Market failures appear whenever a market is unable to work “successfully”, meaning it cannot achieve equilibrium with an efficient allocation of resources, which is known as Pareto efficiency. This imperfection in the price assignment system prevents an efficient resource allocation, and thus, government intervention is considered necessary and justified. Although the concept has been around since Adam Smith, it is unclear who coined the term, even though F. Bator was probably the first economist to use it, in his paper “The Anatomy of Market Failures”, 1958. The most common ways in which market failure appears are externalities, public goods and information asymmetry:
-Externalities are caused when the production or consumption of a good or service has a spill-over effect which is not fully reflected in its price and so no appropriate compensation is paid for it. If the price does not include the true cost of the good or service it will be incurring in market failure. It is important to point out that externalities can be either positive or negative. To prevent negative externalities, governments may add specific taxes to the goods or services to cover its social cost.
– Public goods are defined as non-excludable and non-rival goods, which are the main reasons why the private sector may find it impossible, or at least very difficult, to make an economic profit from producing the goods. Consumers can become as what is known as free riders as they can enjoy the good without paying for it. Due to the poor incentives of the private sector to produce these kinds of goods, it relies in the public sector to provide them.
-Information asymmetry is understood as the difference of information levels between different parties. If one of the parties has more information than the other, it can use it to its advantage and so causing the transactions to be unfair. This kind of information asymmetry may lead to adverse selection and moral hazard, which will lead to market failures. The government can use several measures in order to reduce this kind of market failure, such as, collection and provisions of information, product standards, warrants, etc.