Market Failure

What is market failure?

Market failure occurs when the price mechanism fails to allocate resources efficiently. Resources are either misallocated or inefficiently allocated. The market fails to produce the right products in the right quantities and at the right price. This drives a reduction in economic and social welfare.

Causes of Market Failure

Market failure occurs because of several causes. They are:

1. Externalities: An externality is a cost incurred or benefit received by a third party in an economic activity. A positive externality has a positive impact on the third party whereas a negative externality has a negative impact on the third party. 

2. Information failure: When the correct information between consumers and producers is not communicated, misallocation or inefficient allocation of resources occurs, leading to market failure.

3. Overprovision of demerit goods: A demerit good is a product or service whose consumption is not socially or economically beneficial. In a market economic system, the profit incentive could lead to an over-provision of these goods if they are profitable.

4. Under-provision of merit goods: A merit good is a product or service whose consumption is socially or economically beneficial. In a market economic system, merit gods may be under-produced if not profitable.

5. Lack of public goods: a public good is a product or service that is non-excludable and non-rivalrous. Producers will not be willing to produce public goods as it is not possible to distinguish between payers and non-payers. Lack of these goods often leads to market failure.

Abuse of monopoly power: A monopoly is a producer that can control the price and supply of a particular product or service. Due to the lack of choice, the monopoly may choose to take advantage of this power (for instance hike the prices).