What’s it: Market failure refers to a condition in which the market mechanism doesn’t work, thus creating inefficiency in the market. Demand, supply, and price aren’t in equilibrium. As a result, markets fail to allocate economic resources most efficiently.
In microeconomics, an imperfect market leads to market failure because players have the power to influence prices. In monopolistic competition, producers have some price power through differentiation. Price power is greater when the market operates under an oligopoly or monopoly. Likewise, in oligopsony and monopsony markets, consumers in both markets have power over prices, resulting in market failure.
Long story short, there is no market failure if the market operates under perfect competition. Neither producer nor consumer can influence prices. Also, under this market structure, information is abundantly and fairly available to all parties in making decisions (perfect information).
Furthermore, in a country’s economy, free-market economies, especially Laizes Faire, operate on perfect competition principles. Supply and demand forces determine the prices of goods and services. Any change in one of the forces (e.g., demand) results in a change in price. These changes will eventually lead to a new equilibrium because other forces (supply) also change.
Market failure effects
If the market fails, the market price doesn’t reflect all costs and benefits for producers and consumers. Manufacturers fail to capture the excess costs of production. Likewise, consumers do not receive the most significant benefits from the consumption of goods and services. Overall, the market doesn’t produce products that provide optimal social benefits for both producers and consumers.
Such failures are common in the real world. The market is almost impossible to operate perfectly. You can see that some companies produce harmful waste. Also, the government often sets price controls for certain goods. Likewise, in some markets, firms have price power because they dominate supply in the market. They all contribute to market failure.
Market failure eventually gives rise to allocative inefficiency. It causes the consumption of goods is either excessive or insufficient.
Causes of market failure
As I said, market failure occurs when the market is in a condition of disequilibrium, that is, the quantity demanded doesn’t equal the quantity supplied. The cause is due to market distortions, such as externalities, market control, and monopoly power.
The immobility of production factors is another cause of market failure, for example, due to geographical factors. In this case, the market cannot use the factors of production in the most efficient way.
Furthermore, government intervention, such as taxes, subsidies, price controls, and regulations, is also an example of other factors causing market failures. Such interventions lead to inefficient allocation of resources. In this case, market failure is sometimes referred to as government failure.
Monopoly power arises when firms have power over the market price. In an extreme case, the market consists of only one producer (monopoly). As the sole supplier, the monopolist determines the quantity and quality of the product. That gives monopolist absolute price power unless the government intervenes.
Furthermore, in the more general case, few companies hold a significant share of the market. If they change output, the quantity supplied in the market also changes. Such power enables them to charge a price that is higher than the equilibrium price.
In monopolistic competition, firms also have some power over price. Although the market is composed of many players (as in perfect competition), they can differentiate their offering. They can set their selling price higher than the market price by differentiating its offering from competitors.
Price control also appears not only on the supply side, but also on the demand side. If a market consists of one (monopsony) or several buyers (oligopsony), buyers can influence market prices.
As with the supply side, when there are only a few buyers – relative to market supply – buyers have more bargaining power. They can force sellers to set prices below equilibrium.
Externalities are costs or benefits borne by third parties that are not directly involved in an economic transaction or activity. The two externalities are positive externalities and negative externalities.
Positive externalities provide benefits to third parties. For example, education will not only benefit students but will also benefit the entire society and economy. Likewise, infrastructure development benefits not only the mobility of people and goods, but also real estate developers.
On the other hand, negative externalities are costs that arise and are borne by third parties. For example, smoking isn’t only harmful to smokers but also the health of those around smokers.
Another example of a negative externality is factory waste. It is dangerous for the surrounding community, who may not be factory employees.
Public goods are types of goods that are non-rivalrous and non-excludable. You cannot prevent other people from using it, whether they are paying for it or not. And, when you consume a public good, it doesn’t reduce its availability to others.
Examples of public goods are national defense, sewer systems, street lighting, highways, and public parks.
Public goods cause market failures. Some people pay for the benefits, while others don’t. Even though they don’t pay, they still get the same benefits from public goods.
Take the highway. It is a public good, and people benefit from it, even if they don’t pay taxes.
Of course, those who don’t pay taxes benefit greatly. They spend no money but still enjoy the same benefits as other taxpayers.
The government often issues pricing policies for some goods and services. Two types of price control by the government are the price floor and the price ceiling. Both are outside the equilibrium point, which results in excess supply or excess demand.
The price floor is the minimum price suppliers can charge. To be effective, the government will set it above the equilibrium price, causing an excess supply in the market. The price floor aims to protect the supplier from a too-low price.
The most cited example is the minimum wage. This policy is essential to maintain a decent standard of living for workers.
However, because it is above the equilibrium wage, the labor market is in excess supply. More and more people are willing to supply their labor services to get higher wages. Conversely, firms see wages as more expensive, reducing their demand for labor.
The price ceiling is the maximum price suppliers can charge. The government sets it below the equilibrium price. Its purpose is to protect consumers from conditions that can make goods very expensive.
However, because the price is below equilibrium, the market experiences scarcity (excess demand).
Take, for example, the price of an apartment. Prices lower than equilibrium attract more and more people buying apartments. On the other hand, for apartment developers, prices are so low that they are only willing to supply fewer apartments.
Market information is essential for balancing supply and demand. When each party has insufficient information, either party can influence market equilibrium to maximize their own benefits.
On the part of the buyer, the lack of information may result in them having to pay a higher price than they should. They may not know the fair price (market price) hence cannot make the right decision.
Meanwhile, for producers, a lack of information can make them sell at a lower price than the market price. That, of course, reduces the benefits they should have.
Solutions to market failures
Some experts suggest several steps to encourage the efficient allocation of resources and avoid market failures. One of them is through government policy.
For example, the government can prohibit cars of a certain age from operating in the city center. The aim is to reduce negative externalities due to air pollution.
Likewise, the government can impose penalties for businesses that sell alcohol to minors or generate hazardous waste.
Another example of minimizing market failure is through antitrust regulations. Such regulations can reduce inefficiencies resulting from the use of market forces by firms.
Furthermore, the government can also change the behavior of consumers and producers through selling prices. For products that harm consumers, the government can reduce consumption by raising taxes. For example, the government raises taxes on cigarettes and alcohol to prevent overconsumption. It reduces the harm to unrelated third parties.