Definition of market failure

Resources | Subject Notes | Economics

Market Failure: An Introduction

Market failure occurs when the allocation of resources by free markets results in an inefficient outcome, meaning that society is not getting the maximum possible benefit from those resources.

Defining Market Failure

A market failure is a situation where the market mechanism fails to allocate resources efficiently. This can lead to a loss of economic welfare for society.

It's important to note that market failure doesn't necessarily mean the market doesn't exist; it means the market isn't working as effectively as it could.

Common Causes of Market Failure

There are several reasons why markets can fail. Some of the most common include:

  • Externalities
  • Public Goods
  • Information Gaps
  • Market Power (e.g., Monopolies)

Types of Market Failure

We can categorize market failures into different types:

  • Externalities: Costs or benefits that affect parties not involved in a transaction.
  • Public Goods: Goods that are non-excludable (difficult to prevent people from consuming) and non-rivalrous (one person's consumption doesn't diminish another's).
  • Information Gaps: When participants in the market do not have complete or accurate information.
  • Market Power: When a single firm or a small group of firms can significantly influence the market price.

Table Summarizing Market Failure Types

Type of Market Failure Description Example
Externalities Costs or benefits not reflected in market prices. Pollution from a factory (negative externality) or a vaccine (positive externality).
Public Goods Non-excludable and non-rivalrous goods. National defense or clean air.
Information Gaps Lack of complete or accurate information among market participants. Used car market (adverse selection) or financial markets.
Market Power A firm or small group of firms can control the market price. A monopoly in the energy market.

Further Reading

For a deeper understanding, explore the following topics:

  • Externalities (positive and negative)
  • Public Goods (characteristics and provision)
  • Information Asymmetry (adverse selection and moral hazard)
  • Monopolies and Oligopolies