Causes of market failure

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Causes of market failure

This article aims to explore some of the causes of market failure. It is usually assumed that the market will correct itself if something goes wrong. However, this does not always happen, and some markets do not work properly either. In such cases, there is a market failure. The failure of markets can lead to suboptimal outcomes, such as a lack of innovation and overconsumption of goods that are not worth the price.

 

Definition of market failure

A market failure is the situation when a market is unable to allocate resources efficiently. According to Bækkeskov (2022) it refers to the failure of a market to deliver an optimal result. It occurs whenever a market leads to a misallocation of resources (AQA, 2022). In other words, the distribution of goods and services in the market is inefficient. At times, the costs of production are higher than the benefits, and at other times, demand is less than supply, leading to price issues.

 

List of causes of market failure (Common types of market failure)

There are two main causes of market failure i.e. externalities and monopoly. There are other causes as well, though they are less common.

 

Externalities

An externality is a cost or benefit that is experienced by a third party who is not involved in the transaction. For example, when a manufacturer releases carbon dioxide into the atmosphere, it has an impact on everyone, not just the people who have bought its products. This is a negative externality, as the release of CO2 into the atmosphere is detrimental to the environment. These third-party costs can distort the market and lead to underproduction or overproduction of goods.

 

Monopoly

Monopoly is one of the key causes of market failure. According to Robinhood (2022) a monopoly is a business that dominates a market with little or no challenge from competitors, and thus can do whatever as it pleases in setting prices and producing its goods. In other words, monopoly exists when a firm has control over a certain good or service. Generally, the cause is a lack of regulation and the government issuing a license or patent to one firm or just few firms.

 

Market failure occurs due to monopoly as enough of the goods is not made available for the consumers to buy and/or the price of the good is too high that they cannot afford. The purpose of a perfect market is to enhance the welfare of the society, however, monopoly functions contrary to it; hence the market failure.

 

Public goods

Excludability is a feature of a good where one person cannot use it without preventing others from using it. For example, a car has an excludability feature. Nobody else can use a person’s car while he/she is using it. Public goods are non-excludable in nature. This means that they have the same qualities as a pure common good. Therefore, they experience market failure.

 

The reason for public goods causing a market failure is that a section of the population consuming the goods may fail to pay for it, however, continues with the usage. For example, police and fire services are public goods that every citizen is entitled to enjoy, regardless of whether or not they pay taxes to the government.

 

Examples of market failure

One of the examples of market failure is when dominant seller/s (monopolists) set high prices for their products and services and leave no choice for the consumers other than to buy them with a high price.

 

Another example is when excessive inequality in income distribution leads to inefficient allocation of resources in the market. This is due to the fact that a significant part of the society does not have enough money to buy goods and services that they need. And the rest of the society has more money than they can use. In other words, there is not enough demand for goods and services. Also, there is an insufficient supply of goods and services due to low consumption in the lower income groups. This leads to a less than the optimal level of goods and services being produced and consumed.

 

Effects of market failure

One of the obvious effects of market failure is that resources are not allocated efficiently. In some cases, this may lead to social injustice. A market failure decreases the welfare of society. For example, air pollution is a negative externality that is not accounted for in the price of goods or the cost of production. This leads to a lower quality of life and a decreased welfare for those living in the polluted area.

 

Solutions to market failure

There are several solutions to market failure what can be initiated by several stakeholders. One solution is government intervention. This can take the form of regulation, subsidies, taxes, or spending. Another solution is voluntary action by the private sector. Voluntary action can take the form of philanthropic efforts or self-regulation. A third solution is broader societal action. This can include public education efforts or community-based action.

 

Summary of the causes of market failure

Markets fail when they are unable to allocate resources efficiently. Governments can intervene directly through regulation and legislation, or indirectly by providing public goods that correct the market failure.

 

Hope you like this article: ‘Causes of market failure’. Please share the article link on social media to support our work. You may also like:

Effects of government intervention in markets

Resource allocation and economic systems

Advantages and disadvantages of a command economy

 

Last update: 25 November 2022

References:

AQA (2022) The operation of markets and market failure, available at: https://www.aqa.org.uk/subjects/economics/as-and-a-level/economics-7135-7136/subject-content-as/the-operation-of-markets-and-market-failure (accessed 23 November 2022)

Bækkeskov, E. (2022) Market failure, available at: https://www.britannica.com/topic/market-failure (accessed 23 November 2022)

Robinhood (2022) What is monopoly, available at: https://learn.robinhood.com/articles/6P3iLTPMKiB8jttL4N26hR/what-is-a-monopoly/ (accessed 24 November 2022)

Author: Joe David

Joe David has years of teaching experience both in the UK and abroad. He writes regularly online on a variety of topics. He has a keen interest in business, hospitality, and tourism management. He holds a Postgraduate Diploma in Management Studies and a Post Graduate Diploma in Marketing Management.