Market Failure: What It Is in Economics, Common Types, and Causes

What Is Market Failure?

Market failure refers to a situation defined by an inefficient distribution of goods and services in the free market. In an ideally functioning market, the forces of supply and demand balance each other out, with a change on one side of the equation leading to a change in price that maintains the market's equilibrium. In a market failure, however, this balance is disrupted.

When markets fail, the individual incentives for rational behavior do not lead to rational outcomes for the group. In other words, each individual makes the correct decision for themselves, but those prove to be the wrong decisions for the group as a whole.

Understanding Market Failure

A market failure refers to the inefficient distribution of resources that occurs when the individuals in a group end up worse off than if they had not acted in rational self-interest. In the case of a market failure, the overall group incurs too many costs or receives too few benefits. The economic outcomes under market failure deviate from what economists usually consider optimal and are usually not economically efficient.

Contrary to what the name implies, market failure does not describe imperfections only in market economies. There can be market failures in government activity, too. One noteworthy example is rent seeking by special interest groups. Special interest groups can benefit by lobbying for small costs on everyone else, such as through a tariff. When each small group imposes its costs, the whole group is worse off than if no lobbying had taken place.

Not every bad outcome from market activity counts as a market failure. In addition, while correcting the imbalances underlying a market failure often requires government intervention, private-market actors may also be able to solve the problem. On the flip side, not all market failures have a potential solution, even with prudent regulation or extra public awareness.

Causes of Market Failure

There are many types of imbalances that can affect the equilibrium of the markets. The following list provides an overview of some common causes of market failure.

• Externalities: Externalities occur when the consumption of a good or service benefits or harms a third party. Pollution resulting from the production of certain goods is an example of a negative externality that can hurt individuals and communities. The collateral damage caused by negative externalities may lead to market failure.
  
• Information failure: When there is insufficient information available to certain participants in the market, this can also be the source of market failure. If the buyer or seller in a transaction lacks access to the information on which the price is based, they may be willing to overpay or undercharge for a good or service, disrupting the market's equilibrium.
• Market control: When one party has too much control over a market, this can also create imbalanced pricing and lead to market failure. In the case of a monopoly or oligopoly, a single seller or a small group of sellers can manipulate pricing. In other situations, known as monopsony or oligopsony, it is the buyers that have the advantage. In either case, the disrupted balance of supply and demand could cause market failure.
• Public goods: Public goods are another example of market failure because they defy the tenets of supply and demand that drive the free markets. Public goods and services are nonexcludable—once something like a street light is produced, it is accessible to everyone, and the producer cannot limit consumption only to paying customers. Public goods are also nonrival, as use by one individual does not limit consumption by others. Given these characteristics, the private sector has little incentive to produce public goods, which leads to market failure, and the government usually has to provide these goods or subsidize their production.

Solutions to Market Failure

There are many potential solutions for market failure. These can take the form of private market solutions, government-imposed solutions, or voluntary collective action solutions.

• Private market solutions: In some instances, the solution to a market failure may emerge within the private market itself. For example, asymmetrical information could be solved by intermediaries or rating agencies such as Moody's and Standard & Poor's informing market participants about securities risk. Underwriters Laboratories LLC performs the same task for electronics. Negative externalities such as pollution may be solved with tort lawsuits that increase opportunity costs for the polluter. Radio broadcasts elegantly solved the non-excludable problem by packaging periodic paid advertisements with the free broadcast.
• Government-imposed solutions: When the solution does not come from the market itself, governments can enact legislation and take other measures as a response to a market failure. For example, if businesses hire too few low-skilled workers after a minimum wage increase, the government can create exceptions for less-skilled workers. Governments can also impose taxes and subsidies as possible solutions. Subsidies can help encourage behavior that can result in positive externalities. Meanwhile, taxation can help cut down negative behavior. For example, placing a tax on tobacco can increase the cost of consumption, therefore making it more expensive for people to smoke.
• Collective action solutions: While the government may have the upper hand in developing legislative, tax, or regulatory solutions, private collective action can also help solve the market failure. Parties can privately agree to limit consumption and enforce rules among themselves to overcome the market failure of the tragedy of the commons. Consumers and producers can band together to form co-ops to provide services that otherwise might be underprovided in a pure market, such as a utility co-op for electric service to rural homes or a co-operatively held refrigerated storage facility for a group of dairy farmers to chill their milk at an efficient scale.

The Bottom Line

Market failure refers to inefficient allocation of resources in the free market that occurs when individuals acting in rational self-interest generate sub-optimal economic outcomes. These economic inefficiencies may occur in explicit markets where goods and services are exchanged, or in implicit markets such as the exchange of favors in the legislative process.

The causes underlying market failures include negative externalities, incomplete information, concentrated market power, inefficiencies in production and allocation, and inequality. Government intervention such as taxes and subsidies may be effective in solving market failures, while other solutions may emerge within the private market or through collective actions.