Types of market failure
A market failure is a situation where free markets fail to allocate resources efficiently. Economists identify the following cases of market failure:
Productive and allocative inefficiency
Markets may fail to produce and allocate scarce resources in the most efficient way.
Markets may fail to control the abuses of monopoly power.
Markets may fail to form, resulting in a failure to meet a need or want, such as the need for public goods, such as defence, street lighting, and highways.
Markets may fail to produce enough merit goods, such as education and healthcare.
Markets may also fail to control the manufacture and sale of goods like cigarettes and alcohol, which have less merit than consumers perceive.
Consumers and producers may fail to take into account the effects of their actions on third-parties, such as car drivers, who may fail to take into account the traffic congestion they create for others. Third-parties are individuals, organisations, or communities indirectly benefiting or suffering as a result of the actions of consumers and producers attempting to pursue their own self interest.
Markets work most effectively when consumers and producers are granted the right to own property, but in many cases property rights cannot easily be allocated to certain resources. Failure to assign property rights may limit the ability of markets to form.
Markets may not provide enough information because, during a market transaction, it may not be in the interests of one party to provide full information to the other party.
Sometimes markets become highly unstable, and a stable equilibrium may not be established, such as with certain agricultural markets, foreign exchange, and credit markets. Such volatility may require intervention.
Markets may also fail to limit the size of the gap between income earners, the so-called income gap. Market transactions reward consumers and producers with incomes and profits, but these rewards may be concentrated in the hands of a few.
In order to reduce or eliminate market failures, governments can choose two basic strategies:
Use the price mechanism
The first strategy is to implement policies that change the behaviour of consumers and producers by using the price mechanism. For example, this could mean increasing the price of ‘harmful’ products, through taxation, and providing subsidies for the ‘beneficial’ products. In this way, behaviour is changed through financial incentives, much the same way that markets work to allocate resources.
Use legislation and force
The second strategy is to use the force of the law to change behaviour. For example, by banning cars from city centres, or having a licensing system for the sale of alcohol, or by penalising polluters, the unwanted behaviour may be controlled.
In the majority of cases of market failure, a combination of remedies is most likely to succeed.