Answer
The two main causes of market failure are externalities which is the impact of one person’s actions on the well-being of a bystander. The classic example of an externality is pollution and market power which refers to the ability of a single person or firm (or a small group) to unduly influence market prices. For example, if everyone in town needs water but there is only one well, the owner of the well is not subject to the rigorous competition with which the invisible hand normally keeps self-interest in check.
Work Step by Step
Market failure is the notion that the price mechanism (supply and demand) on its own does not always provide desirable outcomes for society.
Externalities refers to the wider social costs and benefits of production that are not reflected in the price and quantity set by supply and demand. A good has negative externalities if there are unwanted side effects of production, such as pollution from cars. A good has positive externalities if there are widespread benefits. For example, education benefits not only the individual but society as a whole, as a more skilled workforce leads to economic growth. Market failure means that goods with negative externalities are overproduced, while goods with positive externalities are under produced.
The abuse of market power occurs in the case of monopolies, where a firm can set an undesirable price for its good as there is no competition forcing the price down.
