Market Failure: What It Is in Economics, Common Types, and Causes

Amy is an ACA and the CEO and founder of OnPoint Learning, a financial training company. She has nearly two decades of experience in the financial industry and as a financial instructor.

Skylar Clarine is a fact-checker and expert in personal finance with experience in veterinary technology and film studies.

What Is Market Failure?

Market failure is an inefficient distribution of goods and services in the free market. In an ideally functioning market, supply and demand balance each other out. However, in a market failure, something disrupts this balance.

When markets fail, individual incentives do not lead to rational outcomes for the group. Each individual makes correct decisions for themselves, but wrong decisions for the group.

Key Takeaways

• Market failure refers to inefficient allocation of resources when individuals in self-interest produce a less-than-optimal outcome.
• Market failure can occur in explicit markets (goods and services) or implicit markets (elections or legislative process).
• Solutions to market failures include private market solutions, government-imposed solutions, or voluntary collective actions.

Understanding Market Failure

Market failure refers to the inefficient distribution of resources when individuals in a group end up worse off than if they hadn’t acted in self-interest. Economic outcomes under market failure deviate from what economists consider optimal.

Market failure is not limited to the market economy. There can be market failures in government activity as well, such as rent-seeking by special interest groups.

Not every bad outcome from market activity counts as market failure. Also, not all market failures have solutions even with regulation and public awareness.

Causes of Market Failure

Various imbalances can affect market equilibrium. Common causes of market failure include:

• Externalities: When consumption harms a third party, negative externalities can lead to market failure.
• Information failure: Insufficient information can disrupt market equilibrium.
• Market control: When one party has too much control over a market, it can cause imbalanced pricing and market failure.
• Public goods: Public goods defy supply and demand principles. The private sector has little incentive to produce them, leading to market failure.

Solutions to Market Failure

Potential solutions for market failure include private market solutions, government-imposed solutions, and voluntary collective action.

• Private market solutions: Intermediaries and rating agencies can provide information to solve market failures. Tort lawsuits and radio broadcasts are examples of private market solutions.
• Government-imposed solutions: Governments can enact legislation and taxes/subsidies to address market failures.
• Collective action solutions: Private collective action can help overcome market failures, such as self-enforcement of rules and cooperative organizations.

Common Types of Market Failures

Types of market failures include negative externalities, monopolies, production and allocation inefficiencies, incomplete information, and inequality.

Correcting Market Failure

Government intervention is the primary means of correcting market failure. This involves legislation such as antitrust policies, and price mechanisms like taxes and subsidies.

Is Poverty a Market Failure?

Poverty is considered a result of market failure. Government intervention, such as taxes on the wealthy and subsidies for those below the poverty level, can address this issue.

The Bottom Line

Market failure refers to the inefficient allocation of resources in the free market. It occurs when individuals in self-interest produce less-than-optimal economic outcomes. Causes include externalities, information failure, market control, and public goods. Solutions can come from private markets, government intervention, or collective actions.