Steve Bain

Market Failure Types & Causes

The various types of market failure that interfere with the efficient functioning of an economy are many and varied, but their main causes can be classified into broad groupings. On this page I'll discuss all the main variants, with clear examples and analysis.

You should note that there is no such thing as a perfectly functioning market, and thus that all industries suffer from inefficiencies caused by market failures. This does not mean that there is always a role for government to step in and interfere in order to try and correct these failures, and in the vast majority of cases it is best to allow the free-market to reach a competitive solution.

However, when the inefficiency costs are significant, and the causes are known, then there may well be a strong case for government intervention.

Broadly speaking, there are four types of market failure. These relate to:

  • Market Power - when an individual buyer or seller accounts for a sufficiently large proportion of a market then they will be able to influence prices in an unfair way. This is more prevalent for monopolistic sellers, but monopsony power also exists for some buyers.
  • Incomplete & Asymmetric Information - where there is either insufficient information to accurately assess a product's functions and value, or where a buyer/seller has superior knowledge of a product such they gain an unfair advantage in trade negotiation.
  • Externalities - this refers to the costs and benefits of a trade that accrue to third-party individuals. Many goods and services have external costs and benefits that are not accounted for by either buyers or sellers, leading to sub-optimal outcomes for society.
  • Public Goods - the problem with some markets is that they produce goods that are non-exclusive, meaning that once they are sold to one buyer it is impossible to prevent other buyers from gaining access to them free of charge. This fails to give sufficient incentive for firms to produce these goods.
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