What is market failure?
To understand what market failure is, we first need to look at markets working correctly.
The assumption is that if markets are working freely with no imperfections, this will give the most efficient outcome,
The main causes of market failure
Once you understand what market failure is, we need to look at the various reasons why markets do fail. Below are listed the key reasons why markets fail:
Externality
This failure is due to a 'by-product' of a certain production process, or of consuming something, that affects a third party. This effect can be positive or negative.
The wrong market structure
This failure is due to the market structure not following the only truly efficient market structure (i.e. perfect competition)
Public, merit and demerit goods
This failure occurs as the goods being produced are of a nature that the market would under provide, over provide or even fail to provide, if the government did not intervene.
Other ways in which markets fail
There are numerous other reasons why markets fail and these are listed further down in this topic.
Private costs, external costs and social costs
With the example of the factory, we need to divide all the costs to society into private costs and external costs. The social cost of an activity is the total cost of that activity, both privately and externally. So:
Social Cost = Private Costs + External Costs
Let us assume that our factory is making cars. The private costs to the factory owner will include things like wages, the cost of raw materials and rent. The external cost, or externality, is the cost to the third party of cleaning up the waste produced by the factory.
The total cost to society, therefore, must include the private cost, because society's resources are being used in the production process, and the external cost, because some of society's resources must be used to clear up the mess
Positive externalities
As stated earlier, although it is less obvious, there are examples of positive externalities. A good example is education. This includes training by firms as well as what goes on in schools and universities. If you get a good education, there are obvious private benefits; better career prospects and higher future earnings for instance. But there ...
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The total cost to society, therefore, must include the private cost, because society's resources are being used in the production process, and the external cost, because some of society's resources must be used to clear up the mess
Positive externalities
As stated earlier, although it is less obvious, there are examples of positive externalities. A good example is education. This includes training by firms as well as what goes on in schools and universities. If you get a good education, there are obvious private benefits; better career prospects and higher future earnings for instance. But there are external benefits as well. The obvious economic one is that a better-educated workforce is a more productive and efficient one, but there is also the fact that well educated people are less likely to resort to crime. This is almost like an avoidance of a negative externality.
The use of subsidies
Taxes shift firms' supply curve to the left, forcing them, via the market mechanism, to reduce output and increase the price to reflect the external cost. But what if the good in question has external benefits?
If you remember from above, education is an example of a good that has huge external benefits for society, so if it were left to the free market, output (which in this case means the number of people educated) would be lower than the socially optimal level.
In an effort to increase the output of these type of goods, the government can pay subsidies to the producers. This will cause the supply curve to shift to the right resulting in a higher output and lower prices. In fact, education in this country is free for all children up to the age of 16. The subsidy is so big that the price is zero at the point of use.
Public goods
The first point to note is that public goods are not called public goods because they are provided by the public sector (i.e. the government). Although they do tend to be provided by the public sector, this is not the reason for the name!
All public goods have two important characteristics: Non-excludability and Non-diminishability
Non-excludability. A public good is one where it is impossible to exclude anyone from consuming it. I suppose this is why they are called public goods - they are open to the public!
Non-diminishability. Some textbooks call this one non-rivalry. I prefer the former because its title explains what the definition is all about more clearly. If, say, ten people are consuming a certain public good. The arrival of an eleventh person (who cannot be excluded) will not diminish the amount that the existing ten people can consume.
Merit goods
Merit goods are also things that are 'good' for you, but unlike public goods they can be provided privately. The problem is that if they are provided solely by the private sector then they tend to be under-consumed, so, again, the government has to step in to correct the market failure.
The best two examples are health and education. Both of these goods can be provided privately. Some of you may be at a private school (or independent school, as they are called), or your family may have a private health insurance scheme. But, if the government did not step in and provide state schools and the NHS, then numerous families would not be able to afford either. This would cause increased crime and reduced productivity from an underclass of the non-educated, and increased health problems which can also cause problems for the labour market.
There may also be another section of people who can afford to pay for, say, health insurance, but just feel that it is a waste of money. They are young, fit and healthy - why bother? Of course, if they get knocked down by a bus they need the cover pretty quickly, but it is too late. Also, if they have survived the bus and feel they need cover as they get older, they may find that the premiums are higher than they would otherwise have been, or they are not covered for various ailments they have picked up on the way (like a bad back, for example).
In other words, people find it difficult to think long term. A £30 a month premium may seem a lot when you're young and healthy, but it will save you a lot of money over the long term.
The government provides health and education free at the point of use, but the general public does pay for them via taxation. Also, in the case of education, it is seen as so socially desirable that the government legislates to force all children to attend up to the age of 16.
Demerit goods
Merit goods are 'good' for you. Demerit goods are thought to be 'bad' for you. Examples are alcohol, cigarettes and various drugs.
In this case the market fails because these goods are over-consumed if left to the free market. Again, the government must step in to stop this over-consumption. In the case of alcohol and cigarettes, the government imposes quite heavy taxes and duties. This means that their price rises significantly in the hope that this will deter people from consumption. But given that both goods have very inelastic demand curves, the fall in demand is small relative to the tax rise. One wonders if the government keeps raising these taxes because they care about our health or whether it's just a good source of tax revenue!
Some demerit goods are seen as so destructive that the government bans them altogether, illegal drugs being the obvious example.
It is important to note that, just as merit goods provided positive externalities that the government wanted to encourage, demerit goods cause large negative externalities that the government are keen to avoid. The additional costs of demerit goods are there for all to see: an increased burden on the NHS, increased crime and the fact that labour productivity is affected in a negative way, which is bad for the economy as a whole.
