6 Types of Market Failures in Economics

A market failure is a case when the free market just left to operate on its own is going to produce an allocation of goods and resources that is not Pareto efficient. So if you remember from before a Pareto efficient allocation is one in which we could not possibly make anyone better off without making at least one person worse off. That's Pareto efficient and a market failure we're in a situation where we could conceivably make a person better off without hurting anyone else and so if we're in that situation that means that markets have failed we haven't produced this Pareto efficient outcome just by letting free markets operate on their own. So some people would say that implies a role for government intervention then the government could come in and implement a policy that could get us to that Pareto efficient outcome.


Let's talk about some examples. So first off an externality is the classic case of a market failure so there are two types of externalities 
  • Negative externalities 
  • Positive externalities 

Market Failure for Externalities

Let me start with a negative externality because I think it'll be a little easier to understand. Let's take pollution. Let's think that there is a factory that produces steel and when they make steel there are different outputs other than steel, some chemicals, or something that's left over after the process is over. They dump it and they dump it into a river. There's a house upriver where children play in the river. They play in that water and they don't realize that there are chemicals being dumped into this river and the children play and they get sick and have to go to the hospital. Their parents are paying medical bills.


So what is happening here is that one party the steel company is imposing costs on another party the family without reimbursing this family. Now if they had worked out some kind of deal where they said we're going to be dumping chemicals in this river and so, therefore, we will give you $20,000 a year for this inconvenience and the family said they'll take that heartless though it may seem, let's say that actually happened then it's not an externality. What is crucial here is the company or individual or whoever is imposing a cost on another person or party without reimbursing them.

What are Positive Externalities?

A positive externality is different in the sense you think of something like a vaccine. So a vaccine is one party is imposing it or giving a benefit to another party. Now one person is giving a benefit to another person but they're not reaping any of that benefit. So if I get the corona vaccine all the people who work around me or people I encounter there have less chance of getting the coronavirus because I got a corona vaccine. So I have given them a benefit I gave myself a benefit but I also gave them a benefit. Now they don't go and pay me or say "Here's a dollar thank you for getting that corona vaccine." So because I don't reap all of the benefits that accrue to other people then I will be less likely to get a corona vaccine. 


If I got more than just a benefit to myself and actually got all of the benefits that accrue to Society for getting that corona vaccine I might be more likely to do it. So when you have a positive externality, the goods in question will be undersupplied and when you have a negative externality the good in question let's say steal or whatever it is that's being produced it's causing problems will be oversupplied relative to what would be the socially efficient outcome.

Market Failure for Public Goods

A public good is also another situation. When you have a public good that you can have a market failure and so what is meant by the term public good is it's talking about something very specific a good that's going to have two qualities.
  • Nonrivalrous
  • Non-excludable
I know that those might be a little obtuse or they're hard to understand let me just give you an example and make it a little bit easier. So let's talk about national defense and let's take the country of France. So in France, we've got a country with a military and so forth. Now let's say somebody from Spain moves to France. By that when that person moves to France he is not making it harder for anybody else in France to get national defense. He is not interfering with anybody who already lives in France and their enjoyment of France's national defense. Now let me give you an example of something that would be a rival risk. Let's say an apple or a fish, if I eat an apple or I eat a fish then that's one less Apple or fish that somebody else could eat. So its rival risk now when this person moves to France they're not preventing anyone who lives in France from enjoying that benefit of that National Defense. So that's what it means by rival risks.


Non-excludable is that if this person moved to France it would be very hard to say "We're going to have our military in France defend everybody except this person." So what leads to these two properties of public goods is going to create an issue which is called a free-rider problem. The free-rider problem is because of these two characteristics of the public good of this national defense in this example but there are other types, this person who's moving to France they have no incentive to pay any money for national defense unless you tax them and force them to do it. Which are you know the government's getting involved but just voluntarily this person would not pay for this public good.

Free-Ridding Problem

They're not going to pay any money so they will free ride and the reason is they don't have to pay you can't exclude them from getting national defense. If other people are paying for national defense and there's a military and France gets attacked this person will enjoy the benefits of having the military whether they paid any money or not. So because of that way that the public goods are they will either be undersupplied so you won't have enough of them or there won't be any supply of the public good at all and so then people would say well the government can come in and play a role by taxing people taxing this person and everybody else and forcing them to pay for the public good.


Market Failure for Monopoly

Now you will also have a market failure when you have a monopoly situation and a monopoly is a situation where you have a single firm by itself that is supplying the entire market. So if there's just one firm that you can buy goods or services or whatever then you have a monopoly. What this really is? It is a failure of competition. 

What are the Reasons for Monopoly?

The reason for this problem is when you have competition you have a situation with perfect competition, you'd actually have where firms are price takers. So they just have to take the prices given no single firm can influence the price and so what will happen is all the firm's they'll just take set the price equal to the marginal cost of the product. When there's just one firm when there's a monopolist then the monopolist can say "How many of these goods I produce affects the price, so I can set price in a sense by how much I produce and so I will set the price higher than the marginal cost." 


Now the monopolist can't just pick up just about outrageous price that no one will pay because of elasticity of demand. We'll talk about that in another article but just for right now understand that the monopolist can set a higher price than the perfect competition market. Now that's good for the monopolist so as the producer the monopolist is going to have more gains from that but consumers are going to lose out and actually on a net basis society will be worse off. It's because of the monopolies there's a lack of competition and they can charge a higher price so which leads to a market failure.

Market Failure for Incompleteness

Sometimes you'll have something referred to you as an incomplete market. There's some kind of issue with the market and this could be a number of things I just want to give you one example of where basically a market wouldn't develop or it wouldn't completely develop and that would be an insurance market. So sometimes there are problems with insurance markets and the reason that an insurance market would have a hard time developing in certain instances is because of something called 
  • Adverse selection
  • Information asymmetry
I'm going to explain each of these things. They're very important concepts and I'll write more specifically about them in an entirely new article on this topic. So let's say that the people's willingness to pay for insurance, let's say there's a healthy person who says "I'd be willing to pay a premium of $200 a month for health insurance," and the insurance company says "Wow, that's wonderful I actually could give you that insurance for $150 a month." So the insurance company hypothetically could have a profit of $50. The market would develop as just a normally competitive market so their willingness to pay is higher than the cost to actually produce the product of insurance. Now there's an issue here is that when the insurance company says it'll be 150 dollars insurance premium for health insurance but the people who come to sign up for the insurance they might not be healthy, you might have some healthy people who say "I would have been willing to pay $200 and I can get it for $150, I'll come to get the insurance" but you might have sick people who are really sick people want to sign up for the insurance.


Now there's a thing wrong with sick people wanting insurance and so forth but maybe when the insurance company was coming up with this price for the premium they were assuming that the person will be of average health or something like that and if you have mostly sick people who sign up because they're the people who need insurance the most. If you're sick which is an issue called adverse selection then you could have an issue where the insurance company says "Hey we'd be losing money if we charge this premium, we better jack up the premium." So they will put the premium at $225 but then maybe some of the healthy people say "Hey, I was willing to pay $200 because I'm healthy I don't want to pay $225." So they leave and now you're left with an even higher proportion of sick people. 

So the ultimate problem is what's called information asymmetry. This is that you know more about your health than the insurance company does and so that's a problem for the insurance company in terms of trying to figure out how to set the price and how to determine what your price is and so forth.

Market Failure for incomplete information

Sometimes you will have not an incomplete market but incomplete information in the market where the market on its own does not supply enough information to consumers. That could be an issue with lending maybe payday loans people don't understand really what the interest rate is that they're paying or if you think about with pharmaceuticals with drugs, so if you go to get some pharmaceutical drugs or some prescription and if you don't know what's in that drug you might have some kind of an issue. So people say "Well, the government should come in and people don't really understand what's in drugs it's very complicated, so they should come in and force these companies to come up with a label, so they should make them have a label that explains what's in the drug and what the side effects are." 


The market on its own is not going to supply that information and consumers aren't savvy enough to really understand. They don't know a lot about pharmaceutical drugs and so forth.

Market Failure for Hyperinflation

 Also sometimes people will say that there's a market failure when you have just really really high unemployment or inflation. In the 20th century, Germany & Zimbabwe had just really high inflation. Countries right now had an unemployment rate higher than 25%, the United States during the Great Depression at unemployment around 25%. People were living in hobo camps and so forth and so people would say "Look if there's some kind of serious macroeconomic problem where there's that many people want to find work and they can't" that might be indicative of a market failure itself.