Market Failure – Causes and Solutions

What is Market Failure?

Market failure is an economic situation that arises due to inefficient distribution of goods and services in the free market. Individual decisions can prove to be correct but may not support a particular group. Rational individual interests produce inefficient economic outcomes. Prices of goods and services is determined by supply and demand. When quantity supplied of goods and services is not equal to quantity demanded, market failures take place. Market failure may affect the free market are monopoly power, government regulations, prices and minimum wages.

Causes of Market Failure

Market failure can occur due to many reasons.

  1. Public Goods

Public goods are those goods that can be consumed by a large number of people and the cost of such goods remain the same even with increase in the consumers. Features of public goods include non-excludability and non-rivalrous. Non-excludability means that even if a person does not pay for the services or goods provided that person will not be excluded from consuming it. It is non-rivalrous as these goods are consumed by entire population efficiently and never diminishes. Like police services or national defense services are available to people throughout even if they don’t pay taxes. Since, consumers continue to use public goods without paying for it, it results in market failure.

  1. Externality

It refers to the cost from a transaction that affects a third party. This cost is not borne by the producer but by the individual or society as a whole. Externality can be positive or negative. Positive externality positively affects the third party like providing education or conducting a survey or research. However, negative externality refers to negative impact on the third part from consumption of a good. For instance, when factories cause air or water pollution diminishes overall health of the people surrounded by it. The cost of pollution is not incurred by the producer. This is negative externality. Negative externalities are commonly found.

  1. Control of Market

Controlling market is when the seller or buyer have the power to determine the prices of goods and services in the market. This market control is possible in case of oligopoly (few sellers) as well as monopoly (single seller). Sellers can increase the prices of commodities and control the quality of it, which may lead to scarcity.

When the power is in the hands of the buyers, buyers will dominate by accepting the price at which they are willing to buy not the producer’s said price. This leads to unequal supply of goods and demand.

  1. Lack of Proper Information

When buyers and seller have incomplete or improper information, market does function well. If buyers have incomplete information, they might end up buying goods at higher or lower prices. If sellers have sparse knowledge, then might be willing accept a lower or higher prices than the actual production cost.

How can market failure be eliminated?

Market failure can be prevented by government intervention. Imposing strict rules and regulations is an ideal solution. For instance, unethical behavior like selling drugs or alcohol to underage kids can be controlled by implementing legislation. Even when businesses sell goods or services that cause harm to the consumers, high taxes can be imposed on such goods to avoid consumption. This way the individual consuming it as well as the society is protected from harmful effects of it. Subsidies on consumption of goods will encourage businesses to produce goods and will promote positive externality.

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