The main aim of an economy is to create wealth and welfare for the society given the available resources, these resources are scarce and there are multiple users over them due to unlimited human wants
A market facilitates exchange and transaction of goods and services therefore seeks efficient allocation of resources across alternative uses.
Market failure is a situation in which a free market system fails to satisfy society wants i.e. when the invisible hand doesn’t work and the first fundamental theorem of welfare economics does not hold.
Market failure occur when private market does not bring about the optimal allocation of resources (pareto optimum conditions are not met) as a result the government must step in to satisfy human wants
Sources of market failure include:
1) Asymmetric information
For market to function effectively economic agents must be equally well informed about the price and nature of the product being traded.
Asymmetric information arises when one party has more information then the other chooses not to share it with others, this causes market failure
Eg a doctor knows more about medical services than the patient
An insurance buyer knows more about the riskiness than the seller
There are two types of asymmetric information problems
a) Adverse selection /hidden information problems
It occurs before a transaction is done .it occurs when one side of the market cannot observe the type of quality of the product on the other side of the market
It arises when one side of the market cannot observe the type of quality of product on the other side of the market. it arises when one party to the market knows more information and takes advantage of the information egg A used car seller knows more about it than the potential buyer
To reduce adverse selection problem government intervention is necessary egg compelling all citizens to buy insurance
Other methods may include signaling, offering a warranty, screening
b) Moral hazard /hidden action problem
It occurs after a transaction is done, it arises when one party to a transaction or contract passes the cost to his behavior to the other party of the contract passes the cost of his behavior to the other party of the contract
It occurs when the actions of a person are unobservable to the second person i.e. contracting parties cannot always determine the future behavior of the those they are contracting, this causes market failure.
Moral hazard can be corrected through government intervention and also signaling
2) Imperfect competition
A competitive firm expands its production up to where a unit of output is just equal to the market price of the resources needed to produce that unit or marginal cost
If other firms in the market are also competitive the market price of these resources is just equal to the market value of other goods that would be produced using same resources.
Imperfect competition causes market failure e.g. monopoly leads to imbalance of the power in the market i.e. a monopolist restricts quantity supplied and increases prices in the market to make supernormal profits
Oligopoly consist of few big firms dominating the market e.g. petroleum exporters behavior could lead to monopoly power hence market failure
3) Incomplete market
A market is incomplete when the supply is insufficient to meet the consumer’s needs .in this case a market may develop or fail to form completely. incomplete market fails to make optimal allocation of resources and therefore results to market failure
4) Externalities
An externality arises whenever one party makes the other party worse off or better off yet the first party neither bares the cost or the benefits of doing so.
The uncompensated actions of one person on the other person who is not involved in the activity, this represents a market failure for which government action is an appropriate to improve the welfare of the people externalities can be negative or positive i.e. if the impact on the other person is adverse then it is a negative externality and if its impact is beneficially then it is a positive externality
Example of negative externality include pollution, global warming, loud music etc.
Examples of positive externality include good landscaping, asking good question in class
5) Public goods
A public good is non-rival and non-excludable
The market may not work well because the good in question has public good characteristics
Pure public goods have two major characteristics
- They are non-rival in consumption -the marginal cost of the other person consuming the good is zero i.e. consumption of the good by the other person doesn’t affect the opportunity to consume the good
- They are non-excludable there is no way to denying someone the opportunity to consume a public good
Examples of public goods include national defense, street lights, highways
6) Common resource property
Common resources are those which are rival in consumption but not excludable i.e. resources not owned by anyone e.g. ocean, lakes, forest
Individuals acquire common resource property simply by taking it. depletion of these resources by actions of individuals may lead to over exploitation of these resources, this is a market failure and government intervention is require
Thanks for reading this article. Have a fruitful day, won’t you!!!