Market Failure

What is Market Failure?

One speaks of a market failure when the desired economic results cannot be achieved via the market mechanism. The coordination initiated by the market deviates from the optimal allocation of factors of production from an economic point of view and thus gives rise to a need for economic policy action.

In this lesson we will explain to you exactly when a market failure is spoken of, how a market failure occurs and how economic policy reacts to it. At the end you can check your knowledge with a few practice questions.

English: Market failure

Why should you know the market failure?

According to, knowledge of market failure is particularly important with regard to its cause. On the basis of the causes for market failure formulated here, the situation in a market can be better assessed, which can, for example, be relevant to a decision if a market entry is to be planned.

Characteristics of market failure

Market failure is a theory of neoclassical theory and it is always mentioned when the coordination initiated by the market or market participants does not lead to a Pareto-efficient allocation of resources.

This means that one market participant can no longer be better off without making another worse off at the same time.

Typical causes of market failure are:

  • Asymmetrical information
  • External effects
  • Natural monopolies
  • Public goods

In a market economy – free as well as social – the market mechanism regulates which resources go to which market participants. The individual market participants in turn pursue their own interests and strive to achieve the best possible result for them.

Through mutual action, everyone tries to get better offers at the lowest possible prices in order to increase their own benefit as much as possible. This leads to the conclusion that the market should basically allow the most efficient distribution of resources.

However, this goal can only be achieved if the conditions for a perfect market are met:

  • Complete competition
  • Transparency and complete information for each participant
  • Homogeneity of goods
  • No personal preferences between market participants
  • No spatial differences

Since the perfect market only exists on a theoretical level, a relative market failure can always be assumed.

Market Failure

Asymmetrical information

Asymmetrical information is used when potential contractual partners on the market do not have the same information. This information primarily concerns the quality of the product and the risks to be insured.

In this context, reference is made to the Lemons problem described by George A. Akerlof in the used car market.

This is based on the fear of ill-informed market participants that they will be disadvantaged when concluding a contract. According to Akerlof, this means that only the worst vendors sell used cars and consequently there is a negative selection.

External effects

A common reason for market failure lies in external effects. These effects always occur when a trade between two market participants has unintended effects on uninvolved third parties.


A typical example of this is aircraft noise near airports:

Passenger and airline conclude a contract for their carriage. Residents of the airport who are not involved in this contract suffer from the external effect of aircraft noise. However, this is not taken into account by the contracting parties, so that, according to the neoclassical perspective, an efficient allocation of resources can no longer be assumed.

The effects of external effects can be eliminated through government intervention. The external costs are included in the calculation according to the polluter pays principle. This process is also known as internalization.

Market Failure: External Effects

Example of external effects


In addition to pharmaceutical products, a chemical company also produces a large amount of wastewater. This is channeled into a nearby lake.
However, this leads to a sensitive disturbance of this ecosystem, which leads to the death of many fish.

The local fisheries suffer damage, which is one of the external effects and signals a market failure. The damage is not reflected in the prices or in the costs.

The Pareto optimum is clearly missed, as the chemical company is better off because of the cheap disposal of its wastewater, but at the same time the fishing companies are worse off. If it has to pay for the consequences of its environmental pollution and, for example, pay compensation payments to the fishing companies, one speaks of an internalization of external effects, with which the misallocation and thus the market failure is eliminated.

Natural monopolies

Monopolies and cartels can lead to market failures. This concerns, on the one hand, monopoly pricing and, on the other hand, price agreements, both of which prevent the efficient allocation of goods.

If a natural monopoly is formed in a single market, the monopoly is able to determine the market prices. If this monopoly is out to maximize its profits, the market price will regularly be above the marginal costs and thus prevent the Pareto-optimal distribution of the goods.

The cartel occurs particularly frequently in duo and oligopolies when two or more providers agree on their pricing in order to achieve higher prices on the market. In practice, this has been observed time and again with the petrol prices of the mineral oil companies. The state tries to prevent such situations through antitrust laws.

Market failure in public goods

Public goods often have the property that they can be “consumed” by the demanders without them providing any direct consideration in return. Nobody can be excluded from the consumption of public goods and nobody has to pay anything for them.

Typical examples are:

  • Infrastructure such as roads, bridges and sidewalks
  • Climate protection measures
  • Street lighting
  • Education

The problem now is that nobody is willing to pay for something that they could use anyway. To counter a market failure, these public goods must be provided by the state and financed through taxes.