Market failure is a situation where the allocation of goods and services by a free market is not efficient. It means that there is a potential to improve the welfare of society by changing the way the market operates. In this article, you will learn what causes market failure, what are the main types of market failure, and how economists analyze and evaluate market failure.
Market failure can occur for various reasons, but the most common ones are externalities, public goods, asymmetric information, and market power. Externalities are the costs or benefits that affect third parties who are not involved in the production or consumption of a good or service. Public goods are the goods or services that are non-excludable and non-rivalrous, meaning that no one can be prevented from using them and their use does not reduce their availability for others. Asymmetric information is the situation where one party has more or better information than the other party in a transaction, which can lead to adverse selection or moral hazard. Market power is the ability of a firm or a group of firms to influence the price or quantity of a good or service in the market, which can result in monopoly, oligopoly, or monopolistic competition.
Example of externality can include private enterprises polluting the environment which causes health problems for the residents in vicinity of these enterprises increasing their cost of healthcare facilities. The private enterprises' profit doesn't include the harm they have done to the community and the people in the community are not adequately compensated as a result. Asymmetric information has been nicely explained in Nobel Prize winner economist George Akerlof's paper "The market for lemons" where he talks about the information asymmetry that exists between buyers and sellers of used cars. Moral hazard can be observed frequently in the case of insurance where the people who are most at risk take up insurance.
?? Regulatory Responses: Market failure often paves the way for governmental intervention, like antitrust laws against monopolistic practices or environmental regulations. ?? Behavioural Aspects: Asymmetric information isn't just about data; it's also about understanding that data. Behavioural economics shows that people don't always act rationally with the information they have. ?? Network Effects: These can either ameliorate or exacerbate market failures. For example, a platform like Facebook gains value as more people use it, but it also raises concerns about monopoly power.
Market failure can be classified into four main types: allocative inefficiency, productive inefficiency, dynamic inefficiency, and equity issues. Allocative inefficiency is the situation where the market does not produce the optimal mix of goods and services that maximizes the social welfare. Productive inefficiency is the situation where the market does not produce the goods and services at the lowest possible cost. Dynamic inefficiency is the situation where the market does not encourage enough innovation and investment for long-term growth. Equity issues are the situation where the market does not distribute the income and wealth fairly among the society.
?? The Role of VCs in Alleviating Dynamic Inefficiency: Venture capital firms can play a pivotal role by funding startups focused on innovation. This can help correct dynamic inefficiency by pushing the market towards more innovation and competition. ?? Technology & Productive Inefficiency: Technology can be a double-edged sword. While it can help make operations more efficient, tech waste and obsolescence are also dangerous, adding to productive inefficiency. ?? Time Horizon in Allocative Inefficiency: In venture capital, the focus is often on high returns in a short period. This can sometimes exacerbate allocative inefficiency by focusing on 'hot' sectors at the expense of others that might be more socially beneficial in the long term.
Among the main market failures it is worth highlighting the following: a) Imperfect competition. b) Natural monopoly. c) Public goods (see "Public goods"). d) Externalities or external economies (see "External economies"). e) Imperfect and costly information. One of the requirements for the market to be efficient is that the cost of information is zero f) Incomplete markets and asymmetric information. Sometimes certain private markets do not exist due mainly to two causes: the high transaction costs associated with the creation of a market and asymmetric information, which usually manifests itself through two situations that justify the intervention of the public sector: -
Economists use different tools and models to analyze and measure market failure. One of the most common tools is the concept of social surplus, which is the sum of consumer surplus and producer surplus. Consumer surplus is the difference between the maximum price that consumers are willing to pay and the actual price they pay. Producer surplus is the difference between the minimum price that producers are willing to accept and the actual price they receive. Social surplus is maximized when the market is in equilibrium, where the demand curve and the supply curve intersect. Market failure occurs when there is a divergence between the private and social costs or benefits of a good or service, which creates a deadweight loss. A deadweight loss is the reduction in social surplus due to market failure.
?? Role of Government Regulation: Public policy often aims to correct market failure by imposing taxes or subsidies that realign private and social costs. ?? Venture Capital and Market Failure: VCs can sometimes unintentionally exacerbate market failures by inflating costs or reducing service benefits through disruptive models. Conversely, VCs can also fund startups that aim to correct these failures (e.g., fintech companies offering low-fee banking alternatives). ?? Information Asymmetry and Deadweight Loss: In some markets, particularly health, information asymmetry between consumer and producer can lead to deadweight loss. Due to complexity or lack of information, consumers may be unaware of cheaper or more effective alternatives.
Deadweight loss can occur due to taxation where a portion of consumer surplus and producer surplus is taken away by taxation. Deadweight loss can also occur due to putting a price ceiling on the sale pf certain goods which prevent them from being sold at the free market equilibrium price.
Economists also use different criteria and methods to evaluate and compare the extent and impact of market failure. Some of the criteria are Pareto efficiency, Kaldor-Hicks efficiency, potential Pareto improvement, and social welfare function. Pareto efficiency is the situation where no one can be made better off without making someone else worse off. Kaldor-Hicks efficiency is the situation where the winners can compensate the losers and still be better off. Potential Pareto improvement is the situation where a change can make at least one person better off without making anyone worse off. Social welfare function is a function that assigns a value to each possible allocation of goods and services based on some ethical or social preferences. Some of the methods are cost-benefit analysis, cost-effectiveness analysis, and multi-criteria analysis. Cost-benefit analysis is the method that compares the total social costs and benefits of a policy or project. Cost-effectiveness analysis is the method that compares the costs and outcomes of different alternatives to achieve a given objective. Multi-criteria analysis is the method that considers multiple criteria and trade-offs to rank or choose among different options.
?? Role of Ethics in Social Welfare Functions: It's worth emphasizing how cultural and societal values can significantly influence what is considered a 'welfare improvement.' This is especially vital in health, where ethical considerations can be complicated. ?? Cost-Effectiveness vs. Long-Term Impact: Cost-effectiveness analysis often focuses on immediate or short-term objectives. However, long-term impacts can diverge significantly from short-term effectiveness, especially in technology-driven markets. ?? Trade-offs in Multi-criteria Analysis: Multi-criteria analysis can be complicated as it involves weighing different criteria against one another, especially when they are subjective or hard to quantify.
Economists also suggest different policy responses to correct or reduce market failure. Some of the policy responses are taxes, subsidies, regulations, standards, quotas, licenses, public provision, public-private partnerships, and market-based instruments. Taxes are the charges imposed by the government on the producers or consumers of a good or service to internalize the external costs or reduce the demand. Subsidies are the payments made by the government to the producers or consumers of a good or service to internalize the external benefits or increase the supply. Regulations are the rules or laws that restrict or control the behavior or actions of the market agents. Standards are the minimum or maximum levels of quality, quantity, or performance that the market agents have to meet or comply with. Quotas are the limits or restrictions on the quantity or share of a good or service that can be produced or consumed. Licenses are the permits or authorizations that grant the right or privilege to produce or consume a good or service. Public provision is the production or delivery of a good or service by the government or a public entity. Public-private partnerships are the arrangements or agreements between the government and a private entity to jointly provide a good or service. Market-based instruments are the mechanisms or schemes that use market signals or incentives to influence the behavior or actions of the market agents, such as tradable permits, auctions, or vouchers.
?? Unintended Consequences: Implementing these policy responses often has unintended side effects. For example, imposing high taxes on unhealthy food items might help internalize external healthcare costs, but it can also disproportionately impact low-income households. ?? Role of Technology: Technology can sometimes outpace regulation in sectors like fintech and health tech. Policymakers must be agile to respond to new forms of potential market failure introduced by rapidly evolving technologies. ?? Importance of Pilot Programs: Before rolling out a new policy, it's often beneficial to have pilot programs. This ensures the policy has the desired effect and allows for tweaks before full-scale implementation.
Adam Smith invented the metaphor of the invisible hand to try to explain the functioning of markets and the setting of prices through the free play of supply and demand. However, the market is not perfect and sometimes the invisible hand leads to undesirable situations such as social inequalities, the dominant position of some companies or pollution. These are so-called market failures. A market failure is a negative consequence of its functioning and occurs when it is not efficient in allocating available resources. There are five main market failures: the instability of economic cycles, the existence of public goods, externalities, imperfect competition and the unequal distribution of income.