A market failure is an economic situation occurring from an inefficiency in the distribution of goods and services in freely functioning or unhindered markets, thus resulting in an outcome that is not socially optimal or a net social welfare loss. Remember that a market economic system and the free markets are considered as an efficient system for allocating scarce resources within a society.
In a failed free market, the pursuit of self-interest by individual market participants leads to outcomes that are not socially optimal because the entire group or another party incurs too many costs or receive too few benefits. Essentially, each individual makes decisions for his or her benefit. However, these decisions prove to be damning to the entire group or another party. Price mechanism fails to account for all benefits and costs associated with such decision.
Understanding the concept of a failed market requires an understanding of the different types of market failure. Take note that to a certain extent, these types of market failure also correspond to the causes or reasons why free markets fail.
Types of Market Failure and the Reasons Why Markets Fail
1. Production and Consumption Externalities
An externality is a cost or benefit that is unknowingly or involuntarily received by a party due to the production or consumption of a good or service. For example, certain manufacturing processes can lead to pollution that can affect the environment and its community. Mining, unsustainable agriculture, and logging lead to the depletion of natural resources. These are examples of production externality.
Some examples of consumption externalities include smoking that can negatively impact the health of non-smokers through second-hand smoking and the use of plastics that can lead to environmental degradation due to their improper disposals. Positive externalities or when one party confers a benefit on another party but does not reap a reward for providing it also signify a market failure.
2. Information Asymmetry
The lack of symmetry or balance between the knowledge of the buyer and the knowledge of the seller best describes information asymmetry. This imbalance prevents a party from making informed choices, thus resulting in exploitation or the total collapse of the transaction or the buyer-seller relationship.
An example of information asymmetry is an unscrupulous car repair shop that usually recommends doing extensive car repairs to charge exuberant fees. They can easily exploit customers who lack relevant familiarity with automotive vehicles, or they can go out of business due to public mistrust. Note that a buyer can also exploit the seller such as in the case of an antique collector.
3. Principal-Agent Problem
A principal-agent problem is a situation in which an agent is pursuing his or her self-interest at the cost of the interest of his or her principal. Such a situation can lead to a market failure, especially if it transpires within a larger context. As an example, banks that give out loans with low interest rates to increase their customer base of borrowers and thereby, future profitability are compromising the interests of their customer base composed of savings account holders.
In large publicly listed companies, majority shareholders tend to dominate small shareholders regarding decision-making. Nevertheless, note that the principal-agent problem transpires if involved parties have different interests and if there is an information asymmetry. Moral hazard and conflict of interest also lead to this problem.
4. Public Goods and Services
Governments provide non-excludable and non-rivalrous public goods and services such as transportation infrastructures, free health care services, and social welfare programs. Some argue that such provision is an example of market failure because the free market or private entities would not participate due to lack of incentives.
There is also the concept of free-rider or free-loader effect in which certain individuals obtain benefits from public goods and services without paying for them directly. An example of this free-loader effect would involve non-taxpayers who excessively use public roads or consume and abuse social welfare services.
5. Common Access Resources
There are resources that are not owned by anyone but can be used and exploited by everyone. These are common access resources or common property resources. Furthermore, these resources are non-excludable but rivalrous unlike public goods and services. For instance, fisher folks or large fishing companies can exploit marine resources through overfishing or unsustainable practices.
Other examples include unchartered or unregulated and land forest areas that might be exploited through over-extraction of natural resources and illegal settlements. The exploitation of common access resources results in the so-called “tragedy of the commons”.
6. Non-Competitive Markets
The lack of competition is another type and cause of market failure. Note that this situation can be a result of monopolistic situation in which a single business organization remains the sole producer or supplier in a particular market, or a duopolistic situation in which there is only a small number of businesses collectively controlling the market through cartel-like behaviors or collusion.
The lack of competition in a market negatively affects the interest of the consumers through lack of options or alternatives, higher prices, and/or lower quality of goods and services. It can also affect the interest of new market entrants, especially when a dominant business or a group of colluding businesses raise the barriers to entry.
7. Incomplete and Missing Markets
A free and efficient market should be able to produce a good or service based on a cost less than what individuals are willing to pay. However, in an incomplete market, there is a market failure because private entities fail to provide good or service and thereby, respond to an existing demand even though it is cost efficient to do so.
On the other hand, a missing market is another example of market failure in which the providers of good or services fail to meet existing demands due to the absence of favorable market conditions such as incentives or benefits, perfect and effective market coordination, and availability of technology or innovation, among others.
8. Unemployment and Inflation
Periodic episodes of high unemployment and/or sustained rate of inflation also demonstrate a failure in the market. Note that the lack of job opportunities corresponds to the poor performance of the job market due to an overabundance of workers and scarcity of job openings. Furthermore, inflation signifies a decline the purchasing power per unit of money or the devaluation of a particular currency due to factors such as an overabundance of the money supply, cost-push inflation, and demand-pull inflation, among others.