Economics – Market Structure

Market Failure

Market Failure is the inability of the market to allocate resources efficiently to best satisfy
society’s wants. Markets fail for a number of reasons. The causes of market failure lie in four
areas:

● The provision of public goods

● The provision of merit goods
● Externalities- positive and negative
● Monopoly

We can look at Market Failure in two ways: firstly through the supply and demand side. When
there is a constant disequilibrium, there is a market failure. In other words, if supply and demand
never meet, we have market failure.

Second of all, we can look at market failure from the side of pricing. This is where the good or
service produces external benefits or costs that are not reflected in the final price to the
consumer.

Causes of Market Failure

1. Public goods

One of the causes of market failure might lie in the provision of public goods. Public goods are
goods that are collectively consumed by society. They possess two characteristics: non-
excludability and non-exhaustibility.

Non-excludability means that a consumer cannot be excluded from consuming the good, even if
he or she did not pay for it. There is an absence of ownership rights attached to the purchase of
these goods.

Non-exhaustibility (non-diminishability) means that consumption of a public good by one

individual does not reduce the amount available for other individuals to consume. A public good
can be consumed simultaneously by numerous individuals. Examples of public goods are
streetlights, lighthouses and defence.

People who do not pay for a good or service but enjoy its benefits are free riders. If sufficient of
the country’s inhabitants choose to be free riders, losses will be made therefore the incentive to
provide the good or service through the market disappears. This means that the market will fail
because it does not provide a good or service for which there is a need. Public goods can be
under produced as there is little incentive, from a private standpoint
When there is a market failure as a result of the provision of public goods, there is an economic
role for government to play. The government intervenes and supplies public good, this market
failure is eliminated as the good is provided for consumers- government supplies the good,
society collectively consumes the good and it is paid for out of taxation.

2. Merit goods

A second cause of market failure is in the provision of merit goods. Merit goods are goods for
which the social benefits to the community of the consumption of the good far outweigh the
private benefits to the consumer. Some examples of merit goods are education and healthcare.
When there is a healthy and educated workforce, all of society benefits. Productivity increases,
crime falls and output increases. The consumption of merit goods results in benefits falling on
the entire society.

If the choice was left to the consumer, an individual might not consume adequate amounts of
merit goods. Society under-consumes merit goods (that is, it consumes less than the socially
optimum quantity). The market does not supply adequate amounts of merit goods at an
affordable price. The market fails, as the quantity of the good that is produced and consumed
is not sufficient to maximize society’s welfare.

When there is market failure in the provision and consumption of merit goods, the government
might intervene. The government then provides these merit goods free of charge or at a
subsidized price. This encourages more consumption of the merit goods, and the market failure is
reduced.

3. Externalities

Externalities are spillover effects of production or consumption that fall on a third party. When
externalities are created, the market also fails.

The producer and the consumers are the two parties to a transaction. In the course of producing
or consuming a good, a third party might be affected. The third party is external to the
transaction.

Externalities are positive or negative.

A positive externality is a positive spillover that results from the consumption or

production of a good or service. Goods which bring about positive externalities are called ‘merit
goods’. When the third party is affected positively, it is an ‘external benefit’ or a ‘positive
externality’. For example, although public education may only directly affect students and
schools, an educated population may provide positive effects on society as a whole. There is
market failure in that the market undersupplies positive externalities.
 A negative externality is a negative spillover effect on third parties. When the third
party is affected negatively, it is an ‘external cost’, ‘social cost’ or a ‘negative externality’. For
example, secondhand smoke may negatively impact the health of people, even if they do not
directly engage in smoking. Negative externalities usually results when goods are oversupplied
by the market which leads to market failure.

With externalities, the third party has nothing to do with the transaction, but nonetheless
affected. The market has therefore failed to satisfy society’s wants efficiently. The buyer and
seller might be satisfied. However, the market is not efficient, as there is a spillover on the third
party. Note that positive externalities are still a form of market failure as, in the operation of the
market, too little of the good is being produced. If more of the good is produced, then more of
the good and more positive externalities will both be enjoyed. More obviously, when there is a
negative externality, a cost falls on a third party and he is in no way compensated for this cost.
Too much of the good is being produced. Therefore, with negative and positive externalities,
the market fails.

4. Monopolies

Monopolists can raise the price and limit quantity they supply to the market in order to
market in order to maximize their profits. The market thus fails astoo little of the good is
produced and it is sold at too high a price. The monopolist sells at price that is greater than
marginal cost.