Market Inefficiency: The Externality Problem - Essay Example

Market Inefficiency: The Externality Problem [ID Market inefficiencies are a major part of economic theory. Clearly, markets do not always work ideally: We have had the Great Depression, ecological destruction, etc. So what causes market inefficiencies? There are many factors such as incomplete information, irrational behavior, and so forth, but externalities are one of the most serious.Market failures are defined by Investor Words as “A condition in which current prices do not reflect all the publicly available information about security, such as when some individuals get certain information before others, or when some individuals do not properly analyze the available information”.

Market failures, like most market functions, are about information. Markets work the best when they use prices to signal information to producers and consumers the social cost of an item, and allow them to choose among the best options using this information. When markets cant does so, they fail.One of the worst types of market failure is the externality. “An externality is an impact of an economic transaction that falls on someone outside the transaction. The nice smell of your neighbor's barbecue is an example of a positive externality, and your insomnia when he buys new sub-woofers would be a negative one.

These externalities are treated as rare occurrences in economic theory, but the reality is that external effects of our actions are everywhere” (Larson, 2009). Externalities in conventional economic theory are treated as a problem because they prevent producers and consumers from making efficient decisions: If a product made with more pollution costs less, then the society has to pay for pollution. But externalities have all sorts of other impacts. Financial externalities are to blame for the current meltdown: Companies like AIG externalized risk onto the rest of the economy.

Global warming, pollution, habitat loss, species extinction, deforestation, and industrial accidents hurting workers are all examples of externalities.Externalities, unfortunately, have an almost infinite number of sources. Any market that involves industrial production, for example, can have pollution as an externality. The same thing is true of any agricultural market that uses deforestation as a mechanism to gain real estate. If it is cheaper to overwork workers or have them in unsafe conditions, even considering legal liability, then unsafe working conditions will be an externality caused by the expensiveness of safety mechanisms.

And some industries make extensive money off of externalities. Pollution cleanup companies and medical doctors, for example, can benefit from externalities.One problem could be that GDP itself counts externalities positively (Cohn, 2007). One source, then, of externality, is our own flawed macroeconomic theory, that misleads companies!The three best ways to deal with externalities are voluntary consumer and producer behavior, and regulation. Unfortunately, both of the first two require people to ignore their self-interest and thus undermine Smiths' harmony of interest; they also require people to have information outside the market structure, which is inefficient and unsustainable.

Producers who do not engage in externality-producing behavior, for example, can fall behind those who do. Consumers are somewhat more likely to support the kinds of businesses they want to, but certainly, many consumers do not buy green goods because of cost.The best solution, then, is government regulation (Cohn, 2007; Larson, 2009; Butler and Macey, 1996). But how should the government proceed? First of all, local regulation is the best approach (Butler and Macey, 1996). Local and regional governments can make sure that any regulation won't itself produce unwanted externalities.

Second, the government should interfere in the pure market outcome when people's rights are being violated. Pollution violates the rights of non-consumers to have clean health. Third, the government needs to proceed when externalities are so inefficient as to cause extremely anti-social outcomes.Externalities are the most serious market inefficiency and therefore need the most direct and strict government response.