May 31, 2023

Market Failure

Learn why governments intervene in the free market through public goods, natural monopolies, and externalities in this insightful blog post.

When you walk down the street and come across a circus performer entertaining the crowd, have you ever stopped to wonder why they are performing for free? Or why private companies are not providing national defense? The answer lies in the concept of market failure.

Market failure occurs when the private sector cannot provide goods and services profitably or ignores social costs and benefits. There are three types of market failures: public goods, natural monopolies, and externalities.

Public goods, such as national defense, are non-rival in consumption and non-excludable, meaning that consumption by one person does not prevent others from consuming it, and it is difficult to exclude someone from consuming it. Therefore, private firms cannot provide public goods profitably.

Natural monopolies, such as the supply of tap water in a city, occur when the production of a good or service by multiple players results in a doubling of effort and spending. In this case, a single firm, or monopoly, can provide the good or service more efficiently.

Externalities occur when an economic activity affects a bystander who is not a party to that activity. For example, buying an electric car provides a positive externality to society by reducing pollution.

The government intervenes in the market to correct market failures. They may undertake economic activities themselves or regulate private firms to provide goods and services that are not profitable or create positive externalities. For example, the government subsidizes primary education because the benefits of education go beyond the private benefit accruing to a child.

In conclusion, market failures are the reason why the government has a legitimate reason for undertaking economic activities and intervening in their functioning. However, in most other goods and services, the private sector achieves efficient levels of production and consumption through free markets. So, next time you see a street performer or wonder why private companies are not providing certain goods and services, you now have a better understanding of market failures.

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