When markets fail
Markets do not always allocate resources efficiently. Market failure occurs when the price mechanism leads to an inefficient outcome or fails to take into account the full social costs and benefits of production and consumption. In such cases, government intervention may be needed to improve economic welfare.
Main causes of market failure
- Externalities – these arise when the actions of producers or consumers affect third parties. Negative externalities (e.g. pollution) impose external costs, while positive externalities (e.g. vaccination) create external benefits. Markets tend to over‑produce goods with negative externalities and under‑produce those with positive externalities.
- Public goods – these are goods that are non‑excludable and non‑rival (e.g. street lighting, national defence). Because free riders cannot be excluded, private markets may fail to supply public goods. Governments often provide them and finance them through taxation.
- Merit and demerit goods – merit goods (e.g. education, healthcare) have positive externalities and tend to be under‑consumed; demerit goods (e.g. cigarettes) have negative externalities and tend to be over‑consumed.
- Imperfect information – consumers or producers may lack information about product quality or long‑term effects, leading to sub‑optimal choices.
- Market power – monopolies and oligopolies can restrict output and raise prices, resulting in allocative inefficiency.
| Cause | Example | Possible government intervention |
|---|---|---|
| Negative externality | Industrial pollution affecting local residents | Tax on pollutants, regulation, tradable permits |
| Public good | Street lighting | Government provision funded by taxation |
| Information failure | Consumers unaware of health risks of sugary drinks | Labelling requirements, public awareness campaigns |
| Market power | Monopoly controlling supply of water | Antitrust laws, regulation of prices |
Government policies to address market failure include taxes and subsidies, regulation, provision of public goods, and competition policy. However, government intervention can also fail due to information gaps, administrative costs or unintended consequences. A balanced approach is needed to correct market failures while preserving the benefits of market allocation.
