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Market Failure Definition

Market failure in economics is defined as a situation when there’s a faulty allocation of resources in a market. It is triggered when there is an acute mismatch between supply and demand, prices do not match reality or when individual interests are not aligned with collective interests.

A simple example of market failure is when a monopolist seller sets high rates to the products leaving no choice for the buyers than to purchase the overpriced goods.

Key Takeaways

  • A market failure occurs when prices do not match reality. In this distorted market, prices do not represent the supply and demand of a service or product correctly, and there’s a mismatch between the individual needs and supply in a free market.
  • The most common examples and types include missing markets, monopolies, externalities, etc.
  • Solutions to market failure in economics include the use of legislation to prevent people from making decisions that will harm the collective, and education focused on teaching people about the market.

Causes for Market Failure

The definition of market failure revolves around market disruptions arising out of a variety of reasons. In economics, to understand why a market can be considered a failure, we need to understand how markets should work. According to economic theory, markets are mechanisms that coordinate producers and consumers by determining the price.

If markets are working properly, the price of something will be a result of the differences between supply and demand. So, a dysfunctional market would be one in which prices are unreasonable. An example will be if a product has inflation much higher than its actual value.

Imperfections in a market do not necessarily make a failure. All markets tend to suffer from several issues. The main problem is when you cannot use the market prime function: regulate the relationship between buyers and producers.

A simple cause of market failure is when public goods are overused, and there is no accountability for the cost involved. Public goods are available for everyone like the benches in a subway. The cost incurred on their maintenance is taken from the pocket of the taxpayers.

But what about the anti-social elements which harm the public property without even paying for the damage. The amount paid for the repairs will be an unnecessary expense on the taxpayers’ money who had nothing to do with the damage while the culprits cannot be tracked down.

Market Failure

Types of Market Failure

Each cause of market failures triggers a specific type. Let’s check the most common ones below.

#1 – Missing Market

When there were colonies during imperialism, many colonizers forced the farmers to overproduced cash crops like cotton and coffee. This created a shortage of land and resources to produce food like rice, wheat and sugar.

Many colonies suffered through adequate starvation as there was no adequate market for essential food commodities for people to purchase from. Many colonies, after seeking independence, restructured their economy to become self-sufficient in food crops. This is an example of missing markets.

#2 – Monopoly

Monopoly is one of the most common causes. If a single actor acquires all of the means of production in a market, it will basically set prices as they wish because they will face no competition. Often, this company will set prices much higher than they need because no one else can compete with them, so their rational decision will be to profit more.

#3 – Externalities

Externalities and market failure are common. It happens when your consumption of a good affects an uninvolved third-party. In a positive example, someone else’s action helps you. For example, if someone builds a luxury condominium near your house, your property’s value may arise. However, if they build a prison complex, the price will be negatively affected, resulting in a negative externality.

When governments spend too much money, for instance, they can trigger a negative externality, and market failure as the taxpayers end up paying more money for someone that will not benefit them in the same way.

#4 – Unable to attain equal opportunities

When societies fail to allocate resources judiciously, a segment of the population thrives on abundance over the taxpayers’ money while the needy struggles to make basic needs met. This causes a disequilibrium between demand and supply.

#5 – Asymmetric Market Information

Another leading cause is asymmetric information that happens when there’s not enough information to guide buyers and sellers of a good. Because the participants are not well-informed, prices will not reflect the real value of a good and may vary significantly depending on where you buy them.

#5 – Others

Market speculation can also drive prices up and down without representing reality just as quickly. Public goods like national defence are also a type of market failure. Not everybody pays for them (some people, for instance, avoid taxes), but everybody can use them. Finally, several factors, such as geographical unemployment or climate change, can also contribute to such failures.

Example of Market Failure

  • De Beers is a great example of a monopoly and how it can lead to a massive market failure. The South African company controlled over 80% of the world’s rough-diamond production in 1902. As time passed, De Beers’ strength only increased.
  • With aggressive marketing strategies and by controlling demand acutely, De Beers could use its monopoly to efficiently raise the price of its product much further than it would without it.
  • The company made it highly difficult to gain access to supplies and markets for diamonds. As diamonds’ sales declined in the 1930s, De Beers started to push a marketing campaign to increase demand by convincing people that buying a diamond for your fiancé was a romantic idea.

Solutions

Fortunately, there a few solutions that can help markets that are failing. As a general rule, each cause has its one solution. You can’t solve a problem caused by asymmetrical information by imposing taxes, for example. However, other problems could potentially be solved by that.

#1 – Government Interference

Governments have the power to interfere in the economy to get certain results. One of the most common solutions to rational actions harming the market is to change them by imposing taxes or putting sanctions on the industries. This will make it easier or harder to act in a certain way and to modify their behavior.

Anti-thrust laws, on the other hand, are good to prevent monopolies. By determining that the same conglomerate cannot own more than a certain market share, you ensure a freer market in which several companies can compete.

#2 – Private Agreements

Private consortiums can also act to diminish market distortions. By doing this, a group with similar interests join together and enforces agreements between all the group members. They do it because they see collective advantages in enforcing these agreements, and following them will lead to a better overall result.

#3 – Market Education and Information

The best way to solve information asymmetries is to inform the participants of the market well. By teaching the participants the real price of what they are paying, you will solve price fluctuations regarding inaccurate information. Consumer forums, blogs, rating agencies, media and social media all work towards decreasing information asymmetries.

Recommended Articles

This has been a guide to What is Market Failure in Economics and its definition. Here we discuss its reasons, types causes along with example and solutions. You may also have a look at the following articles to learn more –

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