The questions, what is market failure and what are the main causes of market failure, are congenially responsive to each other when we focus at the bigger picture here. The concept itself is a situation in which the allocation of goods and services by a free market is not Pareto efficient, often leading to a net loss of economic value.
It can also be viewed as scenarios where individuals’ pursuit of pure self-interest leads to results that are not efficient – that can be improved upon from the societal point of view. The existence of a market failure is often the reason that self-regulatory organizations, governments or supra-national institutions intervene in a particular market.
Most mainstream economists believe that there are circumstances in which it is possible for government or other organizations to improve the inefficient market outcome.
A market is an institution in which individuals or firms exchange not just commodities, but the rights to use them in particular ways for particular amounts of time. They are institutions which organize the exchange of control of commodities, where the nature of the control is defined by the property rights attached to the commodities.
The Main Causes of Market Failure
Having dissected the question, what is market failure, it is time we analyzed too the main causes of market failure so that we can at least go above the waters of wondering or of being troubled as to finding way out for our various enterprises:
Monopolies
A monopoly is when a single seller controls the market. Monopolies affect the market because sellers are in total control of prices and products, which may lead to high prices for buyers compared to a competitive market.
The seller has no pressure to reduce inefficiencies, and so is likely to produce poor quality goods and services or not enough goods and services while pricing them at a higher cost than the market would otherwise support.
A monopoly may develop when a bigger company buys its smaller competitor. For example, when different investors own two gas companies, a monopoly may be created when the successful investor buys the other company, making him the only gas seller in town.
The government can also create a monopoly when it gives a single company the right to produce certain goods and services. For example, the government can give one company the exclusive right to mine diamonds. This means that this company becomes the only producer of diamonds, hence monopolizing the market.
Market Control
Market control occurs when either the buyer or the seller possesses the power to determine the price of goods or services in a market. The power prevents the natural forces of demand and supply from setting the prices of goods in the market.
On the supply side, the sellers may control the prices of goods and services if there are only a few large sellers (oligopoly) or a single large seller (monopoly). The sellers may collude to set higher prices to maximize their returns. The sellers may also control the quantity of goods produced in the market and may collude to create scarcity and increase the prices of commodities.
On the demand side, the buyers possess the power to control the prices of goods if the market only comprises a single large buyer (monopsony) or a few large buyers (oligopsony). If there is only a single or a handful of large buyers, the buyers may exercise their dominance by colluding to set the price at which they are willing to buy the products from the producers. The practice prevents the market from equating the supply of goods and services to their demand.
Imperfect Information in the Market
Market failure may also result from the lack of appropriate information among the buyers or sellers. This means that the price of demand or supply does not reflect all the benefits or opportunity cost of a good. The lack of information on the buyer’s side may mean that the buyer may be willing to pay a higher or lower price for the product because they don’t know its actual benefits.
Read Also: 3 Market Forces that Impact Business
On the other hand, inadequate information on the seller’s side may mean that they may be willing to accept a higher or lower price for the product than the actual opportunity cost of producing it.
Externalities
Externalities refer to the positive or negative effects of production or consumption on uninvolved third parties. For example, when an investor builds a mall, it can benefit third parties living in the area because the land’s value is likely to go up.
Negative externalities, on the other hand, happen when production or consumption causes a harmful effect on a third party. These effects are not reflected in the cost of the good, which can cause an imbalance in supply and demand.
Imagine a situation where the city officials of Philadelphia give a company the right to re-purpose land used as a public park. The company intends to construct a mega football pitch. However, this transaction has negative externalities because the purchase price of the land by developers does not reflect the true cost of losing the public park.
Losing the park will cost the community in the form of loss of social and recreational space and increases in noise pollution and traffic in the area. Failing to take into account the third parties’ cost means that this action will not achieve a socially efficient outcome.
Externalities affect the market because the price of the goods and services does not reflect the benefits or cost of the goods and services in society. Because of this, companies are likely to under produce or overproduce depending on the externality, which causes market failure.
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Things to Do to Avoid Market Failure
Use of legislation
One of the ways that governments can manage market failures is by implementing legislation that changes behavior. For example, the government can ban cars from operating in city centers, or impose high penalties to businesses that sell alcohol to underage children, since the measures control unwanted behaviors.
Price mechanism
Price mechanisms are designed to change the behavior of both the consumers and producers. For products that cause harm to consumers, the government can discourage their consumption by increasing taxes. For example, taxes on cigarettes and alcohol are periodically increased to discourage their consumption and reduce their harmful effects on unrelated third parties.
