by Janet Grischy

Created on: December 10, 2008

To most mainstream economists, market failure happens when a specific market fails to allocate goods and services properly or sometimes even to provide them. This can happen when a free market is not efficient. Market failure is often cited as a justification for government intervention.

What can cause market failure? The market may not be structured properly, so that competition is impaired. Other times participants in the market may be unaware of the true costs and benefits associated with goods and services in the marketplace, so that prices are out of line with values.

When there is a monopoly, one agent controls all the supply of an item, and has improved pricing power. The same is true, to a degree, when thee are cartels or oligopolies (groups that control supply). Monopsony is the circumstance in which there is only one buyer for the goods or services of many sellers. All of these situations impair competition.

Why would participants be unaware of the true costs and values of an asset? They might get something free that others are paying for, like a man who earns union wages but doesn't pay union dues. They might be grazing cattle on public rangeland in a way that makes it to their financial advantage to strip that land before someone else does (The Tragedy of the Commons). They might be in a situation in which if a financial bet is successful they will keep a lot of money, but if they fail the government will make them whole (Moral Hazard). Some would say market participants go blind in the case of fads and bubbles. All of these situations distort true costs and benefits.

Another situation in which true costs and benefits are hidden is when an insider uses knowledge not available to the public. This is a situation where there is asymmetrical information. Bob knows that his company is about to report a big loss, and the public does not. So he sells, and the public buys. This is insider trading, and it's illegal in the U.S. There are actually people who believe that asymmetrical information is the nature of the world, and therefore it is silly to make a law about it. These are usually people with access to inside information.

When governments intervene in markets, it is usually to try to restore efficiency. Government failure is a term that refers to a governmental failure to restore efficiency, or even a situation when governmental intervention makes things worse. On the other hand, passive government failure refers to lack of intervention that permits growing distortion in the market.

This brief article is an outline. Many worthy economists do not believe that market failure even exists. At the other end of the spectrum, some wise economists think that government has a duty to intervene in markets to promote social values, like decreased income disparities for example. It is a deep subject, and his has been only the shallowest introduction.

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