Market failure by definition is a concept within economic theory wherein the allocation of goods and services by a free market is not efficient. That is, there exists another conceivable outcome where a market participant may be made better-off without making someone else worse-off. Market failures can be viewed as scenarios where individuals’ pursuit of pure self-interest leads to results that are not efficient – that can be improved upon from the societal point-of-view. The first known use of the term by economists was in 1958 but the concept has been traced back to the Victorian philosopher Henry Sedgwick.
Market failures are often associated with information asymmetries, non-competitive markets, principal agent problems, externalities, or public goods. The existence of a market failure is often used as a justification for government intervention in a particular market. Economists, especially micro economists, are often concerned with the causes of market failure, and possible means to correct such a failure when it occurs. Such analysis plays an important role in many types of public policy decisions and studies. However, some types of government policy interventions, such as taxes, subsidies, bailouts, wage and price controls, and regulations, including attempts to correct market failure, may also lead to an inefficient allocation of resources – which is sometimes called government failures. Thus there is sometimes a choice between imperfect outcomes, such as imperfect market outcomes with or without government intervention. But either way, if a market failure occurs, the outcome is not efficient. Many economists believe that it may be possible for a government to improve the inefficient market outcome, while several other schools of thought disagree with this concept totally. Different economists have different views about what events are the sources of market failure. Mainstream economic analysis widely accepts a market failure can occur for three main reasons:
- If the market is monopolized or a small group of businesses hold significant market power.
- If production of the good or service results in an externality.
- If the goods or services is a “public good”.
Let’s look at some situations resulting from these three reasons.
Agents in a market can gain market power, allowing them to block other mutually beneficial gains from trades from occurring. This can lead to inefficiency due to imperfect competition, which can take many different forms, such as monopolies, cartels or others. The monopoly will use its market power to restrict output below the quantity at which the marginal social benefit is equal to the marginal social costs of the last unit produced, so as to keep prices and profits high. As issue for this analysis is whether a situation of market power or a monopoly is likely to persist if unaddressed by policy, or whether competitive or technological change will undermine it over time. It is then a further question about what circumstances allow a monopoly to arise. Economists say that monopolies can maintain themselves where there are “barriers to entry”.