Introduction to market failures

Complete or partial failures

A complete market failure occurs when free markets fail to allocate any resources to a particular need or want.

Complete market failures can occur if markets do not form because of the absence of the necessary conditions for market formation.

Partial market failures arise when some, but not all, of the necessary condition for market formation exist.

Market formation

Markets are likely to form when the following conditions are met:

  1. Goods will be 'private goods', meaning that:
  2. Buyers can be excluded from the market - for example, if they have no ability to pay.
  3. Stocks of goods will diminish when consumption takes place.
  4. Consumers and producers are in competition with each other - they are rivals.
  5. Goods can be rejected if unwanted.
  6. Costs of production increase with output.
  7. Costs and benefits are private.
  8. Costs and benefits are largely known prior to a transaction.
  9. Consumers can be charged are the point of consumption.
  10. Producers can gain revenue and earn a profit.

Types of market failure

Failure to supply pure public goods.

Pure public goods are those which clearly do not meet any of the requirements for market formation above, and include street lighting, lighthouses, defence and policing. This is often referred to as a missing market.

Failure to supply enough merit goods.

Merit goods are those where the benefits of consumption are not fully understood by the consumer, and there is likely to be under-consumption. The benefits of consumption are not just to the individual, but to society in general. Education and healthcare are cited as examples of merit goods.

For example, many individuals experienced 'vaccine hesitancy' during the COVID-19 pandemic and failed to get themselves vaccinated, even though it was 'free'. Vaccinations are a merit good because they provide a wider benefit than may be perceived by the individual.

Failure to limit supply of demerit goods.

Demerit goods are those where the costs of consumption are not fully understood by the consumer, and there is likely to be over-consumption. The costs of consumption are not just to the individual, but to society in general. Alcohol is commonly cited as an example of a demerit good.

When individuals consume alcohol it not only effects them, but if they consume excessive quantities, and over a long period of time, individuals are more likely to be absent from work, or not even be able to work at all. Families can suffer from the direct and indirect consequences of alcohol abuse. Motorists using alcohol are more likely to commit traffic violations and cause accidents.

Failure to prevent harm to the environment.

Environmental harms can result from uncontrolled consumption and production of a wide range of goods and services.

These harms are referred to a negative externalities, and include carbon emissions, general pollution and waste, which can lead to a range of economic problems, including deforestation, global warming and extreme weather events. Markets commonly fail to 'price-in' these harmful effects, with production and consumption unconstrained.

Failure to provide information to make rational choices.

Markets are efficient at allocating scarce resources to need a wide range of wants and needs. However, for various reasons, the information available to consumers and producers is incomplete - there are knowledge gaps which mean that behaviour is often irrational.

In some cases, one party to a transaction knows more than the other party - called asymmetric knowledge - and the party can exploit this additional knowledge.

For example, producers may deliberately confuse consumers regarding price - a practice called price obfuscation. For example, an online seller may offer a good at a particular price, but once through the system the consumer finds that the price offered is not for the exact specification they wanted, or hidden extras start to appear.