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What Is Market Failure? A Look at What Actually Happens

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We already gave you the lowdown on how markets work. Now, what happens when they don’t? Glad you asked because we’re here to answer a big question: What is market failure?

Inefficiency sucks.

In its most basic form, market failures are simply inefficient allocations of resources. Of course, markets can fail for many reasons (more on that later), but the bottom line is that market failure occurs when the supply of a good does not meet the demand of a good.

Now, market failures are much more common than you would think. The end of days isn’t coming just because of a market failure; in fact, market failures kind of happen all the time.

Partial vs. complete failure

There are two types of market failures: partial and complete.

With a partial market failure, the supplier can still produce the good but doesn’t produce the right quantity or sell it at the right price. Thus, the market is inefficient even though it is still technically “working.”

When there is a complete market failure, the supplier isn’t selling the product or is unavailable to provide the service requested. As a result, the market for that good or service essentially goes MIA due to one of the many causes of market failures.

Causes

If market failures are pretty common, then how do they even start in the first place?

Great question. Market failures can happen due to a few different reasons: the power of monopolies, the effects of externalities, the limited availability of public goods and the structure of the market itself.

1. Monopolies

Monopolies can cause market failures by underproducing a good and increasing the price in order to make it more scarce and increase profits.

2. Externalities

Externalities can be either positive or negative; they are the outcomes associated with consuming a product or service. When market failures happen, you can think of externalities as hidden gains or losses.

Positive externalities have an unintended, but beneficial, impact on a person or group not involved in the actual transaction (like you getting to enjoy your neighbor’s awesome flower garden). Negative externalities, obviously, have effects that aren’t so great for a third-party figure, (like your neighbor’s loud stereo keeping you up at night).

The market can often undervalue goods with positive externalities as the third-party benefits aren’t always captured in the original price. Because not everyone is going to pay for their neighbor to keep those roses fresh.

Likewise, goods with negative externalities can often be overvalued by the market as the third-party drawbacks aren’t always captured in the original price. For example, would you pay for your neighbor to turn down their music?

3. Public goods

There are also public goods that can be misallocated and lead to market failure (like your town beach getting so crowded no one can really use it).

4. The market itself

Before we start getting all “Hunger Games” over our limited public goods and resources, let’s consider if the market itself could be the problem. The way some markets are structured, they are almost guaranteed to fail. The market could be just starting and incomplete, or it could have unequal distribution of information.

Dodging market failures

Sometimes governments and regulatory agencies step in when things get funky and try and correct the error through taxes, bailouts, subsidies and price controls. For example, taxing negative externalities (e.g., carbon pollution from factories) and subsidizing positive externalities (e.g., subsidized student loans to increase college enrollment).

Some folks support this kind of intervention, while others believe markets should be allowed to succeed and fail on their own terms. The anti-intervention camp argues that Uncle Sam’s meddling is why the markets fail in the first place because they are not given a chance to correct themselves.

While not everyone might see eye to eye on the solution to market failures, we can agree that market inefficiency is not a great thing for the economy. And when your peers ask, “What is market failure?” you’ll be able to sit them down and explain.

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