In neoclassical economics, market failure is a situation in which the allocation of goods and services by a free market is not Pareto efficient, often leading to a net loss of economic value. Market failures can be viewed as scenarios where individuals' pursuit of pure self-interest leads to results that are not efficient – that can be improved upon from the societal point of view. The first known use of the term by economists was in 1958, but the concept has been traced back to the Victorian philosopher Henry Sidgwick. Market failures are often associated with public goods, time-inconsistent preferences, information asymmetries, non-competitive markets, principal–agent problems, or externalities.
The existence of a market failure is often the reason that self-regulatory organizations, governments or supra-national institutions intervene in a particular market. Economists, especially microeconomists, are often concerned with the causes of market failure and possible means of correction. Such analysis plays an important role in many types of public policy decisions and studies.
However, government policy interventions, such as taxes, subsidies, wage and price controls, and regulations, may also lead to an inefficient allocation of resources, sometimes called government failure. Most mainstream economists believe that there are circumstances (like building codes or endangered species) in which it is possible for government or other organizations to improve the inefficient market outcome. Several heterodox schools of thought disagree with this as a matter of ideology.
An ecological market failure exists when human activity in a market economy is exhausting critical non-renewable resources, disrupting fragile ecosystems, or overloading biospheric waste absorption capacities. In none of these cases does the criterion of Pareto efficiency obtain.
Categories
Different economists have different views about what events are the sources of market failure. Mainstream economic analysis widely accepts that a market failure (relative to Pareto efficiency) can occur for three main reasons: if the market is "monopolised" or a small group of businesses hold significant market power, if production of the good or service results in an externality (external costs or benefits), or if the good or service is a "public good"
Nature of the market
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.
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.