Market Failure

In many cases, markets allocate resources well. Prices guide producers and consumers towards efficient decisions. But in some situations, markets fall short.

Common causes of market failure include externalities, such as pollution, where costs or benefits spill over to others; public goods, such as national defence, which markets underprovide because people can benefit without paying; information problems, where one side knows much more than the other, as in some used car or insurance markets; and market power, where a monopoly can raise prices and restrict output.

For example, without regulation, a chemical company might pollute a river because it does not pay for the damage. The market price of its products would be too low and output too high compared with what is best for society as a whole.

Market failure is often used to justify government action, such as taxes, subsidies, regulation or direct provision. However, government intervention can also fail, so economists weigh the costs and benefits of each response.