What Are the Causes of Market Failure?

According to Wikipedia, there are three main causes of market failure: externalities, monopolies and non-excludability. Externalities refer to a situation where the activities of an entity generate side effects for which the entity has made no provision. One example of an externality is pollution generated as a side effect of vehicle operation. Without measures such as road tolls, most people would operate vehicles without regard for the pollution they generate.

Another example of an externality is the pollution that is the side effect of industrial activities. Without taxes, regulations and similar measures, there would be little incentive for industries to make provision for the side effects of their activities, despite their negative effect on others. The concept of externalities is used to justify the intervention of governments and other overarching organizations in market operations, according to David Pannell of the University of Australia. Failure to enact regulations would result in the general society bearing the cost of negative side effects and offenders failing to pay for the cost of their operations. Such offenders could then sell their products at lower prices than they should.

Another cause of market failure is non-excludability. This refers to a situation where individuals or organizations cannot stop non-buyers from obtaining certain products or services. Such products or services are said to display the attributes of public goods. One example is open-source software. Creators of such software cannot stop others from using or even modifying their creation. If the situation is inadvertent rather than deliberate, it would result in underinvestment in the particular product or service.

Monopolies refer to a situation where an entity or a small group of entities gain excessive market power. Monopolies are an excellent example of market failure. Other causes of market failure include the uneven flow of information and lack of property rights, according to the University of Melbourne.