The Causes of Market Failure

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Why do markets fail to generate socially desirable outcomes? Markets are not infallible. They can fail to organise economic activity in a socially desirable fashion. Markets failure are due to social inefficiency and inequity. In the real world, the market rarely leads to social efficiency: the marginal social benefits of most goods and services do not equal the marginal social cost. Part of the problem is the existence of 'externalities', part is a lack of competition, and part is the fact that markets may take a long time to adjust to any disequilibrium, given the often considerable short-run immobility of factors of production. Let's analyse the types of market failure.


The market will not lead to social efficiency if the actions of producers or consumers affect people other than themselves. These effects on other people are know as externalities: they are the side effects, or 'third-party' effects, of production or consumption. Externalities can be either desirable or undesirable. There are four major types of externality.

1)External cost of production (MSC > MC)

The marginal social cost (MSC) of chemical production exceeds the marginal private cost (MC). For example, when a chemical firm dumps waste in a river or pollutes the air, the community bears cost additional to those borne by the firm. The problem of external costs arises in a free-market economy because no-one has legal ownership of the air or rivers and can therefore prevent or charge for their use as a dump for waste. Control must, therefore, be left to the government or local authorities.

2) External benefits of production (MSC < MC)

Marginal social cost is less than marginal private cost.

One of the example of external benefits in production is that of research and development. If other firms have access to the results of the research, then clearly the benefits extend beyond the firm which finances it. The firm only receives the private benefits, it will...
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