What is Market Failure?

Market failure is the economic situation defined by an inefficient distribution of goods and services in the free market. In market failure, 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 him/herself, but those prove to be the wrong decisions for the group. In traditional microeconomics, this can sometimes be shown as a steady state disequilibrium in which the quantity supplied does not equal the quantity demanded.

Key Takeaways

  • Market failure occurs when individuals acting in rational self interest in a market produce a less than optimal or economically inefficient outcome.
  • Market failure can occur in explicit markets where goods and services are bought and sold outright, which we think of as typical markets, and in implicit markets where favors and special treatment are exchanged, such as elections or the legislative process.
  • Market failures can be solved using private market solutions, government imposed solutions, or voluntary collective action solutions.
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Market Failure

Understanding 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. The economic outcomes under market failure deviate from what economists usually consider optimal and are usually not economically efficient. 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, 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 and for which the consumption by one individual does not limit consumption by others.

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, they also face major difficulty producing the optimal amount. This may be an example of a market failure with no pure solution.

Solutions to Market Failures

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

Asymmetrical information is often solved by intermediaries or ratings agencies such as 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 low skilled workers after a minimum wage increase, the government can create exceptions for younger or less-skilled workers. 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.

Private collective action is often employed as a solution to 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 might otherwise 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.