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. Possibility Of Failure (POF) Rates

    A possibility of failure rate is likelihood that a retiree will ...
  2. Flat On A Failure

    Flat on a failure describes closing out a position and taking ...
  3. Too Big To Fail

    "Too big to fail" is a term for a business that has become so ...
  4. Public Good

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

    Rationing is the practice of controlling the distribution of ...
  6. Rational Behavior

    Rational behavior is a decision-making process which results ...
Related Articles
  1. 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.
  2. Managing Wealth

    The Top Reasons Why M&A Deals Fail

    A significant number of M&A transactions result in failure. Here are the top reasons why it happens.
  3. Insights

    A Practical Look At Microeconomics

    Learn how individual decision-making turns the gears of our economy.
  4. Trading

    How to Break Bad Trading Habits

    It isn't making money on each trade that counts, but developing a long-term plan that works.
  5. Trading

    Massive Hedge Fund Failures

    Flying high one day but not the next - see the stories behind some spectacular meltdowns.
  6. 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
  7. Small Business

    Why Your Family Business Needs a Succession Plan

    It is important to have a succession plan in place for your family business.
  8. Trading

    Understanding Investor Behavior

    Discover how some human tendencies can play out in the market, posing the question: are we really rational?
  9. Small Business

    6 Reasons Why Products Fail

    There are a number of reasons outside of marketing and the actual product that can lead to unmitigated failure.
RELATED FAQS
  1. How is a market failure corrected?

    Find out how to think about market failures, how they tend to be corrected and different proposals about the best way to ... 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 does adverse selection contribute to market failure?

    Examine an brief introduction to the adverse selection theory of market failure, and find out why economists disagree about ... Read Answer >>
  4. 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 >>
  5. What are the main arguments in favor of the privatization of public goods?

    Learn about the main arguments why the task of delivering public goods should be the responsibility of companies under private ... Read Answer >>
Trading Center