What is Market Failure?

When trying to run any sort of business, it’s important to understand the ways in which things could go wrong, so that you can plan to maximise your chances of success. Market failures are a major risk any company faces. So it’s important to understand them before you enter the entrepreneurial world and learn how to become an entrepreneur. And if you’re determined to work in the financial sector, read our brief guide on how to get into financial services. 

Here is a brief introduction to market failures, how they happen and how they can be resolved.
 

What is a market failure?

Market failure is an economic situation where goods and services are not distributed effectively due to factors disrupting the balance of supply and demand, leading to negative consequences for society, the environment, or individuals, and often requiring intervention for resolution.

What is the free market?

A free market is an economic system where prices, production, and distribution of goods and services are determined by supply and demand, with minimal government interference, allowing businesses and consumers to freely engage in transactions for mutual benefit.

How does the free market work?

The free market relies upon the fairly simple concepts of supply and demand. The economic theory claims that a free market will self-regulate, by only supplying as much of a product or service as there is need of, or demand for. In theory, the free market will automatically reach the most efficient distribution: one in which all of the people involved get the best deal possible.

In business, however, most parties will act in their own personal best interests (e.g. try to make the most profit). This is what economists call “rational behaviour”. Even if the individual parties make themselves better off without making anyone else worse off, the market is deemed to have reached an inefficient equilibrium and is counted as a failure. This happens often, as in the real world there are many factors outside a market which affect the way it works.

Examples of market failures

There are many different types of market failure. The most common and important ones are listed below:

1. Ecological

This is when human actors in a market are affecting the environment negatively as a result of their activity. Examples of this include pollution, use of non-renewable resources such as coal, and damage to ecosystems through things like farming.

2. Externalities

Externalities are when the activity of a market begins to affect the people outside of it. These impacts can be positive, such as better transport links built for industry also benefitting local residents. However, when we talk about externalities in the context of market failures, we usually mean negative externalities, such as noise or air pollution affecting people who live near a factory.

3. Inequality

This is when a market fails to distribute benefits equally, and instead widens the income gap between the wealthiest and the poorest. If all the benefits go to a small group of already affluent people, while others remain poor, this is a market failure.

4. Lack of information

This is when some of the people involved in the market, usually the buyers, do not have access to the information necessary to make an informed choice. An example of this is choosing to invest in a company without knowing about the risks involved.

5. Monopoly

A monopoly is when there is only one supplier of a certain good, allowing this single person or company to set the price higher than it would be in a competitive economy (one with several suppliers). This would also mean that the supplier can afford to produce less than in a competitive economy, as they would be able to cover their production costs and earn profit more quickly, which can cause shortages.

6. Moral hazard

This type of market failure happens when an actor in the market will not suffer the consequences of their own bad choices, leading them to take dangerous risks. For example, if banks know that the government will not allow them to go bankrupt, they may make very risky investments.

7. Productive and allocative inefficiency

This type of market failure happens when a limited resource is not produced or distributed in the most efficient way. For example, if I used Victorian farming methods, that would be productive inefficiency, as there are much more modern and effective ways of producing the same amount of farm produce.

8. Public goods

Public goods are available to everyone, and nobody can be excluded from benefiting from them. Examples of public goods are parks, roads and national security. These are funded by taxes, but their most common failure is that even if someone stops paying their taxes, they will not stop receiving the benefits of public goods. It then follows that if everyone stopped paying taxes, the parks would not be maintained and fall into disrepair.

9. Unstable markets

This is when the market never reaches a stable equilibrium. This happens when the conditions that affect supply and demand are constantly changing, such as at times in foreign exchange.

Solutions to market failures

So, now you know all of the most common ways markets can fail. But how can these failures be solved or avoided? Market failures can be solved or mitigated through various means:

Government intervention

The government intervenes in various ways to solve market failures. It can pass laws, which might impose restrictions on land use and protect certain ecosystems from farming. Or it can introduce fines for companies that produce a lot of pollution.

The government can also introduce taxes and subsidies. These are especially effective in reducing negative externalities, as demonstrated by taxes on carbon dioxide emissions. Subsidies, when the government contributes to part of a given cost, may be used to encourage positive externalities.

Wage and price controls can also solve market failures, largely by preventing a monopoly from raising the price of a product or service above a certain level.

A more subtle method the government uses to reduce market failures is advertising, which aims to change people’s behaviours in ways that would make the market equilibrium more efficient. For example, advertising can encourage people to use public transport and thus reduce traffic.

Government failure

However, the market is not the only element in an economic system that can fail. If the measures introduced by the government themselves lead to an inefficient equilibrium, this outcome is known as a government failure. Sometimes there is no way the government can adjust the situation to avoid an inefficient equilibrium. So either way, there would be a market failure or a government failure.

Private collective action

This is when the group of people affected by the market failure group together and all agree to act in a certain way to increase their collective benefits. A cooperative is a group of citizens with similar outlooks and aims, who get organised to provide each other with a service that would otherwise not be provided. This is the most common example of private collective action. It could take the form of carpooling, or a group of adults taking it in turns to look after each other’s children during work hours.

Further learning on economics and next steps

• Find further reading suggestions related to business and market failures in our list of best economics books for students
• For students looking to study economics in university, get a head in your studies by attending Oxford Scholastica Academy’s Business Summer School for teens