What Causes Market Inefficiency - Essay Example

The following situation may lead the market mechanism is not leading to the most efficient output and the market will fail. These situations can be classified under the following head: 1. Externalities 2. Presence of Merit Goods and De-Merit Goods 3. Private Goods and Public Goods Externalities are a situation when a particular business transaction affects other parties that are not directly involved in the business decision process or business operation. The examples of externalities are, suppose that a person is suffering from a contagious disease.

He considers that by going to a doctor, his costs will be the fees paid to doctor and benefits will be the cure of the disease. However, he will not take into account the fact that if he does not go to the doctor, other people might catch the same disease. This will result in less-urgency for him to go to the doctor. This shows how ignorance of negative externalities can lead to overproduction or irrational response. Now, let’s look at the example of a negative externality in the context of a business or economic decision.

Suppose you want to buy a car. The main consideration for the purchase will be the cost of the car and possible benefits attained from the car. However, the market mechanisms will ignore the impact of car purchase on the environment and other parties such as pollution, road congestion, and accidents. This ignorance may tempt you into purchasing the good and hence there will be an over-production of good due to negative externalities.