Market failure

The term market failure is a condition in which the market economy using market forces of
demand and supply and the price mechanism failed to produce the socially optimum level of
output. In other words, the market fails to generate a Pareto efficient outcome. Pareto efficiency,
or Pareto optimality, is an economic state where resources cannot be reallocated to make one
individual better off without making at least one individual worse off. Pareto efficiency implies
that resources are allocated in the most economically efficient manner, but does not imply
equality or fairness. An economy is said to be in a Pareto optimum state when no economic
changes can make one individual better off without making at least one other individual worse
off.
Causes of market failure
There are several causes of market failure such as:
1. The presence of monopolies and other firms with market power
2. The presence of externalities both external costs and benefits
3. The presence of public goods
4. The presence of shared resources leading to the tragedy of the commons
5. The presence of merit and demerit goods
The presence of monopolies
In a monopoly, a single supplier controls the entire supply of a product. This creates a rigid
demand curve. That is, demand for the product remains relatively stable no matter how high (or
low) its price goes. Supply can be restricted to keep prices high. This leads to under provision, or
scarcity which leads to market failure because the monopoly or the firms with market power do
no produce the socially optimum and charge a high price. In other words, they produce less and
charge a higher price as was demonstrated on the graph.

The presence of externalities both external costs and benefits

The presence of externalities both external costs and benefits – an externality can be defined as
any cost or benefits that spills over to a third party that is not a part of the market transaction nor
the production and consumption activities that generates such a cost or benefit. Those who are
adversely affected must receive no compensation and those who benefit must make no payment.
There are two types of externalities, namely an external cost or negative externality and an
external benefit or positive externality.
External cost or negative externality – can be defined as any cost that spills over to a third party
that is not a part of the market transaction nor the production and consumption activities that
generates such a cost. Those who are adversely affected must receive no compensation. An
example of an external cost is the Carib cement. In the process of producing cement, it pollutes
the atmosphere with smoke and persons are adversely affected by the dust nuisance.
Example 2: The Tradewinds Company that manufactures Ffresh orange juice dumps the orange
pulp in the nearby Rio Cobre. This pollutes the river and adversely affect households and fisher
folks in the environment. A major feature of an externality is that it takes place outside of the
market.
Example 3:
External benefit
An external benefit is the benefit gained by an individual or firm because of an economic
transaction but where they are not directly involved in the transaction. External
beneficiaries are collectively called 'third parties'. External benefits can arise from both
production and consumption. In other words, an external benefit occurs when producing or
consuming a good causes a benefit to a third party.
Example of external benefits from consumption
 Cycling to work helps to reduce the level of pollution and congestion. Therefore other
road users have quicker journey times and help to reduce the level of pollution.
 Reduced risk of transferring disease. If you get vaccinated, the personal benefit is your
own reduction in risk of disease. However, if you are inoculated there is also an external
benefit – other people in society are less likely to be infected because you are healthy.
Example of external benefits from production
 Fruit tree pollination. A beekeeper produces honey, but as an external benefit, his bees
help to fertilize nearby fruit trees.
 Reduced global warming. A firm who produces solar panels aims to make a profit.
However, increased supply of solar panels has the external benefit of reducing
greenhouse gases and reducing the impact of global warming.

Demerit goods
Demerit goods are the opposite of merit goods. They not only adversely affect the direct
consumers but adversely affect third parties in that they confer substantial external cost. Example
of demerit goods are tobacco products, alcoholic beverages, gambling and prostitution. In the
case of demerit goods, consumer lack adequate information regarding the dangers of demerit
goods. Left to the consumers, they consume more than the socially optimum amount of demerit
goods, to force consumer to reduce their consumption of demerit goods, the government would
impose a tax on these products.
Economic theory states that the tax will raise the price of the product and will decrease
demand, shifting the demand curve to the left. The extent to which a tax will discourage the
consumption of demerit goods will depend on the price elasticity of demand. The more elastic is
demand, the more the tax will discourage the consumption of demerit goods. The more inelastic
is demand, the more the tax will increase government’s revenue. Note, demerit goods are
addictive and demand would be inelastic, the tax will increase government’s revenue. In the
presence of demerit goods, there is an overproduction, over consumption and over-allocation of
resources. Those resources that are used to increase the production of demerit goods could have
been redeployed to produce more merit goods. This has led to a dead weight loss.
Merit goods
Merit goods are the opposite of demerit goods - they are goods which are deemed to be
socially desirable, and which are likely to be under-produced and under-consumed through the
market mechanism. Examples of merit goods include education, health care, welfare services,
housing, and fire protection, garbage collection and public parks.
In contrast to pure public goods, merit goods could be, and indeed are, provided through
the market, but not necessarily in sufficient quantities to maximize social welfare. Thus goods
such as education and health care are provided by the state, but there is also a parallel, thriving
private sector provision. Indeed, there is considerable disagreement between economists on the
right and left of the political spectrum over the extent to which such goods should be provided by
the state or the private sector.
Market failure occurs when merit goods and services are under-consumed under free
market conditions. Policy intervention can help either through offering financial incentives (e.g.
consumer or producer subsidies) or through behavioural nudges and information campaigns
designed to change our choices.

Public good
A public good is a good or service that can be consumed simultaneously by everyone and
from which no one can be excluded. It is a good for which consumption is non-revival and from
which it is impossible to exclude a consumer. Public goods lead to market failure because of two
characteristics:
1. Non-rival or non-diminishable
2. Non excludable
Non-rivalry means that when a good is consumed, it doesn’t reduce the amount available for
others. For example, benefiting from a streetlight doesn’t reduce the light available for others but
eating an apple would.
Non-excludability: This occurs when it is not possible to provide a good without it being
possible for others to enjoy. For example, if you erect a dam to stop flooding – you protect
everyone in the area (whether they contributed to flooding defenses or not.
A public good is often (though not always) under-provided in a free market because its
characteristics of non-rivalry and non-excludability mean there is an incentive not to pay. In a
free market, firms may not provide the good as they have difficulty charging people for their use.

Examples of public goods

 National defence. If you protect the country from invasion, it benefits everyone in the
country.
  Street lighting. If you provide light at night, you can’t stop anyone consuming the good.
Walking under a streetlight doesn’t reduce the amount of light for others.

 Police service. If you provide law and order, everyone in the community will benefit
from improved security and reduced crime.

 Flood defences – Protecting the coastline against flooding provides benefits for the whole
community.

 The internet. Once websites are provided, everyone can see the website for free, without
reducing the amount available to others (assuming an individual can access for free,
which is not always the case).

Free rider
The problem with public goods is that they have a free-rider problem. This means that it is
not possible to prevent anyone from enjoying a good, once it has been provided. Therefore there
is no incentive for people to pay for the good because they can consume it without paying for it.
 However, this will lead to there being no good being provided.
 Therefore, there will be social inefficiency.
 Therefore, there will be a need for the government to provide it directly out of general
taxation.
Consequences of market failure
When markets fail in an economy, all groups in the economy are affected namely firms,
households, the government, and the economy. In developing countries, the government might
not have the resources to intervene and reduce market failure. In such economies, in such
economies, the consequences of market failure are:
 retrenchment – occurs when workers lose their jobs due to the declining activity of a
firm. If a firm that is producing a negative externality is forced to reduce output or close,
then the workers will be retrenched (laid off and must seek jobs). When a firm produces
less output, it will use less factor inputs (factors of production). If monopolies reduce
economic activity due to government restrictions, retrenchment will also occur. Workers
might be unable to find jobs and perhaps there are none available or may be their skills
do not match the skills the skills needed for the available jobs.

 Unemployment –

 economic depression – occurs when there is falling output in the economy and rising
unemployment. Market failure leads to economic depression as monopolies and firms
producing negative externalities reduce output. These activities lead to unemployment.

 a rise in the levels of poverty - When people are out of jobs, and health and education
services are produces insufficient quantities and at very high prices, this leads to an
increase in poverty. The poor has no job and cannot afford education and training to
make them employable.

 a decline in provision for social welfare – when there is market failure, the government
must intervene. The government must use its resources to provide public goods and merit
goods. Firms producing positive externalities must be given grants to increase output