Market failure

Market failure
See also
Demerit good Bilateral monopoly Price controls Regulated market Government intervention Inflationary gap Open economy Imported inflation Supply shock

Market failure is a situation where the market does not produce the optimal allocation of resources in the economy. It is caused by a variety of factors such as externalities, public goods, asymmetric information, monopoly power, and government intervention.

Externalities occur when an economic transaction has an effect on third parties that are not directly involved in the transaction. These external costs and benefits associated with the transaction cannot be easily taken into account by the market participants, leading to an inefficient outcome.

Public goods are goods that are non-excludable and non-rival in consumption. These goods are provided by the government since private companies cannot make a profit from their production due to their non-excludable nature.

Asymmetric information occurs when one party in an economic transaction has more information than the other. This information asymmetry can lead to market inefficiencies as the party with more information has an advantage over the other party.

Monopoly power occurs when a single firm dominates the market for a particular product or service. This allows the firm to set prices above the competitive level, leading to an inefficient allocation of resources in the economy.

Finally, government intervention can lead to market failure as the government may not have the necessary information or incentives to make the optimal decisions in the economy. Government policies such as taxes, subsidies, and price controls can lead to market inefficiencies and an inefficient allocation of resources.

Example of Market failure

A classic example of market failure is the case of pollution. Pollution is a type of externality, whereby the production of a good or service leads to costs that are not taken into account by the market participants. This leads to an inefficient outcome, as the market will not produce the optimal level of pollution.

Formula of Market failure

Market failure can be represented by the following formula:

$P_{mkt}=P_{opt}+(\epsilon _{1}+\epsilon _{2}+...+\epsilon _{n})$

where P_mkt is the price in the market, P_opt is the optimal price, and ε₁, ε₂, ..., ε_n are the externalities, public goods, asymmetric information, monopoly power, and government intervention that lead to market failure.

Types of Market failure

• Imperfect Competition: Imperfect competition occurs when firms in the market have some degree of market power, allowing them to set prices above the competitive level. This leads to an inefficient allocation of resources as firms are able to extract economic profits from their market power.
• Externalities: Externalities are costs or benefits associated with a transaction that are not taken into account by the parties involved in the transaction. This can lead to an inefficient allocation of resources as the external costs or benefits are not taken into account by the market participants.
• Public Goods: Public goods are goods that are non-excludable and non-rival in consumption. These goods are usually provided by the government since private companies cannot make a profit from their production due to their non-excludable nature.
• Asymmetric Information: Asymmetric information occurs when one party in an economic transaction has more information than the other. This information asymmetry can lead to market inefficiencies as the party with more information has an advantage over the other party.
• Monopoly Power: Monopoly power occurs when a single firm dominates the market for a particular product or service. This allows the firm to set prices above the competitive level, leading to an inefficient allocation of resources in the economy.
• Government Intervention: Government intervention can lead to market failure as the government may not have the necessary information or incentives to make the optimal decisions in the economy. Government policies such as taxes, subsidies, and price controls can lead to market inefficiencies and an inefficient allocation of resources.

Steps of Market failure

• Externalities: Externalities occur when an economic transaction has an effect on third parties that are not directly involved in the transaction. These external costs and benefits associated with the transaction cannot be easily taken into account by the market participants, leading to an inefficient outcome.
• Public goods: Public goods are goods that are non-excludable and non-rival in consumption. These goods are provided by the government since private companies cannot make a profit from their production due to their non-excludable nature.
• Asymmetric information: Asymmetric information occurs when one party in an economic transaction has more information than the other. This information asymmetry can lead to market inefficiencies as the party with more information has an advantage over the other party.
• Monopoly power: Monopoly power occurs when a single firm dominates the market for a particular product or service. This allows the firm to set prices above the competitive level, leading to an inefficient allocation of resources in the economy.
• Government intervention: Government intervention can lead to market failure as the government may not have the necessary information or incentives to make the optimal decisions in the economy. Government policies such as taxes, subsidies, and price controls can lead to market inefficiencies and an inefficient allocation of resources.

Advantages of Market failure

There are some advantages of market failure, including:

• Increased competition: When the market fails, it creates an opportunity for new companies to enter the market and compete with existing firms, leading to increased competition and improved efficiency.
• Improved access to resources: Market failure can lead to increased access to resources, as new companies may enter the market and provide new and improved products and services.
• Greater innovation: Market failure can also lead to increased innovation as companies are forced to innovate in order to remain competitive.

Limitations of Market failure

Market failure can be limited by the use of various policy tools such as taxes, subsidies, and regulations. These policy tools can help to reduce externalities, public goods, asymmetric information, monopoly power, and government intervention that lead to market failure. For example, taxes can be used to reduce externalities by making it more expensive for firms to produce goods that have negative externalities. Similarly, subsidies can be used to reduce the cost of public goods and encourage firms to produce them. Regulations can be used to reduce asymmetric information, by making firms disclose all relevant information to potential buyers. Finally, antitrust laws can be used to reduce monopoly power and ensure a competitive market.

Other approaches related to Market failure

• Perfect Competition: Perfect competition is a market structure in which all firms are price takers, and there are no entry or exit barriers. Perfect competition leads to an efficient allocation of resources in the economy as the firms are forced to produce the output where marginal cost equals marginal revenue.
• Monopolistic Competition: Monopolistic competition is a market structure in which firms are selling differentiated products, and there are no entry or exit barriers. This leads to an inefficient allocation of resources in the economy as firms have some degree of market power and can set prices higher than the competitive level.
• Oligopoly: Oligopoly is a market structure in which there are few firms in the market, and there are significant entry and exit barriers. This leads to an inefficient allocation of resources in the economy as firms have significant market power and can set prices higher than the competitive level.

In conclusion, market failure can be caused by a variety of factors such as externalities, public goods, asymmetric information, monopoly power, and government intervention. Other approaches related to market failure include perfect competition, monopolistic competition, and oligopoly, all of which lead to an inefficient allocation of resources in the economy.

Suggested literature

• Ledyard, J. O. (1989). Market failure. Allocation, Information and Markets, 185-190.
• Zerbe Jr, R. O., & McCurdy, H. E. (1999). The failure of market failure. Journal of Policy Analysis and Management: The Journal of the Association for Public Policy Analysis and Management, 18(4), 558-578.
• Randall, A. (1983). The problem of market failure. Natural Resources Journal, 23(1), 131-148.