Market failure and two of its main causes

What market failure is. Market failure is the situation in which a market left to itself does not produce the efficient quantity of a good: it makes too much or too little, so a different quantity would make society better off. A market economy normally coordinates decisions through prices, which signal what society wants. This works well when a price captures all the benefits and costs of a good and non-payers can be kept out. When those conditions fail, the price signal misleads or there is no price at all. Two main causes follow.

Cause 1: externalities. Whoever decides how much to produce or consume normally weighs only the gains and costs that land on himself. Some activities, however, also make outsiders better or worse off, and the person responsible collects nothing for the gain and pays nothing for the loss, since such side effects are not bought and sold in any market. These unpriced spillovers are externalities. Because they never enter the decision, the quantity chosen differs from the one that is best for society.

• A harmful spillover leads to too much. Our example: during the wedding season a banquet hall in a Lucknow lane plays amplified music until well past midnight, and the families living around it cannot sleep. Its clients pay for the hall, the power and the sound system, but no neighbour is compensated, so the hall carries none of the cost of the damage it does; a harm of this kind is a negative externality. Since the neighbours' lost sleep never enters its sums, the hall keeps the music going for more hours than is best for the lane as a whole.
• A beneficial spillover leads to too little. A positive externality arises when one agent's action benefits another who makes no payment for it. Our example: when parents get a child vaccinated, the other children in the locality also face a lower risk of infection, yet nobody pays the family for that protection. Each family counts only its own gain, so fewer children may be vaccinated than society would want.

Cause 2: public goods. A public good is non-rival and non-excludable: one person's use does not reduce what others can have, and it is extremely hard to keep anyone from enjoying it. A seller finds it very hard to collect a charge from everyone who benefits, and each person hopes others will pay, which is the free rider problem. If its supply is left to the market, the good is provided in an inefficient quantity, even where its total benefit is greater than its cost.

Our example: a lighted, guarded pedestrian path along a stretch of the Mumbai coast. Everyone who walks there is safer, a walker's presence does not reduce another's safety, and non-payers cannot be kept out. A private firm would find it very hard to cover its cost from fees, so without public funding the path would go unbuilt or poorly lit, even if the benefit to all walkers together exceeds the cost.

Conclusion. Market failure means that the market does not reach the efficient quantity. Externalities and public goods are two of its main causes, because in each case benefits or costs fall on people whom the market price does not reach.