How Is a Market Failure Corrected?

Imperfect market outcomes are corrected through a reallocation of resources or a change in the incentive structure. Economists have varying opinions about the nature of market failures and what if any measures should be taken to prevent or correct them.

What Is a Market Failure?

It’s impossible to identify a solution for market failure without clearly identifying what a market failure is and why it persists. The common interpretation of market failure is the failure of a market to live up to the standards of perfect competition that leads to an efficient distribution of goods and services.

This idea is applied in general equilibrium economics when the law of supply and demand fails to reach a state of equilibrium in a free market due to some outside force. Market failure can be identified in many if not all markets.

What Causes a Market Failure?

One of the main causes of market failure is when one participant has control of one or more areas of the market and is therefore able to control the price of a good or service rather than let changes in supply and demand do so. This is often seen in monopolies where a company that has a monopoly sets the price of a product or service regardless of the supply and demand of that product.

A lack of perfect information can also lead to market failure. Buyers and sellers may buy or sell a product at a higher or lower price than what would be reflective of its true benefit or cost when they don’t have all the correct information.

Public goods also lead to market failure because the cost of a public good doesn’t increase when there are more users of that public good. It can lead to market failures if certain users continue to use a public good but don’t pay for it such as through taxes.

Market failures can also be caused by externalities. This occurs when an action impacts a third party that didn’t participate in the decision-making that led to that action. Everyone in a neighborhood benefits from trees being planted if someone plants trees there. It’s a negative externality if a factory in a local town is polluting the town with its fumes.

How to Correct a Market Failure

Using the broad, perfect-competition definition, market failures are corrected by allowing competing entrepreneurs and consumers to push the market further toward equilibrium over time. Markets tend toward equilibrium constantly, never quite reaching it, because of limitations in human knowledge and changing real-world circumstances.

Some economists and policy analysts propose a litany of possible interventions and regulations to compensate for perceived market failures. Tariffs, subsidies, redistributive or punitive taxation, disclosure mandates, trade restrictions, price floors and ceilings, and many other market distortions have been justified on the basis of correcting inefficient outcomes.

Other economists argue that markets are recognizably imperfect but market failure is improperly framed. Rather than asking if markets fail relative to some ideal such as perfect competition, they contend that the question should be whether markets perform better than any other process that humans might invoke.

Free market economists including Milton Friedman and F.A. Hayek argue that markets are the only known discovery process proven to be capable of adjusting correctly to inefficiencies. They contend that regulation interferes with this discovery process, making inefficiencies worse rather than better.

The Bottom Line

A market failure is any interruption in the efficient distribution of goods and services that would otherwise reach equilibrium through the laws of supply and demand. There are many methods to correct it when a market failure occurs, primarily through the introduction of government activities such as regulations, tax adjustments, and subsidies.

Many economists don’t propose interfering in market failures, however, because they believe that free markets will correct themselves eventually over time.