Market Failure

What is market failure?

In economics, market failure describes a situation characterized by the inefficient distribution of goods and services. In these situations, individuals make the best decisions for themselves without considering how those decisions affect the group. In most cases, the team incurs too many costs and too few benefits from the situation.

Financial service professionals use financial risk management software to identify, measure, and plan for financial risks, including market failure. These tools conduct risk exposure analysis across multiple asset classes to actively try to avoid any of these potential incidents.

What leads to market failure?

Different scenarios can lead to market failure, including:

• Externalities: An externality occurs when goods and services consumed impose costs on other related goods and services. In other words, they are the indirect costs or benefits that an associated third-party occurs. There are positive and negative externalities, and they lead to market failure because they disrupt the equilibrium in the market.

• Monopolies: One supplier controls the supply of a product, impacting demand and equilibrium. The lack of competition makes the market lean heavily toward one supplier. Power lies within that supplier rather than spread amongst various competitors. 

• Public goods: In economics, public goods are available to all members of a group or society and are generally paid for by members of the society via taxation. To be considered a public good, the goods must be non-rivalrous and non-excludable, meaning they don’t decrease in supply with consumption and are available to all. Examples of public goods include law enforcement and access to clean air. These goods can lead to market failure when parts of society consume the goods but don’t contribute pay toward them.

• Imperfect information: Both buyers and sellers may be impacted by imperfect information in the market. Prices may not accurately reflect the true opportunity cost of a good. For example, in a used car market, a buyer may not receive the full information from the seller, especially if there are hidden issues in the vehicle. The seller can then increase the price of the car. 

Examples of market failure

One example of a negative externality is traffic congestion. Imagine getting in a car and heading to work. The negative externalities associated with this action are air pollution, car accident risk, and increased road time. In addition to the negative externalities, public roads are considered public goods.

Suppose one brewer opens five local breweries in the same general region. They all have different names and offer different beverages and food items; however, one brewer owns all of them. In this scenario, the brewer creates a monopoly and harnesses control over the local brewery market.

Solutions to market failure

Market failures aren’t all doom and gloom. With the right action and proper next steps, market failures can be corrected. Some of the solutions to market failure include:

• Government intervention and legislation: Governments can enact local, state, and federal laws to help ease certain causes of market failure. They can also place taxes on products they want to discourage people from purchasing. Regulations, taxes, subsidies, tariffs, and adjustments are all options governments can consider.

• Advertising solutions: Certain advertising campaigns and techniques can be used to steer consumers away from purchasing products or services. This solution can be particularly valuable for combating negative externalities like smoking cigarettes. Companies typically use cross-channel advertising software to create these types of ads.

Market failure vs. government failure

In economics, market failure is sometimes compared to government failure. Market failures are inefficiencies that occur in free markets that can sometimes be course-corrected with government interventions. 

Government failures are inefficiencies caused by government intervention and arise from attempting to solve market failures. In other words, the actions of the government create inefficiencies where efficiencies may have existed otherwise.