Market Failure

Reviewed by Annapoorna | Updated on Aug 27, 2020

What is Market Failure?

In economics, market failure refers to a situation where the allocation of goods and services by a free market is not effective and efficient. It often leads to a net social welfare loss. Market failures are usually viewed as scenarios where individuals chase to attain pure self-interest leads to inefficient results that can be fixed as per society.

Understanding Market Failure

Market failure happens whenever the individuals in a group finish worse off than if they had not acted in perfectly reasonable self-interest. This group either incurs too many expenses or receives few benefits. The economic outcomes under market failure vary from what economists usually consider optimal and are generally not efficient economically.

Even though the theory seems simple, it can be mistaken. In contrast to what the name implies, market failure does not describe inherent imperfections in the market economy. Market failures can exist in government activity too.

One remarkable example is the case where the particular interest group seeks the rent. The particular interest group can obtain significant benefits, such as tariffs by lobbying for small costs on everyone else. When each small group imposes its costs, the whole group is worse off than if no lobbying had taken place.

Additionally, not every adverse outcome of market activity counts as a market failure. Nor does a market failure signify that private market actors cannot solve the problem. On the counter side, not all market failures have a possible solution, even with sound regulation or extra public awareness.

Causes and Implications of Market Failure

Economists, especially the micro economists, often are concerned with the causes of market failure and possible means of correcting the same. Public goods are not affected by the quantum of consumption and also non-excludable. Thus, the existence of a market failure is due to the reason that self-regulatory organizations, governments, or supra-national institutions meddle in a particular market.

Its analysis has an important role to play in many types of public policy decisions and studies. However, government policies on taxes, subsidies, bailouts, wage or price controls, and regulations may also lead to inefficient resource allocation, also called government failure.

There is always a tension between the occurrence of two situations. On the one hand, there is an undeniable cost to society due to market failure and on the other hand, the potential for cost mitigation that leads to costs from government failure. Due to this tension, a choice must be made between the imperfect market outcomes with or without government interventions.

If a market failure exists, the market outcome is not to be Pareto efficient. Pareto efficiency refers to a state of resource allocation. Due to this, it is impossible to reallocate to make any one individual or preferred criterion better off by not keeping any individual or preferred criterion worse off.