Question

What are the two main causes of market failure? Give an example of each.

Short answer

The two leading causes of market failure are externality and market power.

An example of market power is the presence of a monopoly market, and an example of an externality is vaccination

Step-by-step solution

Causes of market failure

Market failure is a situation when the free market forces are unable to produce an optimal level of output. Its causes are:

• Externalities: It refers to the effect on a party that is not a part of the market and yet bears the cost or enjoys the benefit from production or consumption of certain good or service. Market power refers to the concentration of power in certain hands that influence the price and quantity in the market.
• Imperfect competition: It is where a small group of individuals has a significant impact on the economy.

Examples of causes of market failure

• Example of market power: In the monopoly market, a single seller controls the price of the produced goods or services. There is a possibility of price discrimination that allows greater profits at the expense of consumers. This leads to inefficient production and causes market failure.

• Example of externalities: Vaccination not only helps the vaccinated people to control the spread of harmful diseases in their bodies but also to other people. This helps the non-vaccinated people as well. Businesses do not take that into account while producing vaccines. This positive externality effect leads to underproduction and thus, creates a market failure due to inefficient production.