Forms of Market Failure

Market failure occurs when a market is unable to, or is prevented from, reaching equilibrium. [1]

Market failures occur in many forms. The two forms of market failure most associated with the need for regulatory intervention are monopoly (including “natural” monopoly) and externalities.

A natural monopoly is market structure in which the prevailing volume of market demand can be served at a lower average cost by a single firm, rather than by two or more firms. In other words a single firm can meet market demand at a lower cost than two or more competing firms could.

Economies of scale are frequently cited as a reason for natural monopoly. In some industries, the fixed costs of initial entry or set-up are so large relative to operational costs that average cost declines over a substantial volume of output. In extreme cases, a firm may not reach the lowest average cost point in its cost function until the available market demand is exhausted. In markets with these characteristics, a single supplier is actually the most efficient form of organization (unlike other monopolies that arise for legal or other reasons).

Public utilities and telecommunications carriers have long been viewed as natural monopolies, but technological change may now be gradually eroding their natural monopoly characteristic. That is because modern technology that relies increasingly on fast computers and software is making plant and equipment more modular and scalable than in the past, and is bringing down the minimum scale that a firm must achieve to operate efficiently.

An externality is a cost or benefit from an economic decision or activity that is not reflected in market prices, and falls without invitation or compensation on unwitting third parties. For example, cars that pollute the air because they are not equipped with pollution control devices impose a cost on society. If the car owners do not have to pay compensation for that cost, the outcome is a negative externality. On the other hand, the value of any network increases (to existing members) when a new member joins. If that member is not rewarded for having created the collective benefit, the outcome is a positive externality.

The effect of an externality is that society as a whole may produce “too much” of a good or service that produces a negative externality, or “too little” of a good or service that produces a positive externality.


[1] Market equilibrium is state in which all resources are allocated and used efficiently, and collective social welfare is maximized.

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