Market failure is a situation where the price mechanism does not account for the entire costs and benefits required to provide and consume a product or a service. There are three categories of market failures namely imperfect competition, public goods, and externalities. Before looking at imperfect competition, it is important to understand perfect competition. Perfect competition is a market situation with many buyers and sellers, who are not barred from entering or exiting the market. Imperfect competition, therefore, is a market situation with barriers to market entry or exit. In this nature of the market, the flow of resources or information is only limited to a particular seller. Monopoly, oligopoly, or monopolistic are three examples of imperfect competition. Monopoly is a market with only one seller or producer of a product. This market structure is characterized by high barriers to entry, which may range from legal protection against the competition to subtle techniques by the producer. In Mexico, for instance, PEMEX (Petroleos Mexicanos) has dominated the gas station industry. Oligopolies are market structures with many sellers or producers but few buyers, thus, sellers have little control over the supply of goods. In America, the tobacco market is oligopolistic because nearly 90% of the product is purchased by Brown & Williamson, Altria, and Lorillard Tobacco Company. Monopolistic competition structure features many producers or sellers of differentiated products; therefore, cannot be substituted. The best example of the monopolistic market are restaurants who make the same foods but with different ingredients and procedures.
The second type of market failure is public goods. There are three characteristics of public products: non-excludability, non-rivalry, and indivisibility. Non-excludability refers to the phenomena that the benefits of a good or service cannot be restricted to only those who have paid for it. For instance, taxpayers fund various public programs including healthcare and national defense. However, the consumption of the services provided by the program cannot be prohibited for individuals who do not pay tax. The act of obtaining benefits from a good or service that one did not directly pay for is known as free-rider. Non-rival means that the consumption of a good or service by one party does not restrict consumption of the same good or service by another party. The marginal cost of supplying a public product or service is, therefore, zero. For instance, if an individual uses public health service, it would not prevent another person from accessing the same service. Indivisibility is the aggregate supply of goods or services like public housing and education. The last type of market failure is externalities. Externalities sometimes called “the neighborhood effect” or the “spillover,” occur when an action of one economic agent generates a benefit (positive externalities) or a cost (negative externalities) to another financial agent. An example of a positive externality is when a firm’s production increases the well-being of a community by boosting business, and the community does not compensate the firm. The social benefit, in this case, would be calculated by adding the special benefit and the external benefit. Negative externality example is the use of large cars like SUVs for safety, but the cars pollute the environment through fossil fuel, causing global warming. The social cost would be achieved by adding the private cost and the external cost.
Imperfect competition, public goods, and externalities are market failures because they lead to inefficient distribution and consumption of goods and services in a free market. For instance, in a monopoly and monopolistic market structures, sellers have full control of pricing because they do not worry about new entries in the market. Therefore, consumers are forced to pay higher while others avoid buying the product or get less quantity. The lone producer demonstrates little or no consideration of the consumer needs and preferences. In oligopolistic situations, buyers have a greater influence on the supply of goods, which may force sellers or producers to sell goods at lower prices that do not reflect the cost of supplying. Public assets, due to the free-rider issue, are inefficiently distributed because the fee of supply is not paid for. Externalities cause market imbalance because the pricing of a good or service does not reflect the social cost or benefit of the good or service. Therefore, sellers or producers may end up under- or over-supplying the good or service.
There are various solutions to market failures. The government can manage imperfect competition through antitrust laws, regulation of monopoly, or nationalization. Antitrust laws are statutes established by the U.S. to protect consumers from unfair business practices and ensure fair competition in a free market. The government can also suppress monopoly power through price regulation and taxation. By nationalizing monopolistic organizations, the producer or seller would have less control of the price of a good or service. To ensure balance in the market of public goods, the government has embraced altruism and strived to produce more goods and services. For negative externalities, the government can increase taxes on goods and services to discourage consumption and internalize costs. For instance, a “sin-tax” on tobacco products subsequently discourages the consumption o tobacco by increasing its cost. For positive externalities, the government can subsidize the price of a good or service to reduce the cost of use. According to the Coase Theorem part I, negotiations between the party imposing the externality and the subject party can result in a socially optimal market quantity. Part II of the theorem suggests that the party harmed by the externality should file a legal suit for the damages and seek compensation.