Market Failure: Definition, Causes & Examples

Market Failure: Definition, Causes & Examples

market failure definition

Market Failure Definition

A market failure occurs when there is an inefficient allocation of resources. In other words, the true cost of a good is not reflected in the price. This might be because a third party benefits, but does not pay for that benefit. Or, it could arise due to a cost that is imposed on a third party without their consent and compensation.

In turn, this leads to an inefficient allocation of resources as a third party bears the cost or benefit. For example, pollution comes at a cost to society and the environment. However, these external costs are not quantified or passed on to the final consumer, leading to a net cost to society.

Key Points
  1. A market failure is where there is an inefficient allocation of resources. This comes either through an undersupply or over-demand, or, where there are externalities.
  2. When a company does not pass on the cost, both internal and external, onto the final consumer, there is market failure.
  3. Solutions to market failure include a number of private, government, and voluntarily collective solutions.

There are many causes of market failure which range from externalities to inefficient supply. For example, the UK’s national healthcare system has a high level of demand as it is free at the point of use. Consequently, it consistently struggles to meet demand, with patients facing long waiting times. Therefore, this is a market failure as demand is not adequately met.

“A market failure occurs when there is an inefficient allocation of resources.”

Supply <> Demand = Market Failure

The inefficient allocation of resources is not just limited to the supply of goods. Market failure can also occur through externalities. This can be both positive and negative. For example, a third party may benefit from a local park being built.

A third party may benefit from a local park being built. Its construction has no direct cost but creates positive externalities in the form of people enjoying recreational actives there. So how is this an inefficient allocation of resources? Well, it creates benefits that customers do not directly pay for. In other words, it creates utility to individuals that it is not represented in its price.

As a result, businesses under-produce such goods as people gain from them indirectly but do not pay for them. For example, people and businesses across the country will benefit from having an educated workforce, but most would be unwilling to pay for everyone else’s education. In turn, if education was privately funded, we would likely see a sub-optimal supply and hence a poorly educated workforce. The same principle can apply to traffic lights and street-lamps. Drivers benefit from them, but they would be unlikely and unwilling to pay for them.

Market Failure Definition Expanded

Market failure occurs when there is an oversupply or undersupply; or, where full costs are not incorporated into the final price. Therefore, a third party may have a cost imposed on them. In economic jargon, we say there is an inefficient allocation of resources.

We can look at Market Failure in two ways. Firstly, through supply and demand. When there is a constant disequilibrium, there is a market failure. In other words, if supply and demand never meet, there is market failure. This might be because there is too much demand and too little supply. Or, alternatively, it might be because there is too much supply and too little demand.

Second of all, we can look at market failure from the side of pricing. This is where the good or service produces external benefits or costs that are not reflected in the final price to the consumer. These are also known as externalities.

Market Failure Examples

Air pollution can cause significant third-party costs through poor air quality which can impact their health. Yet the external cost is not reflected in prices, nor are third parties reimbursed for such. This is known as a negative externality – where the cost is not reflected in the price.

There are also positive externalities, where other parties benefit, but do not pay for it. For example, the government may spend $1 million to build a local park, which creates an external benefit, but a third party may not have spent so much money to receive such a benefit. Resources are therefore allocated inefficiently.

Another example of market failure is in the US dairy market. The industry produces far more than consumers require. Incentivized by subsidies, farmers overproduce dairy products to be eligible for government funds. As a result, most years result in an excessive surplus that governments buy and store. Yet whilst demand in the industry is falling, producers are ramping up production. A clear example of market failure.

Some of the most common forms of market failure include:

  1. Air and Noise Pollution.
  2. Education.
  3. Healthcare.
  4. Water supply and other utilities.
  5. Alcohol.
  6. Policing.

Causes and Examples of Market Failure

Market failure is characterised by disequilibrium and a failure of pricing mechanisms. There are seven main causes which are:

Causes of Market Failure
  1. Negative Externalities
  2. Positive Externalities
  3. Imperfect Information
  4. Monopolies
  5. Merit goods
  6. De-merit goods
  7. Public goods

1. Negative Externalities

Air and noise pollution are two common negative externalities. They both impose a cost onto a third party without consent or compensation. As these costs are not incorporated into the final price, we can consider this a market failure.

Negative Externalities – Market Failure Examples

  1. Traffic
  2. Litter
  3. Obesity
  4. Air Pollution
  5. Smoking Pollution

2. Positive Externalities

Education is a commonly cited positive externality but imposes a cost onto the taxpayer. For instance, the taxpayer may spend $4,000 in taxes. However, the external benefit may not exceed $4,000. As a result, there may be a net negative loss to the taxpayer, meaning resources are inefficiently allocated.

Similarly, the government may build a local park, with the cost reaching $5 million. Yet it provides a positive externality to residents who benefit. Nevertheless, it is a market failure because those residents may not have willingly spent $5,000 in taxes for a benefit.

When the government spends over and above the true social value that people place in that good, there is a market failure because the cost exceeds the benefit.

Positive Externalities – Market Failure Examples

  1. Education
  2. Advertising
  3. Insurance
  4. New Technology

3. Imperfect Information

Sometimes customers simply don’t have enough information. For example, second-hand car sales is a market failure. The customer may not know the true history of the car – how many miles, how many accidents, or how many previous owners has it had? In turn, these are all factors that can impact the price of the final product. As a result, the true value is not aligned to its price, leading to an inefficient allocation of resources.

For instance, the car dealer may know that the car has been involved in a number of accidents and has a number of faults. They value the car at $2,000 as a result, but know that without these issues, the car is worth $4,000. So that is how much they can put it up for. In turn, an unsuspecting consumer may come and purchase the car thinking there is little wrong with it, but only because they have imperfect information.

Imperfect Information – Market Failure Examples

  • Healthcare
  • Food Ingredients
  • Second Hand Cars
  • Online Shopping

4. Monopolies

A monopoly is a market structure that produces an inefficient allocation of resources. As they are the only supplier in the market, it leads to higher prices and an undersupply of goods. The lack of competition in the market allows the monopoly to dictate prices and can often lead to diseconomies of scale and other efficiencies.

For example, De Beers used its monopoly power to control the supply of diamonds in the 20th century. As a result, customers paid higher prices, leading to an inefficient allocation of resources.  

Monopolies – Market Failure Examples

  1. De Beers
  2. Water Supply
  3. Road Construction

5. Merit goods

Some goods such as education provide an external benefit to third parties. However, private individuals may not consider this in the final price. For example, a college education may be worth $100,000 to society and $50,000 to the student. The benefit to society is not considered, so a transaction will only take place if it is a net benefit to them; meaning a cost of anything under $50,000 – the cost to the student. This can cover any good that provides a social benefit that is not considered in the final cost.

Merit Goods – Market Failure Examples

  1. Fruit and Vegetables
  2. Education
  3. School Meals
  4. Museums
  5. Libraries

6. De-merit goods

There are products whereby the true cost is underestimated. For example, smoking causes permanent damage to the lungs, but many consumers undervalue the significance of this in their purchasing decision. Addiction is often a key factor, meaning customers are all too willing to pay over and above the true cost. Generally, they originate from an addiction or dependency. For example, an alcoholic who is desperate for their next glass has a higher willingness to pay than that of an average person.

De-Merit Goods Market Failure Examples

  1. Smoking
  2. Drugs
  3. Alcohol
  4. Violent Games

7. Public goods

For policing or defence, no private company would be willing or able to service the market. At present, there is no feasible way of charging the customer. The average taxpayer may not directly need policing, but benefits from its presence. To put it another way, policing provides positive externalities, yet is unable to charge the full cost to, say, a victim of a burglary. So although many in the public will not directly need the help of the police, they also act as a deterrent, which reduces the level of risk to the public.

Public Goods – Market Failure Examples

  1. Police
  2. Defence
  3. Law
  4. Education

How to Solve Market Failures – Responses

Private markets can often solve market failures. For example, brand image can help resolve imperfect information, and international competition can help destroy monopolies by increasing the number of companies in the market. On occasion, governments intervene to resolve market failures, but can create more permanent government failures. The question is whether such is preferable to the original market failure.

There are a number of ways by which both businesses and governments respond to market failures. For example:

1. Legislation

Governments have introduced laws to prevent people from smoking in certain public places. This negates the negative externalities of smoke inhalation onto third parties. At the same time, it reduces the freedom of the smoker and produces a net disadvantage to them. Similarly, there are regulations that add costs to businesses. For example, the car manufacturing sector is dictated by a number of safety and emission regulations. Whilst these may have made cars safer and more environmentally friendly; they have added billions to the cost of the final product.

2. Resolving Imperfect Information

Some governments such as the UK require manufacturers to provide customers with a breakdown of nutritional information on food packaging. This aims to provide the customer with more knowledge over how healthy or unhealthy a product is. By giving the consumer more knowledge over their purchasing decision, it is argued that imperfect information can be overcome.

3. Subsidies

The US government has historically provided its farmers with subsidies to help keep them in business. The goal is to help stabilize farmers from the fluctuations in the yield of the harvest. For example, due to bad weather, farmers may produce fewer goods than usual, thereby affecting the financial ability to continue into the next season. As a result, more farmers can last through the bad times and provide the nation with food in good times. The cost, however, is significant: approximately $20 billion per year. At the same time, it encourages farmers to overproduce goods such as milk and corn. The benefit is that it keeps farmers in business, but comes at the cost to the consumer. The question is whether it’s worth it.

4. Competition Regulators

In the US, they have what is known as the FTCs Bureau of Competition. This agency looks to prevent monopolies arising, bring forth antitrust cases, and essentially try to ensure that there is a competitive environment.

5. Government Control

Some products and services are deemed so important, that only the government should provide them. Education is a notable example. For instance, it can provide external benefits in the form of a more intelligent workforce. We consider it as a market failure because private firms would not serve the market in a way that would serve the entire population. The drawback is that students can get stuck in under-performing schools, thereby keeping them stuck in their socioeconomic group. Other private solutions have been suggested such as School Choice, but face political resistance.

6. Brand Image

Often the most valuable part of a company is the brand image. On occasion, it’s more valuable than the assets it owns. This is because it is a stamp of approval. A sign that the company is quality and can be trusted. This overcomes a misinformation barrier as customers trust the brand. At the same time, a brand needs to ensure it keeps that trust. If McDonald’s had an outbreak of food poisoning in all of its restaurants; its brand image would be severely damaged, losing it millions of dollars.

Market Failure FAQs

What are examples of market failures?

Market failures occur when there is an inefficient allocation of resources. For example:

Radio: The station broadcasts to all listeners, but is unable to charge them directly. It can’t tell who is listening or whether they have paid. In turn, this makes it unprofitable to the station as it is unable to finance its operations. As a result, advertising stepped in to address the issue.

Street Lights: A market failure in the fact that it is in demand, but no company would be willing to supply it. For instance, a private firm may supply the lighting, but has no reasonable way of collecting money from customers.

De-merit Goods: There are products whereby the true cost is underestimated. Smoking, for example, causes permanent damage to the lungs, but many consumers undervalue the significance of this in their purchasing decision. Addiction is often a key factor; meaning customers are all too willing to pay over and above the true cost.

What are the effects of market failure?

There are four main effects of market failure.

1. No Supply: First of all, no business is willing to supply a good or service despite there being demand.
2. Undersupply: The business may be a monopoly and can restrict supply in order to keep prices high. For instance, De Beers diamonds did this during the 20th Century.
3. Oversupply: In the US dairy market, as a result of government subsidies, farmers significantly overproduce milk. As a result, much of it is thrown away.
4. Externalities: These can be both positive and negative. For instance, air pollution is negative and causes an external cost borne by a third party. Whilst a positive externality such as education creates a positive benefit to society that is not paid for directly by the students.

What is the definition of market failure?

Market failure occurs when there is an oversupply or undersupply; or, where there are costs that are not incorporated into the price, and therefore result in external costs or benefits. In economic jargon, we say there is an inefficient allocation of resources.

About Paul

Paul Boyce is an economics editor with over 10 years experience in the industry. Currently working as a consultant within the financial services sector, Paul is the CEO and chief editor of BoyceWire. He has written publications for FEE, the Mises Institute, and many others.

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