The Coolness of Market Failure

This week let's take a look at Market Failure—the coolest part of Microeconomics, in my opinion. For those of you who have already purchased the Microeconomics course, first of all, thank you, and also this will be familiar to you.

Market failure is happening all around us, all the time, and once you start recognizing it, you’ll see it everywhere.

But what does it actually mean? Let’s root ourselves in a simple definition: Market failure occurs when the free market fails to optimize the allocation of resources.

It doesn’t mean people aren’t buying and selling things—it means the market isn’t functioning in a way that benefits society as a whole.

This inefficiency can lead to either too much or too little of a good being produced, and when that happens, the government often steps in to fix things.


What Causes Market Failure?

Market failure typically stems from four main scenarios, which we can group into two categories of positive and negative outcomes:

  1. Negative Externalities (consumption and production)
  2. Positive Externalities (consumption and production)


Before we dive into examples, let’s explore what we mean by “externalities.”


What Are Externalities?

An externality happens when the consumption or production of a good affects a third party not directly involved in the transaction. These impacts can be positive (benefits) or negative (costs).

Here’s a breakdown:

Negative Externalities

  • Consumption: Smoking is a classic example. If I light up a cigarette in a room full of people, the secondhand smoke harms everyone around me. That health cost isn’t included in the $5 I paid for the pack of cigarettes—it’s an external cost borne by others.
  • Production: Imagine a paint factory in Santiago, Chile. While producing paint, the factory releases air pollution, causing respiratory issues for nearby residents. The cost of treating those illnesses isn’t reflected in the price of the paint, meaning the market overproduces it.


These negative effects lead to what we call demerit goods, which are overproduced and overconsumed.

Positive Externalities

  • Consumption: Education is a perfect example. When you take a course (like this one!), you gain knowledge, but so do the people around you—your family, friends, or colleagues benefit from your improved insights and abilities, even though they didn’t pay for the course.
  • Production: Healthcare is another great example. Governments often subsidize healthcare because healthier citizens benefit everyone. The less likely you are to get sick, the less likely I am to catch something from you.These positive effects lead to merit goods, which are underproduced and underconsumed without government intervention.


Other Types of Market Failure

In addition to externalities, market failure also includes:

  1. Lack of Public Goods: Some goods, like national defense or street lighting, aren’t profitable for private companies to provide, so the government steps in to ensure they’re available.
  2. Common Access Resources: Natural resources like fishing grounds, forests, and irrigation systems are prone to overuse and underproduction because they aren’t owned by any one entity. Governments often manage these resources to ensure sustainability.


Why Market Failure is So Cool

What makes market failure such a fascinating part of economics is its real-world impact.

It explains why governments regulate pollution, subsidize education, and provide public goods. It helps us understand the role of policy in correcting imbalances and making markets work better for everyone.

But it also shows the limits of free markets.

While markets are powerful tools for resource allocation, they aren’t perfect. Recognizing when and why they fail gives us a clearer picture of the economy’s inner workings—and the role we all play in it.

And that’s just cool.

If you are interested in learning more, join 9,100+ students worldwide who have purchased my online Microeconomics course.

Thanks for reading.