What is Market Failure?

What happens when resources are not allocated efficiently or at all?

Formally defined, ‘Market failure is the economic situation defined by an inefficient distribution of goods and services in the free market.’[1]. Traditionally, this can be represented by a steady-state disequilibrium, where supply falls below demand due to an unforeseen external reason, and a shortage occurs. This can drive up prices, but if people cannot afford these or choose not to buy any of the products and switch to a cheaper alternative, companies can go out of business. This reduces supply even further and also reduces revenue whilst increasing unemployment rates. If this occurs on a national scale, the country could enter a recession or bouts of inflation, where prices continue to rise without any increase in wages, making it harder to buy necessities and simple luxuries. This can be assessed through the CPI, or Consumer Price Index, which uses various things from the average cost of grocery shopping to the prices of cars to determine whether or not inflation is occurring. If prices on average increase, this indicates inflation, while falling prices show deflation. An ideal situation would be steady inflation, where prices are reasonable, and the market is in equilibrium. For example, the UK’s national target is 2%, although the actual value is currently far from this.

The baseline is that market failure happens when the market is in a state of disequilibrium and cannot return to equilibrium by itself, which causes the situation to worsen and spiral out of control. Market failure can also occur when the market does not accommodate the needs or wants of the average consumer, which means money is wasted producing goods that will not be bought, again resulting in businesses closing down and unemployment rising. The problem appears when individuals have incentives to behave rationally in their interests. Still, the outcome is irrational for the collective group, so everyone is affected negatively. An excellent example of this is when a psychology professor at the University of Maryland added a bonus question at the end of an exam. This excerpt describes the question from an article in 2015 – ‘Dylan Selterman told his social psychology students that they could earn either two points or six points of extra credit on their final papers. Of course, there was a catch: If more than 10% of the class chose six points, nobody in the class would get the extra credit.’[2] The problem here was that all the students wanted extra credit, so the 2 point option would have satisfied everyone. However, it was more rational for an individual to choose the 6 point option as it would benefit them much more. Most of the students followed this logic and more than 10% chose the more significant choice, and the professor reported that no one received any extra credit. This shows how rational decisions for individuals based on incentives may not be a rational outcome for the group as a whole, leading to no one profiting. There are many different causes of market failure, but the main four are externalities, monopoly/ oligopoly, information asymmetries and factor immobilities, which will be explored individually over the next few posts.

[1] https://www.investopedia.com/terms/m/marketfailure.asp

[2] Excerpt from https://wtop.com/maryland/2015/07/university-maryland-professors-extra-credit-problem-goes-viral/