Loading the player...

What is 'Market Failure'

Market failure is the economic situation defined by an inefficient distribution of goods and services in the free market. Furthermore, the individual incentives for rational behavior do not lead to rational outcomes for the group. Put another way, each individual makes the correct decision for him/herself, but those prove to be the wrong decisions for the group. In traditional microeconomics, this is shown as a steady state disequilibrium in which the quantity supplied does not equal the quantity demanded.

BREAKING DOWN 'Market Failure'

A market failure occurs whenever the individuals in a group end up worse off than if they had not acted in perfectly rational self-interest. Such a group either incurs too many costs or receives too few benefits. Even though the concept seems simple, it can be misleading and easy to misidentify.

Contrary to what the name implies, market failure does not describe inherent imperfections in the market economy — there can be market failures in government activity, too. One noteworthy example is rent seeking by special interest groups. Special interest groups can gain a large 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.

Additionally, not every bad outcome from market activity counts as a market failure. Nor does a market failure imply that private market actors cannot solve the problem. On the flip side, not all market failures have a potential solution, even with prudent regulation or extra public awareness.

Common Types of Market Failure

Commonly cited market failures include externalities, monopoly privileges, information asymmetries and factor immobility. One easy-to-illustrate market failure is the “public good problem.” Public goods are goods or services which, if produced, the producer cannot limit its consumption to paying customers.

Public goods create market failures if some consumers decide to not pay but use the good anyway. National defense is one such public good because each citizen receives similar benefits regardless of how much they pay. It is very difficult to privately produce the optimal amount of national defense. Since governments cannot use a competitive price system to determine the correct level of national defense, this may be a market failure with no pure solution.

Solutions to Market Failures

There are many potential solutions for market failures. Asymmetrical information is often solved by intermediaries or ratings agencies — investors rely on Moody’s and Standard & Poor’s to inform about securities risk; Underwriters Laboratories LLC performs the same task for electronics. Negative externalities, such as pollution, are solved with tort lawsuits that increase opportunity costs for the polluter. Tech companies that receive positive externalities from tech-educated graduates can subsidize computer education through scholarships.

Governments can enact legislation as a response to market failure. For example, if businesses hire too few teenagers or immigrants after a minimum wage increase, the government can create exceptions for younger or less-skilled workers. The 1978 Airline Deregulation Act solved the underproduction of cheap air travel by allowing new price and business competition. One popular public good, radio broadcasts, elegantly solved the non-excludable problem by packaging periodic paid advertisements with the free broadcast. 

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. 

RELATED TERMS
  1. Failure To Deliver

    Failure to deliver refers to a situation where one party in a ...
  2. Flat On A Failure

    Flat on a failure describes closing out a position and taking ...
  3. Externality

    An externality is a consequence experienced by unrelated third ...
  4. Subsidy

    A subsidy is a benefit given by the government to groups or individuals, ...
  5. Public Good

    A public good is a product that one individual can consume without ...
  6. Rationing

    Rationing is the practice of controlling the distribution of ...
Related Articles
  1. Personal Finance

    The Ultimate List of Painful Financial Mistakes

    Here are 24 preventable tax and investment mistakes that advisors see often; mistakes that can ruin your retirement planning.
  2. Trading

    Bucking The Trend With Pattern Failure Strategies

    The best trade could be in the opposite direction when a classic price pattern doesn't behave according to ideal rules.
  3. Small Business

    In Entrepreneurship, Failure Doesn't Have to Be Fatal

    There is an inherent risk to starting any type of business, but being an entrepreneur with a plan can help you succeed or try again if necessary.
  4. Insights

    Novartis’ Heart Drug Fails Late Stage Trials (NVS, AZN)

    Novartis’ RLX030 (serelaxin) failed to meet both the primary endpoints of the trial in treating patients with acute heart failure
  5. Small Business

    Why Your Family Business Needs a Succession Plan

    It is important to have a succession plan in place for your family business.
  6. Insurance

    From Booms To Bailouts: The Banking Crisis Of The 1980s

    The economic environment of the late 1970s and early 1980s created the perfect storm for a banking crisis.
  7. Insights

    Government Regulations: Do They Help Businesses?

    These rules are in place to protect consumers and help businesses thrive at the same time.
  8. Small Business

    Famous Advice From Successful Entrepreneurs

    These famous quotes from some of the most successful entrepreneurs of all time can be used as inspiration for your entrepreneurial dreams.
  9. Investing

    Texas Ratio Rounds Up Bank Failures

    This measure can help investors spot potential trouble in a bank's financials. Find out how.
  10. Insights

    Will Small Caps Continue to Rally Under Trump?

    It remains to be seen what effect Trump's proposed economic policies will have on small businesses.
RELATED FAQS
  1. How do externalities affect equilibrium and create market failure?

    Discover the ways that externalities lead to market failure. Externalities are costs or benefits that go to a third party, ... Read Answer >>
  2. How does a monopoly contribute to market failure?

    Read a simple overview of the theory of market monopoly, where it originated and some contemporary challenges to the classical ... Read Answer >>
  3. How can companies reduce internal and external business risk?

    Understand the difference between two types of operational risk – internal risk and external risk – and how companies can ... Read Answer >>
  4. What are some of the arguments in favor of privatizing public goods?

    Some believe that privatizing public goods will eliminate the free rider problem and introduce competition to reduce price ... Read Answer >>
  5. How do modern companies assess business risk?

    Find out how modern companies assess and mitigate business risks, how those risks can be identified and categorized, and ... Read Answer >>
Trading Center