Market Failure

Updated on March 27, 2024
Reviewed byDheeraj Vaidya, CFA, FRM

Market Failure Definition

Market failure in economics is a situation when 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.

Market Failure

A simple example of market failure is when a monopolist seller sets high rates to the products leaving no choice for the buyers other than to purchase the overpriced goods. Solutions to market failure in economics include using legislation to prevent people from making decisions that will harm the collective and teaching people about the market.

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 using legislation to prevent people from making decisions that will harm the collective and teaching people about the market.

Market Failure Explained

Market failure economics revolves around market disruptions arising from various 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 coordinate producers and consumers by determining the price.

If markets are working properly, the price of something will result from 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.

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 individual needs and supply in a free market. The most common examples and types include missing markets, monopolies, externalities, etc.

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Causes

Imperfections in a marketImperfections In A MarketImperfect market structure is a part of microeconomics in which companies sell different products and services, as opposed to perfect competitive markets in which homogeneous products are sold. Companies in this sector have some pricing power with high barriers to entry, resulting in higher profit margins as each company tries to differentiate their products and services through innovative technology.read more 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 economics is when public goods are overused, and there is no accountability for the cost. Public goods are available for everyone, like the benches in a subway. However, the cost incurredCost IncurredIncurred Cost refers to an expense that a Company needs to pay in exchange for the usage of a service, product, or asset. This might include direct, indirect, production, operating, & distribution charges incurred for business operations. read more on their maintenance is taken from the taxpayers’ pocket.

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.

Types

Each cause of market failure triggers a specific type. Let’s check the most common ones below that cause the market failure graph to fall beyond repair.

#1 – Missing Market

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

Many colonies suffered through adequate starvation as there was no proper market of 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

MonopolyMonopolyMonopoly is the “one-&-only” seller of a good or service in the market & it faces no competition from any other entity. Generally, it is controlled or monitored by the Government to safeguard the customers’ interests. read more is one of the most common causes. If a single actor acquires all of the means of production in a market, it will set prices as they wish because it 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, your property’s value may arise if someone builds a luxury condominium near your house. 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 struggle to meet basic needs. This causes a disequilibrium between demand and supply.

#5 – Asymmetric Market Information

Another leading cause is asymmetric informationAsymmetric InformationAsymmetric information is the knowledge mismatch that happens when one party secures more information about a product or service than the other party to the transaction. The information failure is often seen when the seller is more informed about a product's condition than the buyer.read more 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 and may vary significantly depending on where you buy them.

#6 – Others

Market speculation can also drive prices up and down without representing reality just as quickly. Public goods like national defense are also a type of market failure. Not everybody pays for them (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.

Examples

Let us understand the concept better with the help of a couple of examples that will help us grasp the ebbs and flows of the market failure graph’s behavior better.

Example #1

XYZ Ltd produced customized stationary for their clients. Established in 1974, their company one of the first organizations in the world to provide customized solutions for something as basic as stationary.

Therefore, they were able to price their products well beyond the market prices and attracted plenty of corporate gifting and bulk orders.

As time passed on, their competitors picked up the same strategy and also used the advantage of studying XYZ’s strategies to price their products way better. As a result, XYZ had to cut down their prices and had to market the products around “customization is now affordable” brief.

Example #2

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, a few solutions can help markets that are failing. As a general rule, each cause has its solution. For example, imposing taxes can’t solve a problem caused by asymmetrical information. However, other problems could potentially be solved by that. Let us understand the chance at the revival of market failure economics through the discussions below.

#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 sanctions on the industries. This will make it easier or harder to act in a certain way and 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 shareMarket ShareMarket share determines the company's contribution in percentage to the total revenue generated within an industry or market in a certain period. It depicts the company's market position when compared to that of its competitors.read more, you ensure a freer market in which several companies can compete.

#2 – Private Agreements

Private consortiums can also act to diminish market distortions. For example, a group with similar interests joins together and enforces agreements between 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 market participants well. You will solve price fluctuations regarding inaccurate information by teaching the participants the real price they are paying. Consumer forums, blogs, rating agencies, media, and social media all work towards decreasing information asymmetries.

This has been a guide to what is Market Failure. Here we explain its examples, causes, and types along with its solutions in detail. You may also have a look at the following articles to learn more –