The inability of market institutions to sustain desirable activity or eliminate undesirable activity failure by market structure
Insufficient market participants for active competition failure by incentive
Breakdown of the pricing mechanism as a reflection of all costs and benefits of production and consumption externalities
Differences between private and social costs or benefits
Economic regulation began and continues in part because of the public's perception of market imperfections. It is sometimes believed that unregulated market activity can lead to inefficiency and waste or to market failure. Market failure is the inability of a system of market institutions to sustain socially desirable activities or to eliminate undesirable ones.
A first cause of market failure is failure by market structure. For a market to realize the beneficial effects of competition, it must have many producers (sellers) and consumers (buyers), or at least the ready potential for many to enter. Some markets do not meet this condition. Consider, for example, water, power, and some telecommunications markets. If customer service in a given market area can be most efficiently provided by a single firm (a natural monopoly situation), such providers would enjoy market power and could earn economic profits by limiting output and charging high prices. As a result, utility prices and profits were placed under regulatory control, which has continued with the goal of preserving the efficiency of large-scale production while preventing the higher prices and economic profits of monopoly. When the efficiency advantages of large size are not thought to be compelling, antitrust policy limits the market power of large firms.
A second kind of market failure is failure by incentive. In the production and consumption of goods and services, social values and costs often differ from the private costs and values of producers and consumers. Differences between private and social costs or benefits are called externalities. A negative externality is a cost of producing, marketing, or consuming a product that is not borne by the product's producers or consumers. A positive externality is a benefit of production, marketing, or consumption that is not reflected in the product pricing structure and, hence, does not accrue to the product's producers or consumers.
Environmental pollution is one well-known negative externality. Negative externalities also arise when employees are exposed to hazardous working conditions for which they are not fully compensated. Similarly, a firm that dams a river to produce energy and thereby limits the access of others to hydropower creates a negative externality. Positive externalities can result if an increase in a firm's activity reduces costs for its suppliers, who pass these cost savings on to their other customers. For example, economies of scale in semiconductor production made possible by increased computer demand have lowered input costs for all users of semiconductors. As a result, prices have fallen for computers and a wide variety of "intelligent" electronic appliances, calculators, toys, and so on. Positive externalities in production can result when a firm trains employees who later apply their knowledge in work for other firms. Positive externalities also arise when an improvement in production methods is transferred from one firm to another without compensation. The dam cited previously for its potential negative externalities might also provide positive externalities by offering flood control or recreational benefits.
In short, externalities lead to a difference between private and social costs and benefits. Firms that provide substantial positive externalities without compensation are unlikely to produce at the socially optimal level. Consumption activities that confer positive externalities may not reach the socially optimal level. In contrast, negative externalities can channel too many resources to a particular activity. Producers or consumers that generate negative externalities do not pay the full costs of production or consumption and tend to overutilize social resources.
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