Types of market failure A market failure is a situation where free markets fail to allocate resources efficiently. In other words, left by itself, the free market will not provide for or will cause some sort of problem. There will be a need for some government intervention. Economists identify the following cases of market failure:

Productive and allocative inefficiency Markets may fail to produce and allocate scarce resources in the most efficient way. Examples? Who gets to use the best doctors? How does the market give access to a college education? Is homelessness an efficient way to allocate housing? Others??

Monopoly power Markets may fail to control the abuses of monopoly power. Either by some natural situation (example: a mineral found only in one place on earth) or just the growth of one industry, a monopoly develops that controls a product.

Missing markets Markets may fail to form, resulting in a failure to meet a need or want, such as the need for public goods, such as defense, street lighting, and highways.   Example: So-called “orphan” illnesses where so few people have a disease that drug companies can’t sell enough of a drug to make development profitable.

Incomplete markets Markets may fail to produce enough merit goods, such as education and healthcare – needed goods and services that help society. (A “Merit Good” is a good or service that many believe people should have on the basis of some concept of need, rather than ability and willingness to pay.) Examples? Should healthcare be available free to all? Should Internet access be free to all? Do all people have a right to good food? Others?

De-merit goods Markets may also fail to control the manufacture and sale of goods like cigarettes and alcohol, which have less merit than consumers perceive. For example: a market may exist for something bad for the consumer or dangerous to society.

Negative externalities Consumers and producers may fail to take into account the effects of their actions on third-parties, such as car drivers, who may fail to take into account the traffic congestion they create for others. Third-parties are individuals, organizations, or communities indirectly benefiting or suffering as a result of the actions of consumers and producers attempting to pursue their own self interest. Examples: Pollution, hazardous waste, crime, etc.

Property rights Markets work most effectively when consumers and producers are granted the right to own property, but in many cases property rights cannot easily be allocated to certain resources. Failure to assign property rights may limit the ability of markets to form. Example: land ownership by individuals may block development.

Information failure Markets may not provide enough information because, during a market transaction, it may not be in the interests of one party to provide full information to the other party. Example: People do not hear of defective or dangerous products, or of better pricing by different sellers.

Unstable markets Sometimes markets become highly unstable, and a stable equilibrium may not be established, such as with certain agricultural markets, foreign exchange, and credit markets. Such volatility may require intervention. Example: the stock market crash of 2008

Inequality Markets may also fail to limit the size of the gap between income earners, the so-called income gap. Market transactions reward consumers and producers with incomes and profits, but these rewards may be concentrated in the hands of a few.

***Remedies*** In order to reduce or eliminate market failures, governments can choose two basic strategies:

Use the price mechanism The first strategy is to implement policies that change the behavior of consumers and producers by using the price mechanism. For example, this could mean increasing the price of ‘harmful’ products, through taxation, and providing subsidies for the ‘beneficial’ products. In this way, behaviour is changed through financial incentives, much the same way that markets work to allocate resources.  

Use legislation and force The second strategy is to use the force of the law to change behaviour. For example, by banning cars from city centers, or having a licensing system for the sale of alcohol, or by penalising polluters, the unwanted behaviour may be controlled.

In the majority of cases of market failure, a combination of remedies is most likely to succeed.