Market Failure-Meaning and Causes

Market failure occurs when the free market (market economic system) does not allocate resources optimally. The price mechanism, a major feature of the market economy, is expected to allocate resources in the most desirable and efficient manner. Despite the profit-motive that prevails in a privately-driven or market economy, scarce resources may not be used in the interest of the society. Market failure may be total in which case the operators of the economy do not produce a product at all owing to difficulty in making profit from the provision, e.g. roads, streetlights, etc. The market produces too much or too little of a product when there is a partial market failure.

Though it does not play a major role in a market economy, the government often intervenes in order to correct market failure. There is no guarantee that government intervention will always work. Sometimes, the government makes the situation worse than it was initially. This is known as government failure.

The reasons why the market economic system fails to allocate resources efficiently are explained below.

Externalities
Externalities are the effects of the consumption or production of an economic agent on another economic agent. The market economy is driven by the decisions of private firms and consumers. But both the consumers and producers do not take into consideration the full costs and benefits of their decisions. There are four types of externalities in a free market, namely positive production externalities, negative production externalities, positive consumption externalities and negative consumption externalities.

A positive production externality is a benefit accruing to other members of the society from productive activities of a firm, e.g. new vaccines, open source technology and new business establishment. The adverse effects of production on third parties are called negative production externalities, e.g. air pollution, water pollution, destruction of wildlife habitat, traffic congestion, etc. 

Positive consumption externality is the benefit that a person derives from another person’s consumption, e.g. a vaccinated person does not spread communicable disease to others, walking reduces pollution from car use, education benefits the society by reducing crime rate, etc. Negative consumption externalities are the costs or adverse effects of consumption on the society, e.g. passive smoking, noise pollution, pressure on healthcare system emanating from obesity or alcohol intake, etc.

Non-provision of public goods
Certain goods are not usually provided by the market because it is difficult to make profit from them, e.g. defence, roads, street lights and policing. This is a case of complete market failure as there is no market created at all for the goods. These goods are non-excludable because everyone can access them once provided, e.g. road once constructed is available to everyone. People can use these goods without paying for them (free-rider effect). They are also non-rivalrous, i.e. the use by one person does not reduce the amount available to others, e.g. the use of streetlight by one person does not diminish the quantity available to others.

Under-production of merit goods
Merit goods are goods that are beneficial to others in the society. But they are usually under-provided and under-consumed. The quantity available is less than what is desirable for the economy. They are under-provided because producers only consider their own benefits not the benefits to other members of the society. It is under-consumed because consumers are not aware of all the benefits of these products, e.g. education and healthcare.

Over-production  of demerit goods
Demerit goods are goods that can harm third parties, e.g. alcohol, drugs and cigarettes. They are over-produced because not all costs are accounted for by the producers. And they are over-consumed because not all the costs or harmful effects are considered by the consumers.

Imperfect competition
Perfectly competitive market is an ideal structure that  does not exist. In perfect competition, efficiency is attained as there are many sellers and buyers that trade the most desirable quantity. What is obtainable in reality is imperfect competition such as monopoly and oligopoly. In monopoly, for example, the market is dominated by a firm that can control price or quantity offered to the market. This results in inefficiency in the market owing to the fact that monopolist’s output is less than the socially optimum quantity and economic welfare is not maximised.

Asymmetric information or information failure
People always make the right decisions or choices in efficient markets because every party has adequate information or perfect knowledge about the products on sale. But in reality, one of the parties to a transaction (the seller or the buyer) is more knowledgeable about the transaction than the other party. The effect is that the right product or the right price may not be paid in the market.

A type of information failure is adverse selection that occurs  when the producer or seller has  more information about the product than the other party. One party, usually the buyer, is reluctant to pay a high price because he is not fully aware of the true condition or quality of the product. The more informed party, usually the seller, is unable to attract or choose the best customer for its product. For example, the seller of a second-hand car knows the true condition of the vehicle more than the buyer. The buyer is skeptical and may not want to pay too much for the product. He may end up offering less for the vehicle. If there is equal amount of knowledge the right price would be agreed upon.

Another case of asymmetric information is moral hazard. One of the parties engages in a risky behaviour because it is the other party that will be liable in case of a problem. The party taking the risk has more information about his behaviour than the other party that will be held responsible in case of a problem. For example, an insured person may fail to take the necessary precaution because he knows  insurance company is going to compensate him if a risk occurs such as a car accident. Another example is when some financial institutions engage in risky lending knowing that they will  be bailed out by the government if they run into a serious problem.

Inequality
The amount of goods and services an individual is entitled to in a market economy is determined by his income. However, many people have fewer resources and cannot consume adequate quantity of certain goods, especially essential products. The unequal distribution of income and wealth is thus a problem of the free market that warrants government intervention.

Immobility of factors of production
Mobility is the ease with which resources can be moved to other uses or locations. There is inefficiency when resources, say labour, cannot be transferred to other uses or areas where they will be more productive or needed. For instance, an unemployed worker may not have the skill to do other jobs or may be unwilling to move to other areas where jobs are available for different reasons.