Market failure is said to exist if the use of goods or their production by the market becomes inefficient. This means that there is another outcome that can make all the involved participants better off. Markets failures usually occurs when individuals in their pursuit of their self interests gives outcomes which are inefficient that is they can be improved upon from the point of view of the society. Market failures come about due to existence of non-competitive markets, public goods, imperfect information or externalities. Government intervention in the markets is usually as a result of existence of market failures (Frank, n. d).
For any market to be termed as being efficient, the demand and supply of goods should be determined by the market forces without being influenced by internal or external forces. Such a market is known as a perfect market. Under a perfect market, no single seller sets the prices of goods or services. The prices are set by the forces of demand and supply. There is also no restriction of entry or exit from the market and traders are at liberty to join or leave the market. Under a perfect market, traders only earn a normal profit which as a result of existence of perfect competition. When goods are introduced in a perfect market, few traders have them which initially help them to make supernormal profits, however, since there is no restriction on entry to the market, other traders are attracted by such profits and they join in the market thus bringing the profits down to the normal range. As more trader flood in, the profits go down and they become losses which forces some of the traders to exit the market pushing up the profits to the normal range. This ensures that the market efficiency is maintained and market failures avoided. Also, under perfect completion or market, information is freely available to all individuals which help market to continue operating at efficiency (Gassler, 2007).
Causes of market failures
As mentioned above, there are various causes or sources of market failures. One of cause of market failures is existence of imperfect markets. A market is said to be imperfect if it is characterized by few superpower industries or manufacturers or an agent causing the evolution of monopolies, cartels, monopsonies and/ or monopolistic competition. One or few of these forms should be in operation in any sector of a market for it to be categorized as an imperfect market with imperfect competition. Imperfect markets are created when an agent in the market gains abnormal market power which allows him or her to block entry of mutually beneficial trade. The agent with the market power thus determines the price of goods and drives away other competitors leading to imperfect competition in the market. Imperfect competition in turn leads to market inefficiency thus market failures. Perfect competition is a tool reducing market failures while imperfect competition fuels market failures. Existence of imperfect markets is one of the major causes of market failures (Connolly & Munro, 1999).
Another cause of market failure is the existence of public goods in a market. Public goods are those goods which are non-excludable and non-rivalry. Examples of public goods include health care facilities, defense, Medicare and infrastructure. Such goods are very costly and are usually provided by the state or the government. As stated earlier, for a market to be efficient it must be characterized by perfect competition which is governed by forces of demand and supply. However, in case of public goods, there is no such scenario thus leading to market inefficiencies hence market failures (GREENSPAN, 2009).
Imperfect and asymmetrical information is also another cause or source of market failures. For a market to operate efficiently, information should flow freely with all participants having access to it. This helps in ensuring there is free entry and free exit in the market which helps in maintaining market stability and efficiency. In cases where there is imperfect information meaning that only few individuals or organization have the information, such information can be used to restrict other from entering the market thus creating market imbalance thus inefficiency. There is said to have imperfect information if the buyers and sellers hold different sets of information which could be conflicting. Imperfect information is also said to be inexistence in cases where individuals are not well informed on the risks involved in certain ventures. This leads to market inefficiency thus market failures (Gassler, 2007).
The last cause of market inefficiency or market failure is existence of externalities. Externalities are said to be actions of any individuals or individuals or even firms which affect directly or indirectly affect other participants in the market but the cost or benefits obtained from such actions are not usually reflected in a transactions value. Some of the common externalities include road congestion, pollution or intellectual property. Though such externalities affect the operations of some industries, they cannot be reflected as either costs or benefits which create a difference in the profit margins of the business. Some businesses are more disadvantages leading to inefficiencies in the market thus market failures (Connolly & Munro, 1999).
Connolly, S. & Munro, A. (1999): Major sources of market failure. Retrieved on 17th June 2009 from,
Frank, R. H. (n. d): Market Failures. Retrieved on 17th June 2009 from,
Gassler, R. S. (2007): An Introduction to the Economic Theory of Market Behavior: Microeconomics from a Walrasian Perspective. Journal article of Journal of Economic Issues, Vol. 41
GREENSPAN, A. (2009): Addressing Systemic Risk: Risk of system-wide breakdown is an unavoidable characteristic of market economies. The Wall Street Journal