Imperfect market outcomes are corrected through a reallocation of resources or a change in the incentive structure. Economists have different opinions about the nature of market failures and what (if any) measures need to be taken to prevent or correct them.

Key Takeaways

  • A market failure is when there is an inefficient distribution of goods and services that leads to a lack of equilibrium in a free market.
  • The law of supply and demand is meant to lead to an equilibrium in prices, and when it does not it indicates a factor in the market has failed.
  • Market failure can be caused by a lack of information, market control, public goods, and externalities.
  • Market failures can be corrected through government intervention, such as new laws or taxes, tariffs, subsidies, and trade restrictions.

What Is a Market Failure?

It's impossible to identify a solution for market failure without clearly identifying what a market failure is and why it persists. The common interpretation of market failure is the failure of a market to live up to the standards of perfect competition that leads to an efficient distribution of goods and services.

This idea is applied in general equilibrium economics when the law of supply and demand fail to reach a state of equilibrium in a free market due to some outside force. Market failure can be identified in many, if not all, markets.

What Causes a Market Failure?

One of the main causes of market failure is when one participant has control of one or more areas of the market and therefore is able to control the price of a good or service rather than letting changes in supply and demand do so. This is often seen in monopolies where a company that has a monopoly sets the price of a product or service, regardless of the supply and demand of that product.

A lack of perfect information can also lead to market failure. When buyers and sellers don't have all the correct information they may buy or sell a product at a higher or lower price than what would be reflective of its true benefit or cost.

Public goods also lead to market failure as the cost of a public good does not increase with increased users of that public good. If certain users continue to use a public good but do not pay for it, for example through taxes, then it can lead to market failures.

Market failures can also be caused by externalities, which is when an action impacts a third party that did not participate in the decision-making that led to that action. For example, if someone plants trees in a neighborhood, everyone in that neighborhood benefits from the trees being planted. If a factory in a local town is polluting the town with its fumes, that is a negative externality.

How to Correct a Market Failure

Using the broad, perfect-competition definition, market failures are corrected by allowing competing entrepreneurs and consumers to push the market further toward equilibrium over time. Markets tend toward equilibrium constantly, never quite reaching it. This is because of limitations in human knowledge and changing real-world circumstances.

Some economists and policy analysts propose a litany of possible interventions and regulations to compensate for perceived market failures. Tariffs, subsidies, redistributive or punitive taxation, disclosure mandates, trade restrictions, price floors and ceilings, and many other market distortions have been justified on the basis of correcting inefficient outcomes.

Government intervention intended to correct market failure can often lead to an inefficient allocation of resources, known as government failure.

Other economists argue that markets are recognizably imperfect, but market failure is improperly framed. Rather than asking if markets fail relative to some ideal (perfect competition), they contend that the question should be whether markets perform better than any other process that humans might invoke.

Free market economists, including Milton Friedman and F.A. Hayek, argue that markets are the only known discovery process proven to be capable of adjusting correctly to inefficiencies. They contend that regulation interferes with this discovery process, making inefficiencies worse rather than better.

The Bottom Line

A market failure is any interruption in the efficient distribution of goods and services that would otherwise reach equilibrium through the laws of supply and demand.

When a market failure occurs, there are many methods to correct it, primarily through the introduction of government activities, such as regulations, tax adjustments, and subsidies.

However, many economists do not propose interfering in market failures, as they believe that free markets will correct themselves eventually over time.