Market Failure: Definition & Causes

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  • 0:03 Market Failure: Definition
  • 0:29 Externalities
  • 1:24 Monopolies
  • 1:54 Public Goods
  • 2:46 Merit & Demerit Goods
  • 3:46 Lesson Summary
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Lesson Transcript
Instructor: Kat Kadian-Baumeyer

Kat has a Master of Science in Organizational Leadership and Management and teaches Business courses.

When the market for a given good or service fails to efficiently allocate the resources and utility of that market, it's called market failure. In this lesson, we'll explore some of the main reasons for market failure.

Market Failure: Definition

In economics, equilibrium is when the demand curve and the supply curve intersect, and consumers and suppliers enjoy maximum combined utility and profit. Market failure is a lack of equilibrium, during which consumers experience suboptimal utility and/or suppliers experience suboptimal profits. There are different types of market failure. Let's explore some of the causes for market failures.

Externalities

One cause of market failure is externality, which can be positive or negative. Externalities occur when the market demand for a product or service shifts and an unwitting third party is affected by the change.

Positive externalities occur when a third party inadvertently receives some benefit from a consumer's or supplier's economical choice. For example, as people become more conscious of their carbon footprint, the demand for big, gas-guzzling cars decreases. So, car manufacturers make fewer sales. However, the demand for clean public transportation may increase, a positive impact for public transportation.

With negative externalities, a third party is negatively impacted by a shift in supply or demand. For instance, building a new freeway ramp may alleviate highway congestion; however, if it is built on land that was once used for a botanical garden, those who once enjoyed visiting the garden will experience a negative impact.

Monopolies

Monopolies develop when a single supplier controls the market. Monopolies can cause market failure by under-supplying the market with their products or services. For example, consider the issue of trash management in a large city.

Now suppose that one trash management company creates a monopoly of sorts. If the garbage management company is unable or unwilling to perform its duties, the city will be overrun with trash. As a result, city residents become the innocent victims of the sudden shift in supply.

Public Goods

Public goods are goods whose total cost of production does not increase with consumption. They cause market failure because a market doesn't truly exist for these products.

This cause of market failure results from three smaller causes. Non-excludability means that the public benefits from the goods without paying for them. Non-rival consumption means that each person enjoys the goods without taking away from another person's enjoyment of the same goods. Non-rejectability says that people cannot reject the good.

Consider a public street lamp, for example. While the street light serves a purpose, the number of people utilizing it does not affect the demand for its luminous glow. To take this concept one step further, it's in no business's interest to illuminate every dark street corner if there's no real benefit. The free riders benefit because they enjoy illuminated streets without paying for the service.

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