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Market Failure

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Economics

There may have been a time when an item you would like to purchase was unavailable or its price didn’t match its value. Many of us have experienced this situation. In economics, this is called a market failure.

What is market failure?

Market failure occurs when the price mechanism fails to allocate resources efficiently, or when the price mechanism fails to function altogether.

People have different opinions and judgments in regards to when the market performs inequitably. For example, economists believe that unequal distribution of wealth is a market failure caused by the market’s inequitable performance.

Moreover, the market performs inefficiently when there is a misallocation of resources which causes an imbalance of demand and supply and results in prices either being too high or too low. This overall causes overconsumption and underconsumption of certain goods.

The market failure can be either:

  • Complete: when there is no supply for goods demanded. This results in the ‘missing market.’
  • Partial: when the market is still functioning but demand does not equal the supply which causes prices of goods and services to be wrongly set.

In short, market failure is caused by an inefficient allocation of resources which prevents supply and demand curves from meeting at the equilibrium point.

What are market failure examples?

This section will provide a few examples of how public goods can cause a market failure

Public goods

Public goods refer to goods or services that are provided for everyone in society without exclusions. Due to these characteristics, public goods are usually supplied by the government.

Public goods must attain at least one of two characteristics: non-rival and non-excludable. Pure public goods and impure public goods have at least one of them.

Pure public goods attain both characteristics. Non-rivalry means that one person's consumption of a good doesn’t prevent another person from consuming it. Non-excludability means that no one is excluded from consuming the good; even the non-paying consumers.

Impure public goods exhibit some of the characteristics of public goods, but not all. For example, impure public goods may only be non-rival yet excludable, or vice versa.

The non-rival goods category means that if one person consumes this good it does not prevent another person from using it:

If someone listens to public radio stations it does not prohibit another person from listening to the same radio program. On the other hand, the concept of rival goods (can be private or common goods) means that if a person consumes a good another person cannot consume the same one. A good example of it is food at a restaurant: when a consumer eats it, it prevents another consumer from eating exactly the same meal.

As we said, the non-excludable category of public goods means that everyone can access this good, even the non-tax-paying consumer.

National defence. Both taxpayers and non-taxpayers can have access to national protection. On the other hand, excludable goods (which are private or club goods) are goods that can't be consumed by non-paying consumers. For example, only paying consumers can buy products at the retail store.

Free rider problem

The most common example of market failure of public goods is called the ‘free-rider problem’ which occurs when there are too many non-paying consumers. If the public good is provided by private companies, the supply costs can become too high for the company to continue providing them. This will cause shortages in supply.

An example is police protection in the neighbourhood. If only 20% of people in the neighbourhood are taxpayers who contribute towards this service, it becomes inefficient and costly to provide it due to the large number of non-paying consumers. Therefore, the police that protect the neighbourhood may decrease in numbers due to the lack of funding.

Another example is a free radio station. If only a few listeners are making donations towards it, the radio station needs to find and rely on other sources of funding such as the government or it will not survive. There is too much demand but not enough supply for this good.

What are the types of market failure?

As we briefly mentioned before, there are two types of market failure: complete or partial. The misallocation of resources causes both types of market failure. This may result in the demand for goods and services not being equal to the supply, or prices being set inefficiently.

Complete market failure

In this situation, there are no goods supplied in the market at all. This results in the ‘missing market.’ For example, if consumers would like to buy pink shoes, but there are no businesses that supply them. There is a missing market for this good, therefore this is a complete market failure.

Partial market failure

In this situation, the market supplies goods. However, the quantity demanded is not equal to the supply. This results in a shortage of goods and inefficient pricing that does not reflect the true value of a good demanded.

What are the causes of market failure?

We must be aware that it is impossible for markets to be perfect as various factors can cause a market failure. In other words, these factors are the causes of the unequal allocation of resources in the free market. Let’s explore the main causes.

Lack of public goods

Public goods are non-excludable and non-rival. This means that consumption of those goods does not exclude non-paying consumers nor prevent others from using the same good. The public goods can be secondary education, police, parks, etc. Market failure usually occurs due to the lack of public goods caused by the ‘free-rider problem’ which means that there are too many non-paying people using public goods.

Negative externalities

Negative externalities are indirect costs to individuals and society. When someone consumes this good not only they are harming themselves but also others.

A production factory may be releasing dangerous chemicals that are harmful to people's health into the air. This is what is making the cost of production of the goods so low, which means that their price will also be lower. However, this is a market failure as there will be an excessive production of goods. Moreover, the products won’t reflect their true price and additional costs to the community in terms of a polluted environment and the health risks that it has.

Positive externalities

Positive externalities are indirect benefits to individuals and society. When someone consumes this good not only they are improving themselves but also improving society.

An example of this is education. It increases the likelihood of individuals achieving higher-paying jobs, paying higher taxes to the government, and committing less crime. However, consumers don’t consider these benefits, which can result in the underconsumption of the good. As a result, society doesn’t experience the full benefits. This causes market failure.

The under-consumption of merit goods

Merit goods include education, health care, career advice, etc. and are associated with generating positive externalities and bringing benefits to individuals and society. However, due to the imperfect information about their benefits, merit goods are under-consumed, which causes market failure. To increase consumption of merit goods, the government provides them for free. However, they are still under-provided if we take into account all the social benefits that they can generate.

Overconsumption of demerit goods

Those goods are harmful to society, such as alcohol and cigarettes. Market failure occurs due to information failure as consumers do not understand the level of harm these goods can cause. Therefore, they are overproduced and overconsumed.

If someone smokes they do not realise the effect that they have on society such as passing the smell and negatively impacting second-hand smokers, as well as causing long-term health problems for themselves and for others. This is all due to overproduction and overconsumption of this demerit good.

Monopoly's abuse of power

Monopoly means that there is a single or only a few producers in the market which own a vast majority of the market share. This is the opposite of perfect competition. Due to that, regardless of the product's price, the demand will stay stable. Monopolies can abuse their power by setting prices very high, which can lead to the exploitation of consumers. The market failure is caused by the uneven allocation of resources and inefficient pricing.

Inequalities in the distribution of income and wealth

Income includes the flow of money going to factors of production, such as wages, interest on savings, etc. Wealth is the assets that someone or society owns, which include stocks and shares, savings in a bank account, etc. The unequal allocation of income and wealth can cause market failure.

Due to technology someone receives an extremely high salary in comparison to average workers. Another example is the immobility of labour. This occurs in areas where there are high unemployment rates, resulting in inefficient use of human resources and slowing economic growth.

Environmental concerns

The production of goods raises environmental concerns. For example, negative externalities such as pollution come from the production of goods. Pollution damages the environment and causes health problems to individuals. The production process that generates pollution to the environment means that the market is performing inefficiently, which causes a market failure.

How do governments correct market failure?

In microeconomics, the government attempts to intervene to correct the market failure. The government can use different methods to correct complete and partial market failures. The key methods that a government can use are:

  • Legislation: a government can implement laws that decrease consumption of demerit goods or make the sale of these products illegal to correct market failure. For instance, to reduce the consumption of cigarettes, the government sets 18 as the legal smoking age and bans smoking in certain areas (inside buildings, train stations, etc.)

  • Direct provision of merit and public goods: this means that government engages to provide certain essential public goods directly at no cost to the public. For instance, the government may impose to build street lights in areas that do not have them, to make neighborhoods safer.

  • Taxation: the government can tax demerit goods in order to reduce their consumption and production of negative externalities. As an example, taxing demerit goods such as alcohol and cigarettes increases their price thereby decreasing their demand.

  • Subsidies: this means that government pays the firm to lower the price of goods to encourage their consumption. For example, the government pays higher education institutions to lower the price of tuition for students to encourage education consumption.

  • Tradable permits: these aim to reduce the production of negative externalities by imposing legal permits. For instance, the government imposes a predetermined amount of pollution that firms are allowed to produce. If they exceed this limit they have to buy add-on permits. On the other hand, if they are under permitted allowance they can sell their permits to other firms and generate more profit this way.

  • Extension of property rights: this means that government protects the property owner’s rights. For example, the government implements copyrights to protect music, ideas, films, etc. This helps to stop inefficient allocation of resources in the market such as stealing music, ideas, etc., or downloading films without paying.

  • Advertising: government's advertising can assist in bridging the information gap. For instance, advertisements increase awareness of health problems that can occur due to smoking, or raise awareness about the importance of education.

  • International cooperation among governments: this means that governments from different countries share important information as well as address various problems, and work towards a common goal. This can help to correct market failure as for example the government can address issues such as lack of defence to keep citizens safe. Once this issue is addressed more governments can work together to increase the national defence in their country.

Correcting complete market failure

Complete market failure means that the market is non-existent and the government tries to correct this by establishing a new market.

The government attempts to provide goods such as road work and national defence to society. Without the government’s efforts, there may be no or lack of providers in this market.

In terms of government corrections to the complete market failure, the government tries to either replace the market or completely eliminate it.

The government makes the market of demerit goods (such as drugs) illegal and replaces them by making the markets of secondary and high school education and healthcare free.

An additional example is when the government attempts to abolish the production of negative externalities by issuing fines or making it illegal for businesses to produce pollution above a certain level.

Correcting partial market failure

Partial market failure is the situation when markets are performing inefficiently. The government attempts to correct this market failure by regulating supply and demand, and pricing.

The government can set high taxes for demerit goods such as alcohol to lower their consumption levels. Moreover, to correct inefficient pricing, the government can make maximum pricing (price ceilings) and minimum pricing (price floors) laws.

Government failure

Even though government attempts to correct market failure, this does not always bring satisfactory results. In some cases, it can cause problems that did not exist previously. Economists call this situation a government failure.

Government failure

When the government's interventions bring more social costs than benefits into the market.

The government may attempt to correct the market failure of over-consumption of demerit goods such as alcohol by making it illegal. This can encourage illegal and criminal actions such as selling it illegally, which brings more social costs than when it was legal.

Figure 1 represents government failure in achieving pricing efficiency by setting a minimum pricing (floor pricing) policy. P2 represents a legal price for a good and anything below that includes P1 is considered illegal. However, by setting these price mechanisms, the government fails to acknowledge that it prevents equilibrium between demand and supply, which causes excess supply.

Market failure Graph of government failure StudySmarter

Figure 1: Effects of government interventions in the market - StudySmarter Originals.

Market Failure - Key takeaways

  • Market failure occurs when the price mechanism fails to allocate resources efficiently, or when the price mechanism fails to function altogether.
  • An inefficient allocation of resources causes market failure, which prevents quantity and price from meeting at the equilibrium point. This results in disequilibrium.
  • Public goods are goods or services that everyone in society has access to without exclusions. Due to these characteristics, public goods are usually supplied by the government.
  • Pure public goods are non-rival and non-excludable while impure public goods only attain some of those characteristics.
  • An example of market failure is the ‘free rider problem’ which occurs due to the consumers using goods without paying for them. This, in turn, results in excessive demand and not enough supply.
  • The types of market failure are complete, which means there is a missing market, or partial, which means that supply and demand for goods are not equal or the price is not set efficiently.
  • The causes of market failure are: 1) Public goods 2) Negative externalities 3) Positive externalities 4) Merit goods 5) Demerit goods 6) Monopoly 7) Inequalities in the distribution of income and wealth 8) Environmental concerns.
  • The key methods that governments use to correct market failure are taxation, subsidies, tradable permits, an extension of property rights, advertising, and international cooperation among governments.
  • Government failure describes a situation in which the government's interventions bring more social costs than benefits to the market.

SOURCES

1. Touhidul Islam, Market Failure: Reasons and its Accomplishments, 2019.

Market Failure

Market failure is an economic term that describes when the markets perform inequitably (unfairly or unjustly) or inefficiently.

An example of market failure in public goods is called a free-rider problem. This occurs when there are too many non-paying consumers using goods and services. For example, if too many non-paying consumers listen to a free radio station without giving a donation, the radio station should rely on other funds, such as the government, to survive.

An inefficient allocation of resources causes market failure, which prevents supply and demand curves from meeting at the equilibrium point. The main causes of market failure include: 

  • Public goods

  • Negative externalities

  • Positive externalities 

  • Merit goods

  • Demerit goods

  • Monopoly

  • Inequalities in the distribution of income and wealth 

  • Environmental concerns

There are two main types of market failure, which are:

  • Complete
  • Partial

Both positive and negative externalities can lead to market failure. Due to information failure, goods that cause both externalities are consumed inefficiently. For example, consumers fail to acknowledge all the benefits that positive externalities can bring, causing those goods to be under-consumed. On the other hand, goods that cause negative externalities are overconsumed as consumers fail to acknowledge how harmful these goods are for them and society.

Final Market Failure Quiz

Question

 What is the definition of market failure?

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Market failure is an economic term that describes the situation in which the markets perform inequitably (unfairly or unjustly) or inefficiently.

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What causes market failure?

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Market failure is caused by an inefficient allocation of resources which prevents supply and demand curves from meeting at the equilibrium point.

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Give an example of a market failure.

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The free-rider problem. This occurs when there are too many non-paying consumers using goods and services. For example, if too many non-paying consumers listen to the public radio station without giving a donation, the radio station should rely on other funds such as the government, to survive. 

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What does non-rival goods mean?


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The non-rival goods category means that if one person consumes this good it does not prevent another person from consuming it.

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What is the difference between exclusive and non-exclusive goods?


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Exclusive goods prevent non-paying customers from consuming this good. Non-exclusive goods do not prevent non-paying customers from consuming this good or service.

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What is the difference between pure and impure public goods?


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Pure public goods have both characteristics non-rival and non-exclusive while impure public goods have only one of those characteristics.

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What are the main types of market failure?


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  • Complete
  • Partial


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What does complete market failure mean?


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Complete market failure means that there are no goods supplied in the market at all.

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Give an example of a 'missing market'.


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If consumers would like to buy pink shoes, but there are no businesses that supply them. These results in missing markets for this good.

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What does a partial market failure mean?


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In this situation, the market still functions. However, the number of goods demanded does not equal the supply. This results in a shortage or excess supply and inefficient pricing of the goods.

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What are the main causes of market failure?


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Answer


  • Public goods

  • Negative externalities

  • Positive externalities 

  • Merit goods

  • Demerit goods

  • monopoly

  • Inequalities in the distribution of income and wealth 

  • Environmental concerns

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Question

Give an example of how negative externalities cause market failure.

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Negative externalities are referred to as indirect costs to individuals. For example, production factories may be releasing dangerous chemicals into the air that may be harmful to people's health to lower the cost of production. This will cause market failure as due to lower production costs there will be excessive production that does not reflect the true product's price and an over-polluted environment.

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Give an example of how demerit goods cause a market failure.

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Demerit goods are harmful to society, such as alcohol and cigarettes. Market failure happens as smokers do not realize the effect that they have on society such as passing the smell and negatively impacting second-hand smokers. They can also cause long-term health problems for themselves and for others. This is all due to overconsumption of this demerit good.

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What does monopoly mean?


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Monopoly means that there is a single or only a few producers in the market which own a vast majority of the market share.


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Give an example of how unequal distribution of income and wealth causes market failure.


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The market failure can be caused by the unequal allocation of income and wealth. For example, due to technology someone receives an extremely high salary in comparison to average workers.

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How does the government attempt to correct complete market failure?


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Government attempts to correct the complete market failure by providing goods in a missing market.

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How do governments attempt to correct inefficient pricing?


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To correct inefficient pricing government makes maximum pricing (price ceilings) and minimum pricing (price floors) laws.

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What does government failure mean?


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Government failure is the situation when the government's interventions bring more social costs than benefits into the market.  

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What is a merit good?

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Merit goods are goods for which the social benefits of consumption outweigh private benefits.

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Name an example of a merit good.

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Healthcare.

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Why do merit goods cause partial market failure?

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Because merit goods are under-provided in the market.

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Describe why education is a merit good.

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Education is provided by the market, but in quantities that are not optimal.

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Merit goods lead to _________ .

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positive externalities

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What is the privately optimal level of consumption of a merit good?

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Where demand and supply for a merit good which is not subsidised are in equilibrium.

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What is the socially optimal level of consumption of a merit good?

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The level of consumption that is possible when merit goods are subsidised.

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Why would the government want to subsidise education?

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To reach the socially optimal level of education.

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Why do customers often ignore the full benefit of merit goods?

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Due to imperfect information.

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What is a demerit good?

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A demerit good is a good for which the societal costs of consumption outweigh private costs.

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Name an example of a demerit good.

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Tobacco.

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What are the private costs of a demerit good?

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Private costs include the costs incurred by the individual for purchasing the good and the negative impact of the good on the individual.

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What are the social costs of a demerit good?

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Social costs include the negative externalities that occur during the consumption of the good.

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How do governments try to discourage the consumption of demerit goods?

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By introducing/increasing taxes on demerit goods.

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What are value judgements?

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Value judgements are personal opinions, which characterise what a particular person finds desirable or not.

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Name the two characteristics of private goods.

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They are excludable and rival.

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Name an example of a private good.

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A bag of crisps.

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Explain the idea of rivalry in relation to private goods.

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When a consumer consumes a private good, they diminish the quantity of that private good available to other consumers.

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Name two characteristics of a public good.

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They are non-excludable and non-rival.

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Name an example of a public good.

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Street lighting.

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What is the free-rider problem?

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Even if only a few people pay for the public good, everyone can still enjoy all its benefits for free.

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How do 'free-riders' impact the price mechanism?

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The price mechanism fails if there are free riders, as consumers will not choose to pay for a good they can get for free.

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Why is it complicated to set prices for public goods?

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It is difficult to estimate how much value they will create for consumers.

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Why do governments have to provide public goods?

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Without governments providing public goods, they would result in market failure.

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Explain the tragedy of the commons.

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The tragedy of the commons is an economic concept that suggests that people will always act in their own self-interest and overconsume common resources. As a result, the common resource is destroyed and/or depleted.

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What is a quasi-public good?

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A good for which certain methods could be implemented to exclude free-riders.

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Name an example of a pure public good.

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National defence is a pure public good since it is impossible to exclude free riders.

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Name an example of a quasi-public good.

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Tolls. They can be implemented on motorways in order to exclude free-riders.

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Why is it beneficial to provide public goods for free?

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If there are no capacity restraints on public and quasi-public goods, optimal consumption levels take place when they are provided for free.

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What is the significance of technological change in providing quasi-public goods?

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Technological advances make it possible for governments to charge prices on quasi-public goods.

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What are externalities?

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Externalities are indirect costs or benefits that a third party incurs. These costs or benefits arise from another party’s activity such as consumption.

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Is it possible to sell externalities on the market?

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No, externalities do not belong on the market, so they cannot be bought or sold.

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