What is Market Failure?

Market failures are like weeds in your garden…

Before you plant a garden, you want to make sure the soil is right for your plants to grow. You might till the ground and put fertilizer down to promote the best conditions. But that fertile soil is also perfect for unwanted plants to grow. Although your efforts tend to result in what you expect, there are occasionally unwanted weeds (market outcomes) that you need to address.

A market failure is what economists call a situation in which the market doesn’t reach the best possible outcome on its own. Classical economic theory would imply that these types of failures shouldn't happen. In theory, allowing buyers and sellers to set prices and production levels should result in wanted outcomes. Self-interested buyers tell suppliers what to make by buying the products they want. Rational entrepreneurs make what people want to buy. And competition makes sure prices balance what buyers want and how much it costs a seller to produce.

Adam Smith (the father of classical economics) described it as though an invisible hand guides the market to an efficient outcome. In theory, the laissez-faire (hands-off) government can allow the economy to function without any economic policies, and things should work out just fine. This theory is the idea behind capitalism.

In reality, the free market doesn’t always result in the outcomes that the public wants. When that happens, it’s called a market failure. There are several reasons that the free market can break down. In those situations, the people might want the government to intervene with public policy that improves the state of affairs. But the government sometimes goes too far, preventing the market from working the way it should.

There are several types of market failure, which result in an inefficient distribution of resources. If the free market guides buyers and sellers to make decisions that they regret, or that lead to more harm than good, it’s a market failure. Here are a few such situations.

Adverse selection is a situation in which the seller regrets making a deal because it ends up taking on more risk than it intended, usually not charging a high enough price for it. This type of market failure happens in insurance quite often. The term comes from the problem that offering insurance tends to attract people who are at higher risk.

A moral hazard occurs when a person changes their behavior after buying something, which alters the terms of the deal. For example, imagine that a person starts doing a lot more rock climbing after taking out a life insurance policy. Had the insurance company known about the increased risk-taking, they’d have charged more for the policy.

In some situations, people can benefit from a service without contributing to the cost — like riding a bus without paying the fare. These free-rider situations can lead to inefficiencies in the market if the service is nonexcludable. That’s especially true if the existence of some people not paying their way leads to others withholding their money as well. In the end, the market can break down and stop offering a service that generates more benefits than cost.

Monopolies are situations in which only one company offers a good or service. They are often a form of market failure because they represent a lack of competition. Without competition driving prices and production to the most efficient outcome, monopolies result in a deadweight loss (potential gains from trade that don’t happen).

Another form of market failure occurs when people overuse a resource, which results in reducing its productivity. For example, if people catch too many fish, there won’t be enough to spawn the next generation. That overuse can destroy the fish stock, which is an inefficient outcome of the free market.

One last type of market failure has to do with the merit of the goods and services that the free market creates. In some situations, society may object to the way the market uses resources as inconsistent with the desired outcome. For instance, the population might point to pollution, starvation, homelessness, and untreated disease as evidence that the free market doesn’t solve the right problems.

Markets fail to reach optimal outcomes for a few reasons. Here are a few.

While voluntary trade improves the position of everyone involved in a deal, it might not result in the best outcome for everyone else. Externalities are impacts which people outside the decision must bear. They can be positive externalities, like getting to watch a firework show for free. Or they can be negative externalities, like secondhand smoke.

If you add up the total social costs felt by everyone involved, they might overtake the social benefits. In this way, the rational choice of one person might lead to reduced social welfare (a different outcome than society would prefer). So, the market fails to reach the best result for society.

Public goods can sometimes lead to inefficiencies. While people with personal property rights will manage their resources for the long-term, it’s rational for people to approach public goods differently. For instance, if there were an apple tree in your yard, you might pick the apples at your leisure. But if there were an apple tree in a public park, you might assume the fruit will be gone tomorrow. So you might pick as much as you can today. This lack of property rights, combined with self-interest, can lead to market failure.

The fact that buyers and sellers have different information can prevent the market from working correctly. Without knowing what the person on the other side of the table knows, it’s difficult to determine if you’re buying a quality product or a piece of junk. Information asymmetry can lead to buyers regretting their purchases or walking away from good deals — either scenario may be a market failure.

Occasionally, the market fails to provide a service for which people would willingly pay. This outcome can be a result of very high development costs, communication problems, or high transaction costs. Imagine the military being provided by a private corporation without charging taxes on the population. It’d be an impossible task.

The free market works by redirecting resources toward better uses. If a business is making a product that buyers don’t want, it goes out of business. The workers, money, and materials that the company used inefficiently move on to other uses. However, some factors of production (land, labor, capital, and enterprise) are more challenging to reallocate than others. For example, workers can’t quickly and easily move to new cities or countries to change jobs. And you can’t pick up an acre of land from one place and put it somewhere else.

In some situations, the market can’t reach the best outcome because there is a conflict between what one person wants and the desires of a person acting on their behalf. For instance, the manager of a company might not pursue the most cost-effective source of materials because of some personal relationship with a less-efficient supplier. When the person making a decision (the agent) on behalf of someone else (the principal) has a conflict between what is best for themselves and the company, it can prevent the market from accomplishing the best outcome.

For a free market to work correctly, there can’t be obstacles in its way. Competitive markets allow the law of supply and demand to determine the market price. Sometimes large corporations exert market power to prevent competition from entering a market. One approach is called predatory pricing, in which a monopoly drops its prices to the point that it's impossible for new entrants to make a profit. In other cases, high start-up costs or regulations create barriers to entry. If these barriers result in monopoly power for one firm or otherwise stop a business from succeeding, it can cause market failures.

Free markets sometimes fail because the market isn’t truly free. If the government imposes taxes, permitting requirements, restrictions, price controls, tariffs, or other rules that limit the market, it can fail to achieve the best outcome. In most cases, governmental interference is an attempt to correct a market failure. But, in some cases, those rules can prevent the market from working.

The solution to a market failure depends on its cause. If the market fails because of information asymmetry, then disclosures and due diligence can help. For example, an insurance company might require a physical before writing a life insurance policy. If the failure is a result of self-interested people overusing a resource, privatizing that resource might work.

In the case of things like pollution, in which externalities cause the market to reach an undesirable outcome, taxes can incorporate the external impacts of pollution into a firm’s or individual’s decision-making. For instance, a carbon tax would increase the cost of products that cause pollution, thereby factoring the cost of pollution into the choices consumers make.

If the market drives the economy in a direction that people don’t like, regulations can steer the market toward a better outcome. For example, if the free market leads people into drug addiction, the government can make that product illegal. However, if it’s the regulations themselves that are causing the negative result, removing those rules would be the solution. An example of this would be rent control leading to a shortage of available quality housing.

When the market fails to achieve the best outcomes, the government sometimes steps in to try to fix things. There are a few ways that government intervention happens. First, the government can simply outlaw an undesirable action. Examples include selling addictive drugs, prostitution, and plastic bag bans. However, prohibitions are drastic actions that infringe on personal liberty. That makes them unpopular in places that value freedom.

A less extreme version of government control is through regulating a given activity. That could include screening the quality of food, requiring approval of pharmaceuticals, or demanding training and licensing before providing a service. These regulations don’t prevent a product from being sold, but they attempt to protect consumers.

An indirect intervention can occur through taxation. Cigarette and alcohol taxes are examples of this approach. Rather than telling people they are not allowed to buy these products, the government increases the costs involved. Consequently, fewer of these products get sold. Similarly, the government can step in and correct an allocation problem by forcing everyone to pay for a needed good. Then it provides the service for free to everyone. National defense, roads, education, and health care are examples of this type of intervention.

Finally, price controls and protectionist policies can serve to correct a perceived failure in the market, though these types of policies often result in a government failure. For instance, the Nixon administration placed a maximum price on gasoline to prevent price gouging in the 1970s. Of course, that simply caused a different problem — gasoline shortages. Tariffs (taxes on goods from other countries) are another way the government might attempt to reshape the market. However, these protectionist policies tend to result in higher prices for consumers, again trading one perceived failure for another.

Policymakers often look at the economy to decide if they need to intervene. In some cases, they create policies to restrict international trade. In others, they establish regulations to limit what they view as bad outcomes. Sometimes policymakers break monopoly power, allowing the market to work better. Probably the most common way for market failure to affect policy is through creating programs to pick up the slack, solving social problems that the market doesn’t address.