Types of Market Failures

Unfortunately markets sometimes fail. A market failure occurs whenever one of the conditions necessary for competitive markets does not exist. As you will learn, five main causes of market failures exist.

Inadequate Competition

Over time, mergers and acquisitions result in larger and fewer firms dominating various industries. The decrease in competition tends to reduce the efficient use of scarce resources – resources that could be put to other, more productive uses if they are available. Inadequate competition can occur on both the demand and supply sides of the market. If we consider the supply side of the market, there is no competition when a monopolist dominates. In an oligopolistic market, the temptation to collude is strong. If we look at the demand side of the market, there is little or no competition if the government is the only buyer for space shuttles, hydroelectric dams, super computers, M-1 tanks, or high-technology fighter jets.

A firm that does not face adequate competition could easily spend its profits on huge salaries and bonuses, executive jets, country club memberships, and generous retirement plans. This is one of the reasons that public utilities such as electricity are regulated by the government – to make sure that the firms do not use their monopoly status to waste or abuse resources. Inadequate competition also may enable a business to influence politicians in order to get special treatment that enriches its managers and owners.

Inadequate information

If resources are to be allocated efficiently, everyone – consumers, businesspeople, and government officials – must have adequate information about market conditions. A secretary or an accountant may receive a competitive wage in the automobile industry, but wages for the same skills might be higher in the insurance or banking industry. The consequences of inadequate information may not always be immediate visible, but in the long run it will put a slow drain on the economy, lowering the rate of growth and the overall standard of living.

Resource Immobility

A difficult problem in any economy is that of resource immobility. This means that land, capital, labour, and entrepreneurs do not move to markets where returns are the highest. Instead they tend to stay, put and sometimes remain unemployed. What happens, for example, when a large auto assembly plant closes, leaving hundreds of workers without employment? Certainly some workers can find jobs in other industries, but not all can. Some of the newly unemployed may not be able to sell their homes. Others may not want to move away from friends and relatives to find new jobs in other cities.

Public Goods

Another form of market failure shows up in the form of public goods. Public goods are products that are collectively consumed by everyone. Their use by one individual does not diminish the satisfaction or value available to others. Examples of public goods are uncrowded highways, flood-control measures, national defense, and police and fire protection. When left to itself, the market either does not supply these items at all, or it supplies them inadequately. This is because a market economy produces only those items that can be withheld if people refuse to pay for them. It would be difficult, for example, to deny one person the benefits of national defense while supplying it to others. Because it is so difficult to have all individuals pay for their fair share of a public good, private markets produce too few of them.

Externalities

Many activities generate some kind of externality, or unintended side effect that either benefits or harms a third party not involved in the activity that caused it. A negative externality is the harm, cost, or inconvenience suffered by a third party because of actions by others. The classic case of a negative externality is the noise and inconvenience some people suffer when an airport expands. A positive externality is a benefit someone receives who was not involved in the activity that generated the benefit. For example, people living on the other side of town may benefit from the additional jobs generated by the airport expansion, or a nearby restaurant may sell more meals and hire more workers. Externalities are market failures because their costs and benefits are not reflected in the market prices that buyers and sellers pay. For example, airlines do not compensate homeowners for the diminished value of properties located near a new runaway extension. Nor does a restaurant owner share any additional profits with the airport. As a result, the prices that travelers pay for air travel will not reflect the external costs and benefits that an airport expansion generates.

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