Identifying Market Failures

Part of the Economics For Dummies Cheat Sheet

Sometimes markets fail to generate the socially optimal output level of goods and services. Several prerequisites must be fulfilled before perfect competition can work properly and generate that output level. Causes of market failure include the following:

  • Externalities caused by incomplete or nonexistent property rights: Without full and complete property rights, markets are unable to take all the costs of production into account.

  • Asymmetric information: If a buyer or seller has private information that gives her an edge when negotiating a deal, the opposite party may be too suspicious for both parties to reach a mutually agreeable price. The market may collapse, with no trades being made.

  • Public goods: Private firms can’t make money producing certain goods or services because there’s no way to exclude nonpayers from receiving them. The government or philanthropists usually have to provide such goods or services.

  • Monopoly power: Monopoly power is the ability to raise prices and restrict output in order to increase profits. Both monopolies (firms that are the only sellers in their industries) and collusive oligopolies (industries with only a few firms that coordinate their activities) can possess monopoly power. Monopolies and collusive oligopolies produce less than the socially optimal output level and produce at higher costs than competitive firms.

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