It is argued that the free market may fail to achieve allocative efficiency and productive efficiency because of market failure.
Market failure exists whenever a free market, left to its own devices and totally free from any form of government intervention, fails to make the optimum use of scarce resources.
Types of market failure
Positive externalities. Goods/services that benefit a third party, such as fewer traffic congestion from cycling.
Negative externalities. Goods or services that impose a cost on a third party, such as discomfort caused by passive smoking.
Merit goods - People underestimate the value of the good, such as education. It may also have positive externalities.
Demerit goods - People undervalue the costs of a product, such as smoking. It could also have negative consequences.
Public Goods — Non-rival and non-excludable goods, such as police and national defence. In a free market, public goods are frequently unavailable.
Monopoly Power - When a company controls the market (has a large market share) and may charge higher prices.
Inequality — unequal allocation of resources in a free market, for example, some people experience poverty and homelessness.
Factor Immobility – E.g. geographical / occupational immobility. For example, when there are pockets of high unemployment but it is difficult for unemployed people to relocate and find work.
Agriculture – Agriculture is often subject to market failure – due to volatile prices, fluctuating weather and externalities.
Information failure – where there is a lack of information to make an informed choice.
The principal-agent dilemma. This involves two agents who have opposing goals and information asymmetry. Adverse selection, for example, occurs when a buyer has less information than a seller.
A moral hazard exists. When individuals have an incentive to change their behaviour because others are willing to accept the risk. For example, when banks are government-insured, bankers may make risky decisions that result in bank losses.
Macroeconomic instability occurs when an economy experiences a prolonged recession and substantial unemployment or an inflationary boom.