What is market failure? (Definition, types and solutions)

By Indeed Editorial Team

Updated 7 September 2022

Published 27 April 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

Market failure is a condition that occurs sometimes in a free market. It describes an inefficient distribution of goods and services. Market failure can arise when individuals make decisions that are good for themselves but don't work in the best interests of the whole market or group. Learning about the types of market failure and its causes can help prepare you for a career in finance or project management. In this article, we explore the definitions, types and solutions to market failure, answering questions like, 'What is market failure?' and 'What solutions can help to fix market failure?'.

What is market failure?

Market failure is a condition that can arise in a free market when the distribution of goods and services is inefficient. It occurs when individuals act with self-interest, but this doesn't result in the best outcomes for the whole group. For example, if a company that sells gas increases the price of gas suddenly, this could benefit them and increase profits, but can lead to market failure because the cost of gas is unrepresentative of its value.

Market failure can occur in both implicit and explicit markets, such as markets where parties exchange favours and markets where parties exchange goods and services. Implicit markets include elections, while explicit markets include typical markets, including stock markets and even physical marketplaces. Market failure can be:

  • Partial: when a market is still functional, but it supplies products in an unsuitable quantity or price point

  • Complete: when a market stops selling certain products at all

Related: How to become an economist: a step-by-step guide (with tips)

Types of market failure

There are lots of different types of market failure which can describe ways in which a market can fail for different reasons. It's important to understand the different types of market failure to understand the answer to 'What is market failure?' The list below contains some of the most common types of market failure in both implicit and explicit markets:

Public good problems

The public goods problem is a type of market failure that arises when it's difficult or impossible to exclude people from using a good or service. Once somebody has access to the good or service, it's very difficult to stop them from using it. This occurs frequently with public goods like defence and law enforcement because it's difficult to exclude people from using these goods and services. This means it's very hard to control the supply and cost of law enforcement, alongside knowing what the optimum amount of law enforcement to provide is.

Monopolies

A monopoly describes a situation where there is only one seller of a good or service. This can lead to market failure because the monopoly can charge whatever price it likes for its good or service, since there is no competition. The monopoly can also choose not to produce goods and services that people want, leading to an inefficient allocation of resources. When a seller has such a level of influence that they hold a monopoly over the market, they can abuse this power by increasing prices or limiting the supply of a product to increase demand.

Related: What is a supply and demand curve and how is it useful?

Externalities

Externalities are costs or benefits that emerge because of economic activity by third parties. For example, when a factory emits pollution into the air, the people who live near the factory absorb the costs of that pollution even though they didn't create it. This is an example of a negative externality. Externalities create market failures because the people who create them don't pay for the costs they create. This means that the market won't produce the right amount of goods or services, which leads to an inefficient allocation of resources.

Information asymmetries

Information asymmetry is a type of market failure that arises when one party in a transaction has more information than the other party. This can lead to the party with more information exploiting the party with less information, which can be called 'information asymmetry bargaining power.' For example, imagine you're buying a used car from a private seller. The seller knows more about the car than you do, which creates an information asymmetry, and gives them more bargaining power. This means that the seller can charge you a higher price than the car is worth.

Related: Product orientation and market orientation: how they work

Environmental concerns

Environmental concerns can cause market failures in both implicit and explicit markets. In implicit markets, environmental concerns can lead to the public good problem because it's difficult to exclude people from using a good or service that has environmental impacts. In explicit markets, environmental concerns can lead to market failure because of the externalities that result from economic activity, such as in the example of pollution above.

Factor immobility

Factor immobility is a type of market failure that arises when it's difficult or impossible to move factors of production from one place to another. For example, it might be difficult or impossible to move labour or capital from one sector of the economy to another. This can lead to an inefficient allocation of resources because the wrong factors of production might be present in certain sectors of the economy.

Related: What is scarcity in economics? (With examples)

Property rights

Property rights are the legal rights that people maintain to control the use of a good or service. When these rights aren't clear or well-defined, it can lead to market failure. This frequently is the case with common resources like forests or fisheries, where it's difficult to determine who owns them and who may use them. This can lead to people over-exploiting these resources, which can cause them to run out, severely impacting supply.

Market failure solutions

There are lots of different ways to solve different types of market failures. These include private market solutions, solutions imposed by the government and voluntary collective action solutions. In many situations, the government attempts to solve market failures. This is because the government can impose regulations on businesses and tax them to correct inefficiencies in the market. Some of the most common solutions to market failure are below:

Government regulations

One of the most common ways to solve market failures is through government regulations. Governments can impose regulations on businesses to correct inefficiencies in the market. For example, the government might require businesses to reduce pollution or it might require them to disclose information about their products to consumers, or it can create exceptions for low-skilled workers if an increase in the minimum wage leads to businesses refusing to hire more workers.

Taxes

Governments can also use taxes to correct market failures. For example, the government might tax businesses that create negative externalities like pollution. This would discourage businesses from polluting and would help to correct the market failure. Alternatively, the government might give tax breaks to businesses that engage in positive externalities like R&D or environmental conservation.

Public goods

Governments can provide public goods like healthcare, education and defence to correct the public good problem. This is because the government can finance these goods through taxes, which ensures that everyone has access to them. This doesn't solve the problem of optimisation when governments find it difficult to optimise the exact amount of public goods available to their population.

Social welfare programmes

Governments can also use social welfare programmes to correct market failures. Social welfare programmes are programmes that provide financial assistance to people who can't support themselves. This can include programmes like unemployment benefits, welfare and food vouchers. These programmes help to correct the market failure of unequal income distribution.

Voluntary collective action

Voluntary collective action is a type of market failure solution that happens when people work together to solve a problem that they can't solve on their own. This might involve boycotts or protests, or it might involve working together to create a new organisation. Voluntary collective action can be successful at solving problems like environmental degradation or human rights abuses.

Subsidies

Governments can also use subsidies to correct market failures. A subsidy is a financial assistance programme that gives money to people or businesses to encourage them to do something. For example, the government might give farmers subsidies to encourage them to grow crops that are environmentally friendly. This helps to correct the market failure of environmental degradation and minimises the negative externality of pollution caused by economic activities.

Advertising

Advertising can also help to resolve some issues that a market failure can cause. Advertising can help to inform consumers about the different options that are available to them and it can help businesses to sell their products. This can help to correct the market failure of information asymmetry, where consumers don't have enough information to make informed decisions.


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