Market failure in microeconomics refers to a situation where the allocation of goods and services by a free market is not efficient.

More specifically, market failure occurs when the forces of supply and demand do not result in an optimal allocation of resources, leading to a loss in economic and social welfare. This inefficiency can arise from several factors, including externalities, public goods, imperfect information, and market power.

Externalities are costs or benefits that impact individuals or groups who did not choose to incur those costs or benefits. For instance, pollution from a factory represents a negative externality, as it can adversely affect the health of nearby residents without their consent. Conversely, a positive externality occurs when individuals benefit from their neighbors’ actions, such as when vaccinated children reduce the risk of disease spread in the community.

Public goods are characterized by being non-excludable and non-rivalrous, meaning they are available to everyone, and one person’s consumption does not reduce availability for others. Examples of public goods include street lighting and national defense. The free market often fails to provide these goods because firms lack the incentive to produce them; they cannot exclude non-payers, leading to the so-called ‘free-rider’ problem.

Imperfect information is another source of market failure. When buyers and sellers do not possess complete information, they may make decisions that result in inefficiencies. For example, a buyer might purchase a product harmful to their health because they are unaware of its associated risks.

Market power occurs when a single buyer or seller can influence market prices. Monopolies exemplify this, as they can set prices higher than in competitive markets, resulting in allocative inefficiency.

In each of these scenarios, the market fails to achieve an efficient outcome, which may justify government intervention to correct the failure. Possible interventions include regulation, taxation, subsidies, or direct provision of goods and services. However, government intervention carries the risk of government failure, where such actions may lead to even worse outcomes. Consequently, any decision to intervene must be made with careful consideration.