side effects on the others. For example, if a producer installs a chemical plant and maximizes his output/profits, but he does not make any compensation to those persons who dwell near the plant and have to face the polluted atmosphere. In this way a divergence between private benefits and social benefit may emerge. Again, the investment in a certain line may increase the profit of another investor whose project is complementary to it. In this situation, social benefit may exceed the private benefit. The market mechanism fails to entertain and evaluate these external effects.
Regarding consumption externalities, the external renovation of a house by an owner may lead to enhance the beauty of the whole street. “While” the non-existence of a road etc.to a particular locality may lead to reduce the value of the locality. From the above discussion one finds that private cost and benefit calculations, which are the basis of market allocation, do not provide a sound basis in decision making from the social point of view. Thus, the ‘price’ is not always true that invisible hand will make an identity between private and social interest.