What is Market Failure?
In a market where there is equilibrium, the resources are allocated in the best possible manner and there is 'allocative efficiency'. Allocative efficiency is when situation where Marginal cost is equal to Marginal revenue. However, this is not possible in the real world. Market failure exists when the resources are not allocated efficiently. Community surplus is not maximised and thus there is market failure. From a community's point of view, producer surplus is not equal to consumer surplus. Market failure is thus caused by

* Abuse of monopoly power
* Lack of public goods
* Under provision of merit goods
* Overprovision of demerit goods
* Environmental degradation
* Inequality in distribution of wealth
* Immobility of factors of production
* Problems of information
* Short termism

Externalities
Externalities are a loss or gain in the welfare of one party resulting from an activity of another party, without there being any compensation for the losing party.

This activity can be due to consumption or production of a good or service. If the third party suffers due to this activity then it is known as negative externality. When the third party gains from this activity is it known as positive externality. Marginal Private Benefit is the benefit which is derived by private individuals in the consumption of a good or service. Marginal Private Cost is the cost of producing, specifically marginal costs, which are incurred by private individual while producing a good or service. Marginal Social Cost is the total cost to society as a whole for producing one further unit, or taking one further action, in an economy. This total cost of producing one extra unit of something is not simply the direct cost borne by the producer, but also must include the costs to the external environment and other stakeholders. The market demand and supply curves therefore reflect the MPB and MPC accruing to buyers and sellers. When there is no externality then the intersection MPB (demand) curve and MPC (supply) curve determine the equilibrium price. The price and quantity reflected at this point are ‘socially optimum’ level of production or consumption and the market is said to have allocative efficiency. i.e. MPC=MPB.

At this point the consumer surplus is equal to the producer surplus. However, this is usually not the case in real world. The production or consumption of goods and services do produce externalities and thus the concept of Marginal social benefits and Marginal social costs comes into being. MSB=MPB+Externality

MSC=MPC+Externality
Types of Externalities
Externalities can result either from consumption activities or from production activities There are four types of Externalities
1. Negative externality of Production
2. Negative externality of Consumption
3. Positive externality of Production
4. Positive externality of Consumption

Negative Production Externalities
Negative production externalities are the side-effects of production activities. As a result an individual or firm making a decision does not have to pay the full cost of the decision. Pollution created by firms due to production activities is an example of negative production externality. In an unregulated market, producers don't take responsibility for external costs that exist--these are passed on to society. Thus producers have lower marginal costs than they would otherwise have and the supply curve is effectively shifted down (to the right) of the supply curve that society faces. Because the supply curve is increased, more of the product is bought than the efficient amount--that is, too much of the product is produced and sold. Since marginal benefit is not equal to marginal cost, a deadweight welfare loss results.

The diagram illustrates negative production externality.
The supply curve given by MPC reflects the firm’s private costs of production and the marginal social cost curve given by MSC represents the full cost of production to society. The vertical difference between MPC and MSC represents negative externality. Therefore for each level of output, Q1, social costs given by MSC are greater than the firm’s private costs by the amount of externality. The optimal production quantity is Q*, but the negative externality results in production of Q1. The deadweight welfare loss is shown in blue. Corrective Negative Production externalities

In order to correct negative externality of production and to bring down the production to the optimal level, government can intervene through the following options: Legislation and regulations
Government can pass legislations to prevent or reduce the effects of production externalities. These legislations will lower the quantity of goods produced and bring it closer to the optimal quantity Q* by shifting the MPC curve upward towards the MSC curve. It might include legislations to * Limit the emission of pollutants by setting limits to the extent of pollutants produced by a firm. * Limit the production to a certain level.

* Force polluting units to install technologies which reduce emissions. Putting Taxes
Government may impose a tax on the firm either on per unit of production or per unit of pollutants emitted. These will lead to a shift of MPC curve upwards towards the MSC curve and thus reducing output and bringing it closer to socially optimal level i.e. Q*. The diagram below shows th...

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