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Causes Of Market Failure Essays

This essay presents three kinds of market failure. Information asymmetries, positive and negative externalities, and public goods are among its main features. The appropriate allocation of resources is a common theme throughout this essay. Acknowledging some key differences between public goods and private goods, determinations of what goods are most desirable and what allocation best satisfies societal goals and wants ultimately requires some value judgments. The reader receives information with which to distinguish public goods from private goods and to gain a better understanding of the role of governmental interventions. As a role primarily devoted to the reallocation of resources, the explicit purpose those interventions is to ensure the production and availability of the goods and services that society deems desirable and able to satisfy a wide array of diverse wants. Government often steps into the marketplace when there is an absence of incentives for private enterprise to provide and offer them. It also enters the market when there is a need to adjust resource allocations in order to diminish the effects of a two-party transaction on a third or external party. The reader of this essay also learns that government enters the market for other reasons as well.

Keywords Externalities; Governmental Interventions; Information Asymmetries; Private Goods; Public Goods; Resource Allocations; Societal Goals; Value Judgments

Economics: Market Failure


A commonality exists among the diverse efforts of high school students who search for colleges, motorists who travel on freeways, and those who purchase gasoline. Aside from their deliberate intent to move from one point in time and space to a different point, these individuals unknowingly experience a market failure in one form or another. Market failures are of three varieties: Information asymmetries, public goods, and externalities. Let us begin this essay with a brief introduction to each type of market failure.

  • Information asymmetry appears relevant to the search processes of college-bound high school seniors who probably hold lots of data and receive a great deal of advice, but lack complete or accurate information to arrive at a sound decision.
  • A public good, for example, is in the concrete and asphalt pavements that motorists use in our daily travels.
  • An externality appears relevant as the price of gasoline tends to omit the costs of removing carbon monoxide from the air all of us breathe whether we own or use a motor vehicle.

All three kinds of market failure arise from a misallocation of resources. The allocation of resources is a critical component in studies of economics and in advancing the frontiers of production and of knowledge. Knowledge accumulates in a variety of ways and economics is a social science informing us that the strength of a market system resides primarily with its efficient allocation of resources. Efficiency in allocation requires a market in which prices reflect the true cost of producing the combination of goods most valued by consumers. More importantly, efficiency is an elusive concept in that it attempts to account for the preferences of parties directly or indirectly involved in a marketplace transaction.

It is safe to assume that consumers want to pay the lowest price for gasoline, producers want to receive the highest price, and parties outside the transaction want to be free from inhaling pollutants. However, the market price they pay at the gas pump typically omits the cost of removing carbon monoxide from the air we breathe. Obviously, this is a major weakness of a price-oriented market system and in the overarching conceptual and analytic frameworks. Like most scientific fields, advancements to the frontiers of economic knowledge can occur by comparing theoretical propositions to hard data. Those comparisons take time requiring systematic analysis and the testing of a set of underlying assumptions.


In the sections ahead, this essay applies and discusses real issues as they relate to the topic of market failures. As readers progress through this text, they will find coverage of issues in resource allocation, three types of market failure, and the roles of government in dealing with marketplace situations. A significant portion of this essay draws from, refers readers to, textbooks (Arnold, 2005; Guell, 2008; McConnell & Brue, 2007) commonly employed in introductory economics courses. As is the typical case for coursework in economics, we will begin this essay with an introduction of a set of applicable and useful assumptions.

A Set of Economic Assumptions

Studies in economics usually begin by learning and acknowledging a specific set of assumptions.

  • First and foremost among the assumptions relevant to this essay is the ceteris paribus assumption, which by translation into English means all else held constant.
  • A second assumption is that consumers and producers behave as rational agents who have access to full, perfect information relevant to their decisions.
  • Third is the assumption that transactions engage individuals or a group who are limited in terms of the resources and influences they bring to an exchange decision.
  • The last assumption relevant to this essay is that an exchange between two parties produces benefits and costs for them only thereby omitting or ignoring the relevance of their exchange to a third party or larger society.

When any number of the latter assumptions become unrealistic or fail to hold true economists typically characterize the situation as a market failure.

Some Perspectives on Market Failure

This section summarizes some circumstances in which the government increases the amount of information available to marketplace participants, implements measures to correct the allocation of resources, and induces the shifting of resource allocations between private and public sectors. It also provides the reader with some comparable perspectives on market failure. McConnell & Brue (2007) define market failure as the following:

The inability of a market to bring about the allocation of resources that best satisfies the wants of society; in particular the over allocation or under allocation of resources to the production of a particular good or service because of externalities or information problems or because markets do not provide desired public goods (p. G-15).

Determinations of what goods are most desirable and what allocation best satisfies social wants requires some value judgments. In general, economists consider themselves free to accept or to reject those value judgments. The origin of their indifference stems, in part, from the discipline's orientation to testing assumptions that are cast in the form of objective "what is" as opposed to those in the form of subjective "what should be" statements. In addition, normative statements often take the form of policy recommendations that reflect social goals. As something worthy of brief mention here, welfare economics is a topic that specifically focuses attention on what actions, if any, government should take in redistributing income.

Some of those actions are presumably more effective than others by whatever measure one wants to choose, but coverage of such an approach is largely beyond the scope here. Furthermore, this essay tends to ignore government failures though many scholars focus their attention to the connections between government failures and market failures. Moreover, for those readers who hold an interest in exploring the divergence between market failure policy and social goal policy, they will find a concise summary published in a recent article by Winston (2006) wherein he writes:

Government policy seeks to improve microeconomic efficiency by correcting a market failure, defined by Bator (1958), as the failure of a system of price-market institutions to stop 'undesirable' activities, where the desirability of an activity is evaluated relative to some explicit economic welfare maximization problem. Accordingly, a market failure can be defined as an equilibrium allocation of resources that is not Pareto optimal-the potential causes of which may be market power, natural monopoly, imperfect information, externalities, or public goods (p. 2).

Bearing the name of Italian sociologist and economist Vilfredo Pareto (1848-1923), readers should keep in mind that Pareto optimality is a measure of efficiency. It refers to a situation in which any additional changes in an outcome or an existing allocation of economic resources will make one party better off but only at the expense of making another party worse off. In other words, Winston is referring to a market failure as a situation in which governmental actions will help some and hinder others. In addition, he includes a set of causes broader in content than we will cover in this essay. Specifically, we will focus our attention on imperfect information, externalities, and public goods and omit market power and natural monopoly.

In his article, Winston points out the breadth and depth of gaps in theoretical approaches to and empirical research on market failures and on effectiveness of market failure policies. Most scholars would readily agree that hard data leads to relevant findings, but the normative nature of...

Definition of Market Failure This occurs when there is an inefficient allocation of resources in a free market. Market failure can occur due to a variety of reasons, such as monopoly (higher prices and less output), negative externalities (over-consumed) and public goods (usually not provided in a free market)

Types of market failure:

  1. Positive externalities – Goods/services which give benefit to a third party, e.g. less congestion from cycling
  2. Negative externalities – Goods/services which impose cost on a third party, e.g. cancer from passive smoking
  3. Merit goods – People underestimate the benefit of good, e.g. education
  4. Demerit goods – People underestimate the costs of good, e.g. smoking
  5. Public Goods – Goods which are non-rival and non-excludable – e.g. police, national defence.
  6. Monopoly Power – when a firm controls the market and can set higher prices.
  7. Inequality – unfair distribution of resources in free market
  8. Factor Immobility – E.g. geographical / occupational immobility
  9. Agriculture – Agriculture is often subject to market failure – due to volatile prices and externalities.
  10. Information failure – where there is a lack of information to make an informed choice.
  11. Principal-agent problem – Two agents with different objectives and information asymmetries


Key Terms in Market Failure

  • Externalities:  These occur when a third party is affected by the decisions and actions of others.
  • Social benefit:  the total benefit to society =
    Private Marginal Benefit (PMB) + External Marginal  Benefit (XMB)
  • Social Cost: is the total cost to society =
    Private Marginal Cost (PMC) + External Marginal Cost (XMC
  • Social Efficiency: This occurs when resources are utilised in the most efficient way. This will occur at an output where social marginal cost (SMC) = Social Marginal Benefit. (SMB)

Overcoming Market Failure

Market failure and behavioural economics

Behavioural economics examines how individuals often act in a non-rational manner – contrary to the expectation of conventional economic models. These types of ‘irrational behaviour’ can lead to a type of market failure where people make poor choices. For example.

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