What Is an Example of Market Failure?

Market failure describes a situation where a free market’s allocation of goods and services is inefficient. This means resources are not distributed to maximize societal well-being or economic output. This leads to a net loss of economic value, preventing optimal outcomes. Markets fail to produce the quantity or quality of goods and services society desires at the most efficient price, highlighting limitations within unregulated markets.

Externalities

Externalities represent a type of market failure where the production or consumption of a good or service imposes costs or confers benefits on a third party not directly involved in the transaction. These unintended consequences are not reflected in the market price of the good, leading to an inefficient allocation of resources. The presence of externalities means that either too much or too little of a good is produced from society’s perspective.

Negative externalities occur when an activity imposes a cost on an uninvolved third party. For instance, industrial pollution from a factory discharging waste into a river can harm local ecosystems and affect the health and livelihood of downstream communities. Residents may incur increased healthcare expenses due to respiratory illnesses, or local fishing industries might face reduced catches, leading to lost income and property value depreciation. The financial burden is typically borne by the affected community, not the polluter.

Noise pollution from construction projects is another negative externality. Loud sounds and vibrations can disrupt nearby businesses, leading to reduced customer traffic and revenue. Residents near the site might experience sleep disturbances, potentially leading to increased medical consultations or reduced productivity. These uncompensated costs are not factored into the construction company’s operational expenses.

Positive externalities arise when an activity generates benefits for a third party without direct payment. For example, widespread vaccination against infectious diseases provides community immunity, protecting even those who are not vaccinated. This collective protection reduces the overall incidence of disease, alleviating strain on public healthcare systems and preventing economic losses from absenteeism. The societal financial gain from a healthier populace far exceeds the private benefit to the vaccinated individual.

The restoration of historic buildings offers positive externalities beyond the property owner. Such renovations can enhance the aesthetic appeal of an area, attracting tourism and increasing property values for surrounding homes and businesses. The preservation of cultural heritage can also foster community pride and attract economic development. These broader economic benefits are not fully captured by the individual who undertakes the restoration.

Public Goods

Public goods represent another form of market failure, characterized by non-rivalry and non-excludability. Non-rivalry means that one person’s consumption of the good does not diminish its availability for others. For example, multiple individuals can simultaneously benefit from national defense without reducing its protective capacity for any single person. Non-excludability means it is difficult or impossible to prevent individuals from using the good, even if they have not paid for it.

This combination often leads to the “free-rider problem,” where individuals benefit from a public good without contributing to its cost. If people can enjoy benefits without paying, private entities have little incentive to provide such goods, as they struggle to recoup investment. Consequently, the private market tends to under-provide public goods, or not provide them at all.

National defense serves as a prime example of a public good. It protects all citizens, regardless of individual tax contributions, making it non-excludable. Protection offered to one person does not reduce availability for another, demonstrating its non-rivalrous nature. Due to the free-rider problem, national defense is predominantly funded through general taxation.

Street lighting is another common public good. Once installed, it benefits everyone in the area, and it is impractical to prevent someone from using the light if they haven’t paid. The illumination available to one person does not diminish it for another. Municipal governments typically finance street lighting through local property taxes or general fund revenues.

Basic scientific research also functions as a public good. Knowledge from fundamental research is often non-rivalrous, as its use by one scientist does not prevent another from using it. It is also largely non-excludable, as once published, access is difficult to restrict. Without government grants or public funding, private firms might underinvest in basic research.

Information Asymmetry

Information asymmetry occurs when one party in a transaction possesses more or better information than the other. This imbalance creates an uneven playing field, leading to decisions that may not be economically optimal or fair for the less informed party. The party with superior information can exploit this advantage, potentially to the detriment of the other participant.

The used car market illustrates this, as sellers know more about a vehicle’s condition than buyers. This informational advantage can lead to “adverse selection,” where buyers, fearing a “lemon,” are unwilling to pay a high price for any used car. This often results in good quality used cars being undervalued and withheld from the market, leaving a disproportionate number of lower quality vehicles for sale. Buyers face the financial risk of unforeseen repair costs, while sellers of well-maintained vehicles may receive less than their car’s true worth.

The insurance market frequently demonstrates information asymmetry. “Adverse selection” arises when higher-risk individuals are more likely to purchase insurance. This leads to an insurance pool with a disproportionately high number of high-risk clients, compelling insurers to raise premiums. This can make insurance unaffordable for healthier, lower-risk individuals, exacerbating the adverse selection spiral.

Moral hazard occurs after a contract is signed, when one party changes behavior due to protection from risk. For instance, with full coverage car insurance, an individual might become less careful driving, knowing the financial burden of an accident is covered. This increased risk-taking can lead to higher claims and premiums for all policyholders. Insurers mitigate moral hazard through deductibles, co-pays, and policy exclusions, shifting some financial risk back to the insured.

Market Power

Market power is a form of market failure where a single firm or a small group of firms holds significant control over the price and supply of a good or service. This dominance allows them to set higher prices and produce lower output than in a competitive market. This scenario prevents the market from reaching an equilibrium where prices reflect the true cost of production and consumer demand.

Monopolies, where a single seller controls the entire market, exemplify market power. Natural monopolies, like local utility companies, often arise where infrastructure costs make it economically efficient for only one provider to operate. Without regulation, these companies could charge exorbitant prices, leaving consumers no alternatives. Government oversight typically dictates pricing structures to ensure fair access and prevent excessive financial burdens on consumers.

Oligopolies, characterized by a few dominant sellers, also exhibit significant market power. In industries like telecommunications, a handful of large companies may control most market share. This limited competition can lead to tacit collusion or parallel pricing, keeping prices higher than in a fragmented market. Consumers may face higher costs for services with limited choices and reduced innovation.