What is Market Failure? 

To understand Market failure, we need to first understand welfare economics. An Italian economist, Vilfredo Pareto stated that allocation of resources in an efficient manner such that an economic change, which harms no one and makes someone better off, indicates an increase in social welfare. It is also called Pareto Optimality, where resources cannot further be reallocated without harming one. This does not apply to those economic changes, which harm some and benefit others. social welfare increases if the utility of any of its members' increases and none decrease in the economy. 

When a market fails to efficiently allocate goods and services to the members of the society in the economy. It is a situation where market forces do not serve the perceived "public interest". In other words, Pareto Optimality is not achieved. we can obtain optimum welfare in competitive market conditions through economic restructuring. But in real life, there are market constraints. Therefore, we are unable to attain optimum welfare which leads to market failure in the economy. 

The two main reasons for which it fails are,

(1) Sub-optimal market structures

(2) The lack of internalization of costs or benefits in prices.  

Imperfect Competition  

A perfect market is a market where sellers sell different goods and services set their prices and acquire a market share of the economy. An imperfect market violates these criteria of perfect competition. There may also be imperfect competition in markets due to buyers or sellers who lack information about prices and the goods being traded or due to a time lag in a market. Monopoly (only one seller of a good), Oligopoly (small number of sellers), Monopolistic competition (many sellers producing highly, differentiated goods), Monopsony (only one buyer of a good), Oligopsony (a small number of buyers). Imperfect competition is one of the standard examples of market failure, which leads to the non-achievement of Pareto optimality. It is on this basis that economic policy is usually suggested as necessary to reduce efficiency. 

Natural Monopoly 

When a single firm is the only supplier of a particular kind of product or service because of the capital cost structure of the industry that restricts another entry.  This cost advantage over other actual or potential competitors abstains from creating economies of scale. Example: utility industries like electricity, natural gas transmission. Natural Monopoly is different from coercive monopolies, in which industry is economically viable if allowed but potential competitors are restricted from entering the market by law or by force in the economy. Ideally, the government sets the prices of such products which are both viable to the buyer as well as the consumer of such products and services because if sellers set prices, it will be too high for the target consumers to afford it. Thereby, a condition of sub-optimal market structure will arise. Thus, such products are regulated by the government. 

Imperfect Knowledge or Imperfect Information 

In Perfect competition, it is assumed that all knowledge and information are available to all the buyers and sellers of the industry and they arrive at an acceptable price to achieve equilibrium and condition of Pareto optimum is achieved. In real life, not all information is available to the buyer and seller.  Imperfect information refers to the situation where buyers and/or sellers do not have all of the necessary information to make an informed decision about the price or quality of a product. Asymmetric information means when either the buyer or the seller, has more information about the quality or price of the product than the other party. This leads to misallocation of resources in the economy, where the consumers may be paying more for cheap quality products and firms may produce more than the demand prevailing in the market.

For example, The real estate agent exploiting the little knowledge of potential buyers about the property and its location. Cigarette manufacturers not informing smokers of its health risk. The buyer of financial products, unaware of the risk of share market fluctuations. 

Externality 

An externality occurs when a decision causes costs or benefits to individuals or groups other than the person making the decision. In other words, the decision-maker does not bear all of the costs or reap all of the gains from her action. Firms produce what sells in the market with intention of profit maximization. Externalities undermine the welfare benefits to society as a whole. Thus, externality prevents the achievement of Pareto optimality even in a perfect competition market.  

Types of Externalities:  

• Positive externality : A group or an individual planting trees in the local area beneficial also for others living in the area. Example of a positive externality, beneficial externality, external benefit, or external economy. 
• Negative externality : Pollution caused by a firm in process of its production causing harm to others. Example of a negative externality, external cost, or external diseconomy.  
• Common property resource : Excessive harvesting of fishes in deep water sea by a fishing company depleting the availability of fish for the other companies. Example of a common property resource or the Tragedy of the commons. 
• Network externality : An individual or group of individuals taking the Covid vaccine to enhance immunity from Covid -19 thus encouraging the others in the locality to get the vaccination done. Leading to the general acceptance of the vaccination. Example of a network externality.  

Externality and Coase Theorem  

Nobel laureate Ronald Coase, explains that under perfect competition private and social costs will be equal. He addressed a well-known problem of market externalities, known as the ' Spillover Effect”. It happens when the cost of production is shared by a third party other than the buyer. The theorem states that both parties will arrive at an efficient outcome without any intervention from the government.  The Coase Theorem is based on assumption that property rights are well defined, the number of people involved is small and bargaining costs are minimal and no transaction cost is involved. 

The best example is the pollution caused by the factories for their production, if factories dump their hazardous waste in nearby rivers and land without treating it, it will affect the environment in the local areas which will further have an adverse effect on the residents of that area. In this situation, neither the factory nor the residence owns the right to the barre land and the rivers regardless of which residents have to bear the negative cost of factory production.  

Limitations of Coase Theorem  

• Bargaining is difficult: It is always difficult to reach consent between two parties because of differences in size and power which may give one party better negotiating power than the other. 
• No transaction cost involved: It is difficult as even if both parties are in the same area, there is legal fees and cost involved in agreeing to two parties as a legal binding agreement. 
• Distribution of income is affected: Once the property right is assigned to one party; it starts receiving some compensation or derived income from other parties.

Public Goods and Market Failure

Public Goods possess two properties. 

• It is non-rivalrous, which means that there is no scarcity of consumption after being produced and everyone can avail benefit from it without sacrificing anyone else's interest. 
• It is non-excludable, which means that once produced or developed, it is very difficult to prevent people from gaining access to the good. Examples of Public goods are roads, national defense, health, and welfare programs run by the government. 

The problem with public good is that a free market is unlikely to produce its optimum amount. Important public goods such as national defense will be under-produced due to the free-rider problem. In practice, this problem has been solved through government intervention and the provision of public goods by the state. Public goods are different from the private goods produced and sold in the market by the firm for profit maximization and the consumers who are able and willing to pay the price of the products are benefited from it. Private goods can serve the purpose of Public goods.  

The market fails to solve the entire economic problem. Firstly because of externalities by which we mean situations, where consumption benefits are shared, cannot be limited for particular consumers where "economic activity results in social cost which are not paid for by the producer or the consumer who causes them. Second, the market can respond only to the effective demands of consumers as determined by the prevailing state of the income distribution. Third, their problems of unemployment, inflation, and economic growth prevailing the economy.  

Therefore, Government intervention happens when the government gets involved in the market and takes necessary measures to correct the market failure. Government can use regulations of price, provide better information or make better policies to change resource allocation. Market-based government policies are based to affect the demand and supply conditions of the economy to reach Pareto Optimality. 

Example: providing subsidies on the product. Whereas non-market-based government interventions, the government directly intervenes in the market by legally enforcing regulations. Example: Banning the selling of liquor in the state. Government intervention is required to fulfill the demands of the public good of the economy. The intervention of the Government in providing public goods must be viewed with positive externalities. 

Government Failure: Government failure happens when the interventions result in even more inefficient use of resources in the economy. Imperfect information can lead to inefficient allocation of resources. Short Term, when government provides public services to win voters' trust in the upcoming elections. Evasion, When the government sets higher tax slabs it can lead to tax evasion and encourage black marketing. Higher implementation cost. Government officials and monopolies make influence regulators favor the producers. 

Context and Applications 

This topic is significant in the professional exams for both graduate and undergraduate courses –  

• BA Economics 
• BA Economics Honors 
• MA Economics 
• Master of Finance 
• Master of Business Analytics 
• Master of Business Administration 

Related Courses 

• Accountancy 
• Human Resources 
• Economics of Money and Banking  
• Advanced Macroeconomics 
• Strategic Business Management