The term 'Market Failure' is included in the Economics edition of the Financial Dictionary. Get your copy on Amazon in Kindle, Paperback or Audio edition. Choose your edition here...
Market failure refers to a scenario where rational behavior does not prevail and lead to optimal economic outcomes for the group involved. This break down occurs because the individual incentives are insufficient to lead the participants to do what is best for the greater common good.
When such failure happens, every person will still make the ideal choices for himself or herself, but these will turn out to be the incorrect choices for the group as a whole. This is a function of microeconomics. It is depicted as a steady state disequilibrium where the amount supplied is not sufficient to match the amount demanded.
Such market failure transpires as individuals representing a group end up with a worse outcome than if they had not engaged in decisions that resulted in their own best interests. These groups end up with fewer benefits or pay costs which are too high. This sounds like an easy to understand idea, yet it is often deceptive and thus can be misidentified.
The name is a misnomer itself. It has nothing to do with any intrinsic problems within the market economy construct. Market failures could occur within government sponsored activities just as easily. A classic example surrounds those groups with special interests that are looking for affordable rents. These groups are able to obtain an outsized influence by lobbying government for costs on everyone outside of their own group, such as with tariffs. As other small groups are able to impose their own higher costs, the entire population proves to be in a poorer state than if no one had lobbied the government in the first place.
Another difference has to do with results. Not every negative outcome that results from market activity is classified properly as a market failure. These failures also do not mean that actors in the private marketplace are not able to address and resolve the problem themselves either. At the same time, all market failures do not have a possible solution. This is the case even when the public has been made aware of the problem or a sensible law is in effect.
A number of typical types of market failures exist. Among the most frequently mentioned are monopoly privileges, externalities, factor immobility, and information asymmetries. The so called “public good problem” represents a simple to grasp example. These public goods refer to services or goods where the maker is not able to limit the amount of consumption to those customers who pay.
Market failures can occur with public goods when there are consumers in the market place who choose to utilize the goods but refuse to pay. National Defense is a classic example of this as a service that benefits all citizens whether they pay or not. No one could practically produce the best quality and quantity of national defense on a private basis. Governments similarly are not able to employ a competitive pricing system to ascertain the right amount of national defense. This represents a classic market failure for which there is no definitive solution.
Solutions to a number of potential market failures exist. Information which is asymmetrical can be addressed using ratings agencies like Standard & Poor’s or Moody’s to detail risks of securities. In the world of electronics, this service is provided by Underwriter’s Laboratories LLC. Negative externalities like pollution can be handled by lawsuits that make it more expensive for the polluter to operate this way.