Market Failure
Market failure is a situation in which the free market, left to itself, fails to allocate resources efficiently, resulting in an outcome that is not socially optimal. Market failures provide the principal economic justification for government intervention in the economy.[1]
Definition
A market failure occurs when the conditions required for an efficient market—such as perfect competition, complete information, and the absence of externalities—are not met. In such cases, the market generates a level of output or a pattern of prices that does not maximise social welfare, and government action may improve the outcome.[1]
Causes of market failure
| Type | Description |
|---|---|
| Externality | Costs or benefits imposed on third parties not reflected in market prices. |
| Public Goods | Goods that are non-excludable and non-rival, which markets tend to underprovide. |
| Market power (Monopoly) | Firms with market power restrict output and raise prices above the competitive level. |
| Imperfect information | When buyers or sellers lack the information needed for efficient decisions. |
| Asymmetric information | When one party knows more than the other, leading to adverse selection or moral hazard. |
| Common resources | Rival but non-excludable resources that are overused, the "tragedy of the commons". |
Policy responses
Governments may respond to market failure through a range of instruments, including:
- Regulation and competition policy to curb market power.
- Taxes and subsidies to correct externalities.
- Direct provision of public goods.
- Information disclosure requirements to address asymmetric information.
- Property rights assignment to manage common resources.
Limitations
Government intervention to correct market failure may itself be imperfect, a phenomenon known as government failure. Policy interventions can create unintended distortions, impose administrative costs, or be captured by special interests, so the costs of intervention must be weighed against the benefits of correcting the market failure.[1]