Market failure occurs when the free market fails to allocate resources efficiently, leading to a loss of economic and social welfare. This justifies government intervention to correct inefficiencies.

Causes of Market Failure

Externalities

Externalities occur when the actions of individuals or firms have unintended side effects on third parties. Negative externalities (e.g., pollution, traffic congestion) lead to overproduction and social costs, while positive externalities (e.g., education, vaccinations) lead to underproduction and under-consumption in a free market. Governments use taxes, subsidies, and regulations to address externalities.

Public Goods

Public goods (e.g., street lighting, national defense) are non-excludable and non-rivalrous, meaning individuals cannot be prevented from using them, and one person's use does not reduce availability for others. As a result, firms have little incentive to provide them, leading to underprovision without government intervention.

Monopoly Power

In an unregulated free market, firms may develop monopoly power by controlling a large portion of the market. This can result in higher prices, reduced output, and lower consumer surplus. Governments use competition policies, anti-trust laws, and price regulations to curb monopolies. We will look at this in more detail in Theme 3.

Information Asymmetry

If one party in a transaction has more or better information than the other (e.g., used car sellers knowing more about vehicle quality than buyers), it can lead to market inefficiencies. This can cause moral hazard and adverse selection. Governments implement regulations such as mandatory disclosures and quality standards to reduce information asymmetry.