A principle justification for governmental intervention in the economy. The ideal market place is supposed to be efficient, but in reality this is not the case. It fails in key ways. Which helps explain why many governing agencies exist. Governments on all three levels in the United States were established largely to create markets.
- Market Failure: What It Is in Economics, Common Types, and Causes.
What Is Market Failure?
Market failure, in economics, is 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 in one side of the equation leading to a change in price that maintains the market's equilibrium. In a market failure, however, something interferes with this balance.
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 just in the market economy—there can be market failures in government activity, too. One noteworthy example is rent seeking by special interest groups.2 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.4
- 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.6 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.
Externalities:
- Clean Water Act.
- National Environmental Policy Act.
Information failure:
- Securities Exchange Act of 1934.
Market Control:
- Sherman Anti-Trust Act.
Public Goods:
- The U.S. Constitution.
- Federal-Aid Highway Act of 1956.
