Question

Identify four sources of market failure

Short answer

The four sources of market failure are Market Power, Externalities, Public Goods, and Incomplete Information.

Step-by-step solution

Definition of Market Failure

Market failure is a situation where in a free market, the allocation of resources, that is, the goods and services, are not allocated efficiently or are not Pareto efficient as suggested by the neoclassical economists, which can cause such failure for several reasons, among them being market power, also called monopolistic behavior, negative externalities, public goods, and incomplete information in the respective economy.

Identifying Four Sources of Market Failure 

Market Power

It refers to those situations where the firm does not work under perfectly competitive market conditions andbehaves monopolistically. In a perfectly competitive market, the free market predefined prices and quantities, also known as the ‘invisible hand’ by Adam Smith. However, in a monopoly market, the situation is quite different. The firm induces a relatively high price above the equilibrium price. For example: due to high prices, some consumers cannot buy the product; however, a firm whose cost is well below the price does not lower its equilibrium, which further affects the economic welfare causing a high deadweight loss in society, thus, causing market failure.

one can show market failure through the diagram below:

Thus, in the figure, we can see that monopolist is charging a price well above the equilibrium price resulting in a deadweight loss in the diagram, which results in market failure.

Externalities

Externalities are those situations where a particular production process causes harm to a particular group of entities and results in an external cost to be borne by that entity to lower the harm caused by the process. These are also termed negative externalities. For example, Air pollution caused by a brick kiln nearby can cause a lot of harm to the environment and the entities living beside it. It may cause several breathing issues, leading them to bear costs such as installing an air-purifying machine and medical bills to cope with asthma. Such leads to a negative impact on social well-being leading to market failure.

In the diagram above, it can be seen that externalities have raised the price from the optimal equilibrium and also reduced the output. Thus, leading to market failure.

Public Goods

Public goods are those goods that arenon-rival and non-exclusive. If a person buys such a product, then the other entities can readily be a free rider, thus causing a problem. For example, the mayor of a town buys lots of fireworks at Christmas, and he announces that there will be a firework show in a playground, and to enter the ground, one needs to pay $5 each. However, the fireworks can be seen anywhere, even from a person’s roof, leading to a free ride problem as nobody will be willing to pay $5 when they can easily enjoy the firework from their roof, which leads to market failure nobody will buy such goods.

Incomplete Information

Market failure due to incomplete information arises when entities are not aware of the situations or resources that will result in efficient allocation of resources, resulting in inefficiency in the market. For example, A utensil firm imports steel from another country as it does not have information about a steel plant nearby. It results in a high cost borne by the firm in the production process, resulting in a price rise. Such, in turn, reduces the demand for its utensil. If the firm happened to have information regarding such, then there would have been an efficient allocation of the resource. Thus, such incomplete information leads to market failure.