What is Market Failure?
Market failure happens when the market mechanism results in a misallocation of resources, meaning resources are used for goods and services that do not serve society's best interests. This misallocation prevents maximization of social welfare, leading to either complete or partial market failure. For a deeper insight into how resource allocation impacts economics, see Understanding Scarcity and Opportunity Cost in Economics.
Causes and Types of Market Failure
1. Under-Consumption of Merit Goods (Information Failure)
- Merit goods are under-provided and under-consumed because consumers lack full awareness of their benefits.
- Example: Healthcare and vaccinations, which benefit individuals and society.
- Due to lower demand influenced by information failure, private providers may under-supply these goods.
- Government intervention, like the UK's National Health Service, helps increase consumption and provision.
2. Over-Consumption of Demerit Goods
- Demerit goods cause more harm than users realize, impacting both individuals and third parties (externalities).
- Example: Cigarettes may be over-consumed due to lack of information about their dangers.
- Governments often intervene (e.g., taxation, regulations) to reduce consumption for societal benefit.
- These concepts align with insights in Understanding Market Efficiency: How Smart Money Drives Price Movements.
3. Missing Markets and Public Goods
- Public goods are non-excludable (cannot prevent anyone from benefiting) and non-rivalrous (one person's consumption doesn't reduce availability for others).
- Example: National defence benefits all regardless of payment.
- Lack of incentive for private firms leads to no or under-provision.
- The free-rider problem arises when people benefit without paying.
- Governments typically provide such goods to ensure availability.
- For broader economic perspectives, consider Understanding the Four Types of Economies in Introductory Economics.
4. Lack of Competition (Market Power)
- When one or few firms dominate, they may set higher prices than in competitive markets.
- Reduced competition decreases the incentive to lower costs, leading to allocative and productive inefficiency.
- This inefficiency can further worsen resource allocation and consumer welfare.
- Explore more on market dynamics in فهم الاحتكار: تأثيره، أنواعه، والقوانين المنظمة له.
Summary
Market failure occurs due to failures like information asymmetry, externalities, public goods characteristics, and market power concentration. Understanding these types highlights why markets alone sometimes fail to provide optimal social outcomes and the role of government in addressing these inefficiencies.
If you have further questions or want to explore these topics in depth, please reach out via the contact details in the video's description or visit the accompanying website for additional resources.
In this video covering the A2 specification we will learn about the concept of market failure. By the end of this video you will be able to explain why market failure occurs
and identify the various types of market failure. When does market failure occur? It occurs anytime the market mechanism leads to a misallocation of resources.
Before we considered efficiency and efficient resource allocations. Now we need to consider why the market mechanism results in efficient outcomes. A misallocation occurs when resources are allocated to the goods and services that do
not serve the best interests of society. Therefore, the market mechanism fails to achieve an outcome in which social welfare is maximised. This creates market failure.
The cigarette example should be clearer to you as we approach the end of the video. It’s important to remember that market failure can be complete or partial. Complete market failure results in missing markets, in which no market exists to provide
a good. We’ll see what a partial market means in the types of market failure. Next we’re going to consider four types of market failure.
By understanding each of these we will have a clearer picture of why markets don’t efficiently allocate resources every time and start to consider possible solutions. The first cause of market failure is the under-consumption of merit goods.
This is actually the result of information failure. I’ll explain why in a moment. A merit good is a good that is under provided and under consumed in a market.
Since consumers are not aware of their full benefits, they lack the information to consumer more of it. This is an example of information failure.
Since the demand is relatively low for such products, they are less likely to be profitable and therefore under provided. I’ve put a picture on the right of the introduction of the National Health Service in the UK.
Healthcare can be considered a merit good for multiple reasons. For now let’s consider the case of vaccinations. If one individual seeks treatment it benefits the greater society.
Therefore a case can be made for the government to provide such goods. This stands in contrast to private healthcare providers, as they may have less incentive to do so due to the profit motive.
The second cause of market failure we’ll consider is the over consumption of demerit goods. Demerit goods cause greater harm than the user realises.
This could be both to the individual and other third parties. This impact on third parties is called an externality, which we will explore shortly in another video.
Due to a lack of information about the harm of consuming such a good, like cigarettes, they may be over consumed. The government may intervene to reduce the amount of cigarettes being consumed in order
to benefit the greater society. Thirdly, a case can be made for missing markets. Missing markets may be a problem associated with public goods.
A public good is a good that is non-excludable and non-rival. Non-excludable means that no one can be excluded from benefiting from it. Meaning, if someone doesn’t pay tax they can still receive a benefit from the country’s
national defence. Non-rival means the consumption of one person does not reduce the amount available for someone else to consume.
This also holds true in the discussion of national defence. Since there is little to no incentive for producers to supply these goods and services, they are either not provided or under provided by the market.
Producers also face the free-rider problem in which those who do not pay for a good are able to enjoy it. There would be little that could be done to encourage consumers to pay for a good if it
is possible to be a free rider. Once again, we build a case for government provision of such goods. Finally, we have to consider markets that lack competition.
Perhaps there is significant market power in the hands of one or a few firms. In markets where a single firm or a group of firms control the market, prices may be higher than they would be in more competitive conditions.
Firms would not face competition that would drive them to lower prices. This lack of competitive pressure could lead to allocative inefficiency. Additionally, due to the lack of competition, firms do not face the pressure to reduce costs.
This will lead them to produce at higher average costs, resulting in productive inefficiency. By now you should be able to explain why market failure occurs and identify reasons four types of market failure.
If you have any questions or comments, leave them below or email me. Visit my website to dig a bit deeper into these topics and explore some of the growing library of resources available.
All my contact information is in the video description. That’s us done for now and I will see you in the next one!
Market failure occurs when the allocation of resources by the market is inefficient, causing goods and services not to reflect society's best interests. This misallocation means social welfare is not maximized, highlighting situations where markets alone don't deliver optimal economic outcomes, making government or policy interventions necessary.
Merit goods are beneficial products like healthcare or vaccinations that consumers often undervalue due to information shortages. This lack of awareness leads to under-consumption and under-provision by private suppliers, causing a market failure. Governments typically step in to provide or subsidize these goods to improve consumption levels and social welfare.
Demerit goods, such as cigarettes, are over-consumed because consumers underestimate their harmful effects on themselves and others. This overuse creates negative externalities, and because private markets don't account for these costs, government intervention through taxes or regulations is often necessary to reduce consumption and address the market failure.
Public goods are characterized by non-excludability and non-rivalry, meaning people can't be prevented from using them, and one person's use doesn't reduce availability for others—for example, national defense. Since private firms can't easily charge consumers, these goods are under-provided or not provided at all, leading to the free-rider problem and market failure, which governments usually resolve by supplying these goods themselves.
When market power is concentrated in the hands of one or a few firms, they can set higher prices and reduce incentives to cut costs, leading to inefficient allocation of resources. This lack of competition results in allocative and productive inefficiency, hurting consumer welfare and causing market failure. Regulatory policies often aim to promote competition to prevent such outcomes.
Information asymmetry occurs when consumers or producers lack full knowledge about a product's benefits or harms, leading to poor decision-making like under-consuming merit goods or over-consuming demerit goods. This misinformed behavior disrupts optimal resource allocation, making information provision or regulation essential to correct the resulting market failure.
Grasping the causes and types of market failure enables policymakers to design targeted interventions—such as providing public goods, regulating harmful products, encouraging merit goods consumption, or promoting competition—to correct inefficiencies. This understanding ensures resources serve society better, maximizing social welfare and economic efficiency.
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