Different economists have different views about what events are the sources of market failure. Mainstream economic analysis widely accepts that a market failure in relation to several causes. These include if the market is "
monopolised" or a small group of businesses hold significant
market power resulting in a "failure of competition"; if production of the good or service results in an
externality (external costs or benefits); if the good or service is a "
public good"; if there is a "failure of information" or
information asymmetry; if there is
unequal bargaining power; if there is bounded rationality or irrationality; and if there are macro-economic failures such as unemployment or inflation.
Failure of competition Agents in a market can gain
market power, allowing them to block other mutually beneficial
gains from trade from occurring. This can lead to inefficiency due to
imperfect competition, which can take many different forms, such as
monopolies,
monopsonies, or
monopolistic competition, if the agent does not implement perfect price discrimination. ,
electricity transmission is a natural monopoly. Due to enormous
fixed costs and small
market size, one seller can serve the entire market at the downward-sloping section of its
average cost curve, meaning that it will have lower average costs than any potential entrant. It is then a further question about what circumstances allow a monopoly to arise. In some cases, monopolies can maintain themselves where there are "
barriers to entry" that prevent other companies from effectively entering and competing in an industry or market. Or there could exist significant
first-mover advantages in the market that make it difficult for other firms to compete. Moreover, monopoly can be a result of geographical conditions created by huge distances or isolated locations. This leads to a situation where there are only few communities scattered across a vast territory with only one supplier. Australia is an example that meets this description. A
natural monopoly is a firm whose per-unit cost decreases as it increases output; in this situation it is most efficient (from a cost perspective) to have only a single producer of a good. Natural monopolies display so-called increasing returns to scale. It means that at all possible outputs
marginal cost needs to be below
average cost if average cost is declining. One of the reasons is the existence of fixed costs, which must be paid without considering the amount of output, what results in a state where costs are evenly divided over more units leading to the reduction of cost per unit.
Public goods Some markets can fail due to the nature of the goods being exchanged. For instance, some goods can display the attributes of
public goods wherein sellers are unable to
exclude non-buyers from using a product, as in the development of inventions that may spread freely once revealed, such as developing a new method of harvesting. This can cause underinvestment because developers cannot capture enough of the benefits from success to make the development effort worthwhile. This can also lead to
resource depletion in the case of
common-pool resources, whereby the use of the resource is
rival but
non-excludable, there is no incentive for users to conserve the resource. An example of this is a lake with a natural supply of fish: if people catch the fish faster than the fish can reproduce, then the fish population will dwindle until there are no fish left for
future generations.
Externalities A good or service could also have significant
externalities,). Externalities can be positive or negative depending on how a good/service is produced or what the good/service provides to the public. Positive externalities tend to be goods like vaccines, schools, or advancement of technology. They usually provide the public with a positive gain. Negative externalities would be like noise or air pollution. Coase shows this with his example of the case
Sturges v. Bridgman involving a confectioner and doctor. The confectioner had lived there many years and soon the doctor several years into residency decides to build a consulting room; it is right by the confectioner's kitchen which releases vibrations from his grinding of pestle and mortar ( ). The doctor wins the case by a claim of nuisance so the confectioner would have to cease from using his machine. Coase argues there could have been bargains instead the confectioner could have paid the doctor to continue the source of income from using the machine hopefully it is more than what the Doctor is losing ( ). Vice versa the doctor could have paid the confectioner to cease production since he is prohibiting a source of income from the confectioner. Coase used a few more examples similar in scope dealing with social cost of an externality and the possible resolutions. in
Midtown Manhattan,
New York City, which leads the world in urban automobile traffic congestion, but which has implemented
congestion pricing in January 2025 to address the problem
Traffic congestion is an example of market failure that incorporates both non-excludability and externality. Public roads are common resources that are available for the entire population's use (non-excludable), and act as a
complement to cars (the more roads there are, the more useful cars become). Because there is very low cost but high benefit to individual drivers in using the roads, the roads become congested, decreasing their usefulness to society. Furthermore, driving can impose
hidden costs on society through pollution (externality). Solutions for this include
public transportation,
congestion pricing, tolls, and other ways of making the driver include the
social cost in the decision to drive. The Coase theorem points out when one would expect the market to function properly even when there are externalities. A market is an institution in which individuals or firms exchange not just commodities, but the
rights to use them in particular ways for particular amounts of time. [...] Markets are institutions which organize the
exchange of control of commodities, where the nature of the control is defined by the property rights attached to the commodities. Nonetheless, views still differ on whether something displaying these attributes is meaningful without the information provided by the market price system.
Information failures Information asymmetry is considered a leading type of market failure. and
moral hazard. Most commonly, information asymmetries are studied in the context of
principal–agent problems.
George Akerlof,
Michael Spence, and
Joseph E. Stiglitz developed the idea and shared the 2001 Nobel Prize in Economics.
Unequal bargaining power In
The Wealth of Nations Adam Smith explored how an employer had the ability to "hold out" longer in a dispute over pay with workers because workers were more likely to go hungry more quickly, given that the employer has more property, and have fewer obstacles in organising. Unequal bargaining power has been used as a concept justifying economic regulation, particularly for employment, consumer, and tenancy rights since the early 20th century.
Thomas Piketty in
Capital in the Twenty-First Century explains how unequal bargaining power undermines "conditions of "pure and perfect" competition" and leads to a persistently lower share of income for labor, and leads to growing inequality. While it was argued by
Ronald Coase that bargaining power merely affects distribution of income, but not productive efficiency, the modern behavioural evidence establishes that distribution or fairness of exchange does affect motivation to work, and therefore unequal bargaining power is a market failure. Notably, the price of labour was excluded from the scope of the original charts on supply and demand by their inventor,
Fleeming Jenkin, who considered that the wages of labour could not be equated with ordinary markets for commodities such as corn, because of labour's unequal bargaining power.
Bounded rationality In
Models of Man,
Herbert A. Simon points out that most people are only partly
rational, and are emotional/
irrational in the remaining part of their actions. In another work, he states "boundedly rational agents experience limits in formulating and solving complex problems and in processing (receiving, storing, retrieving, transmitting)
information" (
Williamson, p. 553, citing Simon). Simon describes a number of dimensions along which "classical" models of rationality can be made somewhat more realistic, while sticking within the vein of fairly rigorous formalization. These include: • limiting what sorts of
utility functions there might be. • recognizing the costs of gathering and processing information. • the possibility of having a "
vector" or "multi-valued" utility function. Simon suggests that economic agents employ the use of
heuristics to make decisions rather than a strict rigid rule of optimization. They do this because of the complexity of the situation, and their inability to process and compute the expected utility of every alternative action. Deliberation costs might be high and there are often other, concurrent economic activities also requiring decisions. The concept of bounded rationality was significantly expanded through behavioral economics research, suggesting that people are systematically irrational in day-to-day decisions.
Daniel Kahneman in
Thinking, Fast and Slow explored how human beings operate as if they have two systems of thinking: a fast "system 1" mode of thought for snap, everyday decisions which applies rules of thumb but is frequently mistaken; and a slow "system 2" mode of thought that is careful and deliberative, but not as often used in making ordinary decisions to buy and sell or do business.
Macro-economic failures "Unemployment, inflation and "disequilibrium" are considered a category of market failure at a "macro economic" or "whole economy" level. These symptoms (of high job loss, or fast rising prices or both) can result from a financial crash, a recession or depression, and the market failure is evident in the sustained underproduction of an economy, or a tendency not to recover immediately. Macroeconomic
business cycles are a part of the market. They are characterized by constant downswings and upswings which influence economic activity. Therefore, this situation requires some kind of government intervention.
Persistent labor shortages Widespread and persistent domestic labour shortages in various countries are examples of market failure, whereby excessively low
salaries (relative to the domestic
cost of living) and adverse
working conditions (excessive
workload and
working hours) in low-wage industries (
hospitality and leisure,
education,
health care,
rail transportation,
warehousing,
aviation,
retail,
manufacturing,
food,
construction,
elderly care), collectively lead to
occupational burnout and attrition of existing workers, insufficient
incentives to attract the inflow supply of domestic workers, short-staffing and regular
shift work at
workplaces and further exacerbation (
positive feedback) of staff shortages. Poor job quality and artificial shortages perpetuated by salary-paying employers, deter workers from entering or remaining in these roles. Labour shortages occur broadly across multiple industries within a rapidly expanding economy, whilst labour shortages often occur within specific industries (which generally offer low salaries) even during economic periods of high unemployment. In response to domestic labour shortages, business associations such as
chambers of commerce,
trade associations or
employers' organizations would generally lobby to governments for an increase of the inward
immigration of
foreign workers from countries which are
less developed and have lower salaries. In addition, business associations have campaigned for greater state provision of
child care, which would enable more women to re-enter the labour workforce at a lower wage rate to achieve
economic equilibrium. However, as labour shortages in the relevant low-wage industries are often widespread globally throughout many countries in the world, immigration would only partially address the chronic labour shortages in the relevant low-wage industries in
developed countries (whilst simultaneously discouraging local labour from entering the relevant industries) and in turn cause greater labour shortages in developing countries. ==Interpretations and policy examples==