Market Failure

Market failure occurs when the action of the market does not create an optimal outcome. Causes of market failure can be attributed to three main reasons: first, market distortion i.e. monopoly or oligopoly, where market power is concentrated in the hands of a few participants. Second, the market creates an ‘externality’ that is not factored into the cost of production. For example, a paper mill pollutes a nearby water source causing a loss of amenity to the local community, although the costs are not borne by the mill or included in the price of the finished product. Third, is a market failure as a result of the goods or services being a ‘public good’. These are goods or services that are not diminished by being consumed by any one party. For example, a ship using the light source from a lighthouse to navigate safely into harbour does not mean there is a reduction in the ability of others to also use the same lighthouse. Everyone benefits from the lighthouse whether they have contributed to paying for it or not. As a result, few are actually prepared to pay for the cost of the lighthouse. The market is said to have failed, as many want the lighthouse and the light it provides, but few are prepared to pay for it. Thus, the State intervenes to ensure the supply of lighthouses meets demand. See also Market Distortion.

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