In this lesson, we will examine the term market failure. We’ll look at the types and causes of market failure and then test your new knowledge with a quiz.
Definition of Market Failure
We’ve all had the experience of running to the store to pick up something we need, only to find out that the item is out of stock. We can wait until the item comes back into stock or grab a similar item that is currently in the store.
As we reach for the replacement product, we ask ourselves: why doesn’t the store supply enough products to meet the demand of the consumers? The answer to this question is market failure.Market failure occurs when products that consumers demand do not equal the amount of supplies offered. Any time markets fail to allocate resources efficiently, the situation results in market failure.
Types of Market Failure
Now that we understand the definition, let’s take a look at the two different types of market failure.
- Complete market failure: This happens when a market does not supply any products at all.
- Partial market failure: Unlike complete market failure, products are supplied. However, the market produces either the wrong quantity of product or charges the wrong price.
Causes of Market Failure
So how does a market failure occur? There are several reasons. Let’s examine some of the more common reasons why markets fail.
- Equality or fairness issues: When a market fails to limit the gap between income earners and generates an unacceptable distribution of income, a market can fail.
- Incomplete or unstable markets: A lack of certain types of merit goods and services produced can lead to market failure.
Examples of merit goods and services include education and healthcare. Unstable and volatile markets, such as those associated with agriculture, credit or foreign currency, may require some type of action to keep them from failing.
- Inefficiency: Sometimes, a market does not distribute or offer limited resources in the most efficient way, which can cause it to fail.
- Information failure: During a transaction, two parties may fail to exchange everything they know. For example, one of the parties may not want to share all of its information because it may not benefit the marketability of its products. Demerit goods, such as cigarettes, are a good example of challenging products. If tobacco companies inform the public about the negative side effects of smoking, it may affect their ability to sell cigarettes.
- Monopolies: The inability of a market to control how monopolies use or abuse their power can lead the market to failure. For example, charging high prices while offering consumers a limited number of options can have a negative effect on a market.
- Missing markets: When there is a need or a demand for a good or service, but no established marketplace, the market may fail.
One example of missing markets are public goods, like streets and street lights.
- Negative externalities: Sometimes, individuals don’t realize how their actions can affect others, which leads to a negative externality, such as pollution. While many of us drive cars and trucks that cause air pollution, how many of us realize the ways in which that pollution irritates the lungs of others?
- Property rights: When consumers, manufacturers and production entities can own property, markets perform at their best.
Conversely, an inability to allocate property rights can prevent markets from establishing at all.
A market failure is a situation when resources are not efficiently allocated. This happens when demand and supply are not equal. Complete market failures occur when no products are supplied at all. Partial market failure can happen when products are supplied in the wrong quantity or price.
Some causes of market failure include incomplete or missing markets, a lack of certain types of merit goods and services produced; inefficiency, when a market does not distribute or offer limited resources in the most efficient way; monopolies, charging high prices while offering consumers a limited number of options; and property rights, an inability to allocate property rights can prevent markets from establishing at all; equality and fairness issues, when a market fails to limit the gap between income earners and generates an unacceptable distribution of income; information failure, when two parties fail to exchange everything they know; and negative externalities, when individuals don’t realize how their actions can affect others, can also cause market failure.