when the price mechanism causes a misallocation of resources within a free market.
How Market Failure Works
The economies on which we depend are made up of markets defined as any space in which goods or services can be exchanged, usually for money. The term also relates to broad markets, where the goods or services in question do not necessarily get exchanged all in the same place. Generally, economists depend on natural market forces to do the heavy lifting in terms of shifting prices and ensuring that those who need the goods most get them. "Market forces" are characterized into three functions, making up something called the price mechanism. These are:
- The signaling function
- The incentive function
- The rationing function
First, prices signal to buyers how much of a product they should buy, considering how much money they have and how much welfare they can extract from the product. The price also incentivizes firms to produce the item because of the opportunity to make a profit. Finally, the consumers who want the item the most get it because they are the most willing to pay the price. Economists understand that the simple process this represents is incredibly hard to predict, and they, therefore, leave the market to supply whatever quantity it wants and at whatever price.
Usually, these two things are correct. However, the price mechanism doesn't take all data into account; it only considers how willing consumers are to buy a product. Therefore, problems surrounding sustainability and similar topics present because the market does not care for them.
Examples of Market Failure
Externalities are a key cause of market failure. An externality is a scary term used to characterize the common-sense effects of some products. For example, some goods carry social benefits/disadvantages, which are different from the private benefits/disadvantages. One example is the healthcare market. The more healthcare an economy provides, generally, the better, from a social perspective, the economy is. However, in a free market, healthcare is usually underprovided because, understandably, some people will rather not go to their doctor if it means avoiding a fee. However, this results in health problems across society, which is bad for an economy – it cannot run with sick workers. The market, therefore, is failing because the price mechanism is causing it to under provide. Linking this back to the definition, a misallocation of resources occurs: the relevant resources are not being provided, such as doctors, medical equipment, and land for hospitals and surgeries.
A second example is the oil market. Companies have the opportunity to make a lucrative profit by selling oil, which is their private benefit. However, there is a negative externality associated with oil because it contributes to global warming. If consuming lots of oil, then society's consequences and the economy's future will be severe. Despite this, the price mechanism will incentivize firms to extract lots of oil from the ground, employing workers, and buying up machinery for extraction and transport. This represents a misallocation of resources.