Market failure occurs when the allocation of goods and services by a free market is not efficient. This can happen for various reasons, but two main causes are:
1. Externalities
Externalities are costs or benefits that affect a party who did not choose to incur that cost or benefit. A classic example is pollution from a factory. When a factory pollutes the air, it may reduce the overall quality of life for people living nearby. This negative externality is not reflected in the market price of the factory’s products, leading to overproduction of goods that cause pollution because the factory does not bear the full costs of its actions.
2. Public Goods
Public goods are goods that are non-excludable and non-rivalrous. This means that they can be consumed by many people at the same time, and no one can be excluded from using them. A prime example of a public good is national defense. Since it benefits everyone in a country regardless of their individual contribution, there is little incentive for private firms to produce such a service, leading to underproduction in the market. This underproduction represents a market failure as the good is essential for the overall security and well-being of society.