MEANING AND CAUSES OF MARKET FAILURE

The meaning of market failure is very simple. Market failure occurs when the free market fails to produce the socially optimum quantity.

Market failure is a situation in which the allocation of goods and services in a free market is not efficient.

More appropriately, market failure occurs when the price mechanism fails to account for all the costs and benefits needed to consume and produce a good.

When the market fails, the free market is not supplying the socially optimum output.

This simply means that the demand and supply in the market are not producing the quantity when price equals the marginal cost of consumption, thereby, causing allocative inefficiency.

Several factors can cause market failure, including externalities, underproduction of merit goods, overproduction of demerit goods, lack of public goods, and information failure.

Let's see how each of them caused externalities.

Externalities

For a market not to fail, the cost and benefit of an economic transaction must be borne by the buyer and seller involved in that economic transaction.

However, in many real-world cases, economic transactions seldom affect only the buyer and seller involved in that transaction. Rather, it affects third parties.

This introduced the concept of externalities. As the name suggests, an externality is an effect that an economic transaction has on individuals who are external to that transaction.

For example, consider second-hand smoking. individuals who are not directly engaged in smoking may experience discomfort and respiratory problem when severely exposed to this second-hand smoking. Hence, they bear a negative externality

Externality may be negative, as is the case in the second smoking, or positive.

A good example of positive externality is the case of vaccination.

Although vaccination against covid-19 may directly affect the receiver, However, a vaccinated population will mean no or few cases of the disease are recorded in society. Thus, this has a positive effect on society.

The underproduction of merit goods

For a market to be allocative efficient, it must produce the social-optimum quantity.

However, and as we have seen in the real world, firms and society tend to produce a lesser quantity of merit goods. 

Merit goods are goods that provide positive externalities or effects when consumed.

Surely, the earlier case of vaccination against covid-19 is a good example of merit good.

This is because others who have not been vaccinated also benefit since they can no longer get the disease from those vaccinated.

Another example of merit goods is education. A well-educated population may provide a positive effect on society.

However, and as always in the case of merit goods, education is under-produced because individuals who make decisions regarding how much education we receive do not quite understand the benefit of an educated society.

If merit goods are under-produced, then the market fails because the price mechanism does not produce the socially optimum output.

Over-production of demerit goods

Demerit goods, as you might imagine, are the direct opposite of merit goods.

So, while merit good provides a positive effect on the consumer, demerit good usually provides a negative externality.

Cigarette provides a good of demerit goods. When consumed by an individual, It will not only cause adverse health effects to the consumer, it also poised serious respiratory and health problems to individuals who may be exposed to the smoke. 

However, as we have seen in our community today, smoking is fast becoming a popular culture in our society.

Since demerit good is being over-produced, the market will certainly fail because the free market is not producing social-ideal quantity.

Lack of public goods.

For goods to be called public goods, they must be non-excludable and non-rivalrous.

Non-excludable, in the sense that other consumers can not be excluded from consuming the goods once it is provided.

Public goods are also non-rivalrous in that the consumption by one consumer does not diminish the consumption that other consumers are receiving from them.

The best-known case of a public good is national defence

The government can not successfully prevent any of its nationals from being defended (non-excludable) nor can the protection of one citizen affect the protection of another citizen (non-rivalrous).

While the non-excludable and non-rivalrous nature of the public good may sound good, it, however, provides little incentive from a private standpoint. Hence, most public goods are under-produced.

Why?

There is little incentive for the market to produce so many of the goods since it is non-excludable.

If a good is non-excludable, how can the government or firm charge for it?

Hence, fewer public goods are produced. This perhaps explains why many governments spend less on national defence.

Yes, you might be right to say that you paid for national defence through tax. However, not everyone paid tax (for example tax evaders). 

The problem created here is that some people tend to free-ride without necessarily paying for it. This is called the free-rider problem. 

Free-rider and Market Failure

Information failure

Perhaps, a less-known cause of market failure is information failure. Information failure may arise because people do not perceive how good or bad a thing is for themselves and their neighbourhood.

As research has suggested, most second-hand smoking could be avoided if smokers are adequately aware of the consequences of their actions on themselves and society at large. 

Another occurrence of information failure is in vaccination activities. People, especially those that live in rural areas, are not adequately informed of the importance of vaccination. 

If they are aware that the vaccinated population means fewer cases of the disease will be recorded, they may perhaps get vaccinated.

That will be all for now. If you have got questions relating to economics, you can ask our telegram community

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