# Market Failure: What It Is in Economics, Common Types, and Causes

> **Definition**
>
> A market failure is an adverse outcome in a free market system in which the forces of supply and demand fail to ensure the efficient distribution of goods and services.

## What Is Market Failure?

A market failure is an adverse outcome in which the forces of supply and demand fail to achieve balance, leading to an inefficient distribution of goods and services in the free market.

The theory of [supply and demand](https://www.investopedia.com/terms/l/law-of-supply-demand.asp) states that these two forces inevitably balance each other out in an ideally functioning free market. The level of products produced will match the level of demand for the products, with prices for the products rising or falling to maintain equilibrium.

In a market failure, the balance is disrupted. Although market failure is an economic concept, it has implications beyond economics.

> **Key Takeaways**
>
> In a case of market failure, the market may be any set of individuals acting in rational self-interest.Normally, their joint actions should achieve an efficient distribution of goods and services. That is, supply should match demand at a price that is acceptable to all.Market failure is a failure of equilibrium that produces poor consequences for some or all market participants.

![Market Failure](https://www.investopedia.com/thmb/98_JEjCNUapqcGwJ8Y_Rtjb8gHs=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/Market-Failure-V3-ab96ad16afee413ea84ce9c9fe30038d.jpg)

*Market failure can be complete (a market doesn't exist for a particular good or service) or partial (there's a market but the wrong quantity of goods or at the wrong price). — Matthew Collins / Investopedia*

## How Market Failure Happens

A market failure refers to the inefficient distribution of resources that occurs when the individuals in a group end up worse off than if they had not acted in rational self-interest. In the case of a market failure, the overall group incurs too many costs or receives too few benefits. The economic outcomes under market failure deviate from what economists usually consider optimal and are usually not [economically efficient](https://www.investopedia.com/terms/e/economic_efficiency.asp).

Contrary to what the name implies, market failure does not describe imperfections only in market economies. There can be market failures in government activity, too. One noteworthy example is [rent-seeking](https://www.investopedia.com/terms/r/rentseeking.asp) by special interest groups.

Special interest groups can benefit by lobbying for small costs on everyone else, such as through a [tariff](https://www.investopedia.com/terms/t/tariff.asp). When each small group imposes its costs, the whole group is worse off than if no lobbying had taken place.

Not every bad outcome from market activity counts as a market failure. In addition, while [correcting the imbalances](https://www.investopedia.com/ask/answers/042115/how-market-failure-corrected.asp) underlying a market failure often requires government intervention, private-market actors may also be able to solve the problem. On the flip side, not all market failures have a potential solution, even with prudent regulation or extra public awareness.

## Causes of Market Failure

Many types of imbalances can affect the equilibrium of the markets. The following list provides an overview of some common causes of market failure.

*   **Externalities:** [Externalities](https://www.investopedia.com/terms/e/externality.asp) occur when the consumption of a good or service benefits or harms a third party. Pollution resulting from the production of certain goods is an example of a negative externality that can hurt individuals and communities. The collateral damage caused by negative externalities may lead to market failure.  
    
*   **Information failure:** When there is insufficient information available to certain participants in the market, this can also be the source of market failure. If the buyer or seller in a transaction lacks access to the information on which the price is based, they may be willing to overpay or undercharge for a good or service, disrupting the market's equilibrium.
*   **Market control:** When one party has too much control over a market, this can also create imbalanced pricing and lead to market failure. In the case of a monopoly or oligopoly, a single seller or a small group of sellers can manipulate pricing. In other situations, known as [monopsony](https://www.investopedia.com/terms/m/monopsony.asp) or [oligopsony](https://www.investopedia.com/terms/o/oligopsony.asp), it is the buyers that have the advantage. In either case, the disrupted balance of supply and demand could cause market failure.
*   **Public goods:** Public goods are another example of market failure because they defy the tenets of supply and demand that drive the free markets. Public goods and services are nonexcludable—once something like a street light is produced, it is accessible to everyone, and the producer cannot limit consumption only to paying customers. Public goods are also nonrival, as use by one individual does not limit consumption by others. Given these characteristics, the private sector has little incentive to produce public goods, which leads to market failure, and the government usually has to provide these goods or subsidize their production.

## Solutions to Market Failure

There are many potential solutions for market failure. These can take the form of private market solutions, [government-imposed solutions](https://www.investopedia.com/financial-edge/0710/4-government-interventions-did-they-work.aspx), or voluntary collective action solutions.

*   **Private market solutions:** In some instances, the solution to a market failure may emerge within the private market itself. For example, [asymmetrical information](https://www.investopedia.com/terms/a/asymmetricinformation.asp) could be solved by intermediaries or rating agencies such as Moody's and Standard & Poor's informing market participants about securities risk. Underwriters Laboratories LLC performs the same task for electronics. Negative externalities such as pollution may be solved with tort lawsuits that increase [opportunity costs](https://www.investopedia.com/terms/o/opportunitycost.asp) for the polluter. Radio broadcasts elegantly solved the non-excludable problem by packaging periodic paid advertisements with the free broadcast.
*   **Government-imposed solutions:** When the solution does not come from the market itself, governments can enact legislation and take other measures as a response to a market failure. For example, if businesses hire too few low-skilled workers after a minimum wage increase, the government can create exceptions for less-skilled workers. Governments can also impose taxes and [subsidies](https://www.investopedia.com/terms/s/subsidy.asp) as possible solutions. Subsidies can help encourage behavior that can result in positive externalities. Meanwhile, taxation can help cut down negative behavior. For example, placing a tax on tobacco can increase the cost of consumption, therefore making it more expensive for people to smoke.
*   **Collective action solutions:** While the government may have the upper hand in developing legislative, tax, or regulatory solutions, private collective action can also help solve the market failure. Parties can privately agree to limit consumption and enforce rules among themselves to overcome the market failure of the [tragedy of the commons](https://www.investopedia.com/terms/t/tragedy-of-the-commons.asp). Consumers and producers can band together to form co-ops to provide services that otherwise might be underprovided in a pure market, such as a utility co-op for electric service to rural homes or a cooperatively held refrigerated storage facility for a group of dairy farmers to chill their milk at an efficient scale.  
    

## Explain Like I'm 5

Market failure occurs when the process of the exchange of goods and services doesn't benefit everyone in society. In an ideal market, individuals make choices that are good for all members, not just for themselves; however, market failure occurs when individuals make decisions that are self-serving and negative for others.

For example, consider a factory that causes air pollution. This may not bother the owners of the factory but it is harmful to other members of society because the air they're breathing is damaging to their health.

Market failure can happen due to many reasons, such as when people don't have enough information to make good decisions or when a few people or companies have too much control over prices. When these problems arise, the market doesn't fix itself, and other solutions, like government intervention or collective action are needed to restore balance.

## What Are Common Types of Market Failures?

Types of market failures include negative externalities, monopolies, inefficiencies in production and allocation, incomplete information, and inequality.

## How Can Market Failure Be Corrected?

The primary means by which market failure can be corrected is through government intervention. This requires the government to pass legislation such as [antitrust](https://www.investopedia.com/terms/a/antitrust.asp) policies and to incorporate various price mechanisms such as taxes and subsidies.

## Is Poverty a Market Failure?

Poverty is considered to be a result of market failure. When a recession hits, the poverty rate increases because employees lose their jobs or lose working hours, which results in no income or less income.

Inequality, which is a component of market failure, can eventually lead to poverty when wealth is not distributed equally throughout society. This can be remedied with government intervention, such as by taxing the wealthy more or incorporating subsidies for those below the poverty level.

## The Bottom Line

Market failure refers to the inefficient allocation of resources in the free market that occurs when individuals acting in rational self-interest generate sub-optimal economic outcomes. These economic inefficiencies may occur in explicit markets where goods and services are exchanged or in implicit markets such as the exchange of favors in the legislative process.

The causes underlying market failures include negative externalities, incomplete information, concentrated market power, inefficiencies in production and allocation, and inequality. Government intervention such as taxes and subsidies may be effective in solving market failures, while other solutions may emerge within the private market or through collective actions.

> **Article Sources**
>
> 1.  Bator, Francis M. “[The Anatomy of Market Failure](https://courses.cit.cornell.edu/econ335/out/bator_qje.pdf).” _The Quarterly Journal of Economics,_ vol. 72, no. 3, August 1958, pp. 351–379.