Market failure can be defined as the situation in which the allocation of goods and services by free market is not efficient. It occurs as market fails to fulfill its obligation the most common failures involve cases of inadequate competition, inadequate information, resources immobility, public goods and imperfect competition. These failures occur on both the demand and supply sides of the market.
Government failure occurs when the government intervenes in the market to improve the market failure actually makes the situation worse. When market failure exist there is a reason for possible government intervention to improve the outcome, but it`s not clear that government action will improve the result since the politics of implementing the solution often lead to further problems. Government can intervene to the market through subsidies, bailouts, wage and price controls, taxes and regulations. Attempts to correct market failure may also lead to an inefficient allocation of resources.
Causes of Market Failure
There some reasons that lead to market failure are:
1. Inadequate competition
Inadequate competition exist when the economy market is monopoly that is the market is controlled by one person or a small group of people. The greatest danger of monopoly is that it denies consumers the benefit of competition, people cannot depend on the free market system to allocate resource efficiently or to bring the greatest satisfaction instead they must depend on the monopolist who is above the market. Monopolist uses it positions to prevent competition or restrict production, this bring shortage that causes higher prices also may lead to misallocation of scarce resource.
2. Inadequate information
If resources are to be allocated efficiently everyone that is consumers, business people and government officials must have adequate information about market condition. When adequate information is not available it`s difficult to employ and distribute resource at efficient level that can maximize benefit to whole society, hence inadequate information can lead to not only confusion in the market but also inefficient allocation of resource.
3. Resource immobility
Another reason to market failure is immobility of resources. The efficient allocation of resource requires land, labor, entrepreneurs and capital to be free to move to market where returns are at the highest. Hence when resource are restricted to move can lead to market failure as resource can be allocated at inefficient level or under utilized.
4. Externalities
Externalities can be defined as an economy side effect that either benefit or harm a third party not directly involved in the activity. Externalities can be classified into two ways positive and negative externalities. Positive externalities are benefit produced by an activity to the third party, for instance planting tree around your area of resident can benefit other through having fresh air. Negative externalities occur if an action harms a third party. For instance the smoke produced by the firm resulting pollution hence firm pollute air that the society live nearby a affected, In this case the firm is made better off while people external to the firm are made worse off. Externalities are classified as the reason for market failure because their costs and benefits are not reflected in the price paid by the buyers and sellers at the goods they produce or purchase and no compensation of harmful made by production activities.
5. Public goods
Public goods are those goods whose are collectively consumed by the whole society for example roads, national defense, police, fire protection etc as are non exclusive (no one can be excluded from it is benefits) and are non rival (consumption by one person doesn’t preclude consumption by other). Public goods lead to market failure as no payment made on public goods, once a public goods are supplied only to one person it is simultaneous supplied to all where as a private goods is supplied only to the individual who purchase it can use it.
6. Imperfect competition
A type of market that does not operate under the rigid rules of perfect competition. Perfect competition implies an industry or market in which no one supplier can influence prices, barriers to entry and exit are small, all suppliers offer the same goods, there are a large number of suppliers and buyers, and information on pricing and process is readily available. Forms of imperfect competition include monopoly, oligopoly, and monopolistic competition.
7. Market Power
Market power is also one of the reasons of causing market failure. Market power, which refers to a firm, can influence the price by exercising control over its demand, and supply. It does not exist when there is a perfect competition, but it does when there is monopoly, cartels, or monopolistic competition. The invisible hand of the market leads to an allocation of resources that makes total surplus larger as it can be. As monopolies can lead to an allocation of resources unlike from a competitive market, the monopolists keep its prices and profits high by using its market power to restrict output below the socially efficient quantity. The monopolists choose the profit-maximizing quantity of output at the intersection of the marginal-cost curve and the marginal-revenue curve. It is not at the lowest point of the average total cost curve, intend that the available resources are not fully use and it will fail to produce an efficient allocation of resources. The inefficiency of monopoly also can be measured with a deadweight loss triangle area between the marginal-cost curve and the demand curve, which reflects the total surplus loss and the costs of the monopoly producer. Buyers who have willingness to pay less than the price will not buy it. It is the reduction in economic well-being that fall out from the monopoly’s use of its market power.
Market Failure Recovery
When markets failure occurs, it will eventually affect economic recession, social unemployment rate to increase, financial deficits, and inflation and so on. In order to seek full employment, price stability, maintain economic growth and international revenue as well as expenditure in balance; government will launch a series of economic policies to intervene the market economy and to correct market failures. Government policy is a kind of coercive force which is a noticeable act that controlled by individuals and organizations’ performance during the trade. Moreover, the government policies are divided into three parts, which consist of taxes, price control and subsidies.
Tax is an imposed manner which the burden of a tax is shared among participants in the market. When a tax is imposed on goods, this will affect supply curve to shift upward by the amount of the tax. In addition, taxes can directly and indirectly affect on other area such as cigarettes, petrol, and alcoholic drinks.
Price control is the import and export of goods or services on the enforcement of price-fixing measures. At the equilibrium price, there will be no shortage or surplus. The government may prefer to keep prices above or below the equilibrium. There will be a shortage, if government sets a maximum price below the equilibrium price. Price will not be allowed to rise to get rid of this shortage. This is called a ‘price ceiling’. There will be a surplus, if government sets a minimum price above the equilibrium price. Price will not be allowed to fall to get rid of this surplus. This is called a ‘price floor’. For instance, fluctuation in weather can affect the crops. If industry demand is price inelastic, prices are possibility to fluctuate severely at a minimum price that can prevent a fall in producers’ incomes that would accompany periods of low prices. Whilst, if government sets a maximum prices to prevent them from rising above a certain level. This will generally be done for reasons of fairness. In wartime, or times of famine, the government may set maximum price for fundamental goods so that poor people can afford to buy the goods. Government keeps prices down for the consumers.
Besides that, subsidies are also other forms of public policies to overcome market failure. Government policies are very common in countries and it is benefit a lot of industries. Other than that, agriculture, education, free school meals, employment, state benefits, transport, working tax credits, regional development, housing are also some examples of the subsidies from government.