Market Failure – All That You Want To Know

What is Market Failure ?

Market is a structure that allows buyers and sellers to exchange any type of goods, services or information. The exchange of goods or services, with or without money, is a transaction, This structure can be physical or virtual (digital).

Failure means not getting the desired outcome.

Market Failure is the failure of a market to deliver an optimal result or output. OR

In Economics terms –

Market Failure is a situation in which there is an inefficient distribution or allocation of available resources or goods and services in the free market economy.
In other words, each individual makes the correct decision for him or herself, but those decisions happens to be the wrong for the group or for the others persons.

Where did this term come from ?

The first known use of the term by economists was in 1958, but the concept has been traced back to the Victorian philosopher and economist Henry Sidgwick (31 May 1838 – 28 August 1900).
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The descriptions of market failure were developed in the middle of the 20th century as part of a larger school of Keynesian welfare and macroeconomics. Important contributors included Arthur C. Pigou, Francis Bator, William Baumol, and Paul A. Samuelson. Those theorists were concerned with the correspondence between free market outcomes and social welfare optimization.
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Why the market failure happens ?

Market failure can happen due to a lot of reasons, such as monopoly, negative externalities, public goods etc

Causes of Market Failure

Public Goods – It is a good or service which is provided without profit to all members of a society, either by the government or by a private individual or organization. Public goods are often not provided in a free market.

In economics, a public good is a good that is both non-excludable and non-rivalrous, which means an individuals cannot be excluded from use or could benefit from it, without paying for it, and it’s use by one individual does not reduce availability to others or the good can be used simultaneously by more than one person.
Public Goods are non-rival and non-excludable, e.g. – police, national defence.

Monopoly Power – It is a market structure in which there is a single seller, selling a unique product in the market. In a monopoly market, the seller faces no competition, as he is the sole seller of goods with no close substitute, So he enjoys the power of setting the price for his goods as he has the high (or nearly all) market share. e.g. – Railway in India

Merit Goods – Merit goods are those goods and services that the government feels that people will under-consume, and which ought to be subsidised or provided free at the point of use so that consumption does not depend primarily on the ability to pay for the good or service. Merit goods may also have positive externalities.
People underestimate the benefit of this type of goods, e.g. education.

Demerit Goods – Demerit good is “a good or service whose consumption is considered unhealthy, degrading, or otherwise socially undesirable due to the perceived negative effects on the consumers themselves”. It is over-consumed if left to market forces. It may also have negative externalities.
People underestimate the costs of this type of goods, e.g. smoking, drinking, recreational drugs, gambling etc.

Negative Externalities – A negative externality is an economic activity that creates a negative effect on an unrelated third party. It can arise due to production or the consumption of a good or service.
Goods/services which impose a cost on a third party, e.g. – air pollution, water pollution, smoking,

Asymmetric Information – Asymmetric Information is a situation in which there is unequal knowledge between each party of a transaction, that one party has better information than the other party. This creates an imbalance in a transaction.
There is a lack of information to make an correct decision. e.g. – financial markets, insurance markets, second hand or used cars market etc.

Asymmetric Information has two types – Adverse Selection & Moral Hazard

Adverse Selection – It is a situation where buyers and sellers have different information, so that a participant might participate selectively in trades which benefit them the most, at the expense of the other trader. OR
It is a situation in which one party in a deal has more accurate and different information than the other party. e.g. – used car market.

Moral Hazard – It is a situation in which one party gets involved in a risky event knowing that it is protected against the risk and the other party will incur the cost. It arises when both the parties have incomplete information about each other.
When individuals have incentive to change their behaviour when others take the risk.
For example, in financial markets, when banks are insured by the government, bankers take risky decisions which can cause bank losses, a person who has a health insurance takes the risk of life by smoking, drinking, driving or by living a careless life etc.

Principal Agent Problem – This problem arises when one party agrees to work in favor of another party to get some incentives in return.
Two parties with different objectives and information asymmetries. It is also a part of Asymmetric Information.
For example – adverse selection where a buyer has less information than the seller, seller can exploit buyer.

Positive Externalities – A positive externality is the positive effect of an activity on an unrelated third party. Similar to a negative externality, it can arise on the production side, or on the consumption side.
Goods or services which give benefit to a third party, e.g. Education, maintaining garden or house or environment etc.

How this problem can be solved ?

Solution to excess use of goods – taxation & penalties
Governments can manage market failures is by implementing taxation or penalties that changes behavior of the peoples. For example, the government can ban cars from operating in city centers, or impose high penalties to businesses that sell alcohol to underage children, since the measures control unwanted behaviors.

Solution of Adverse Selection – This problem can be solved when Producers provide warranties, guarantees, and refunds for the product they are selling (used product). This is particularly notable in the used car market.

Solution of Asymmetric Information – This problem can be solved when information will be available to all at free of cost or at a very desirable price.