Market Failure

Definition

Market failure is an economic term that refers to a situation where the allocation of goods and services is not efficient, meaning either the quantity produced is insufficient or is overproduced. It occurs when the free market does not distribute or create resources in the most economically advantageous manner. This can be a result of a variety of factors, such as monopoly power, negative externalities, and public goods.

Phonetic

The phonetic pronunciation of the keyword “Market Failure” is: ‘mɑːkɪt ‘feɪlyər

Key Takeaways

1. Imperfect Information: Market Failure can occur when all participants do not have all the necessary information to make rational decisions. This lack of information can cause inefficiencies and failures in the market.
2. Externalities: These are costs or benefits that affect parties who did not choose to incur them. Negative externalities can lead to overproduction of goods or services, while positive externalities can lead to underproduction, both of which contribute to Market Failure.
3. Public Goods: These are goods that are non-excludable and non-rival. Due to these characteristics, public goods can be underproduced in a market economy, leading to Market Failure as it creates situations where there can be free riders who benefit from the good without paying for their share.

Importance

Market failure is an important concept in business and finance as it denotes a situation wherein the allocation of goods and services by a free market isn’t efficient. It results from an imbalance in economic conditions that can lead to a misallocation or wastage of resources, or to inequality in the distribution of wealth. Understanding market failure helps businesses and policymakers identify situations where intervention might be necessary for an equitable and efficient outcome, like improved regulation or the application of fiscal or monetary policies. It is a key concept in identifying the limitations of free markets and the potential benefits of government regulation or other forms of intervention.

Explanation

Market failure serves an integral purpose in economic studies by signifying a situation where resources may not be allocated efficiently in a free market. It highlights areas where the private entities (individuals, business organizations) cannot efficiently organize production or distribution of goods and services, requiring intervention to correct the imbalance. Such scenarios may involve instances where the market does not supply the products that people want or does not produce the right number of goods at suitable prices providing a gap in supply and demand. The evaluation of market failures is used by economists and policymakers to advocate for governmental steps to rectify these inefficiencies, which could be in the form of regulations, price controls, or taxes. For example, in the case of a ‘public good’ like street lighting, which is non-excludable and non-rivalrous, market mechanisms alone might fail to provide it sufficiently, as people are tempted to become “free riders” and benefit without paying. Thus, the concept of market failure helps to devise policies to prevent such instances and ensure optimal, fair distribution of resources to benefit society.

Examples

1. Overfishing in Seas: Overfishing is an example of a market failure known as a ‘common property externality.’ Fishermen have unrestricted access to fishing areas, and since they are concerned with maximizing personal profit, they tend to ignore the impact of their actions on others. The end result is depletion of the fish stock beyond their level of sustainability, destroying the ecosystem and threatening the livelihoods of future fishermen. 2. Healthcare: The healthcare sector is often cited as an example of market failure due to information failure and asymmetry. Patients usually lack in-depth medical knowledge and thus heavily depend on their doctors’ expertise. This could potentially lead to over-treatment or over-charging. Similarly, insurance companies may deny coverage to high-risk individuals, resulting in a situation where the most in-need individuals may not have access to healthcare. 3. Environmental Pollution: This is a classic example of a ‘negative externality’. Companies may release pollutants into the environment to cut costs, but these actions have costs that are borne by society as a whole – in the form of health hazards, destruction of natural habitats, and climate change. This is a market failure as companies profit at the expense of society’s wellbeing, and without intervention like regulation and fines, the market fails to deliver an efficient outcome.

Frequently Asked Questions(FAQ)

Related Finance Terms

• Externalities
• Public Goods
• Information Asymmetry
• Moral Hazard
• Monopoly Power

Sources for More Information

• Investopedia
• Corporate Finance Institute
• Indeed
• Wikipedia