Understanding market failures

This blog is the sixth in our series on the key concepts to consider when thinking about local economic growth policies. We’re using the series to test-drive a way of explaining concepts in economic growth that we hope to use in new training and resources. We are keen to hear from readers, particularly those in local and central government, about whether they find these useful and accessible, and if there are other topics you would like to see us cover. 

What are market failures?

Market failures are things that stop markets from working efficiently. While this sounds a little cryptic, the examples discussed below highlight what this means in practice for different types of market failure. Understanding market failures is important, because they’re a key reason why policymakers might want to intervene in a local economy.

There are many different types of market failures.

For example, there may be plenty of firms willing to supply commercial advice and loans for businesses looking to export but some businesses that could successfully export their goods and services may not know about the benefits of exporting, that support is available, or be able to assess the quality of different supports on offer. This is an information deficiency or information asymmetry – a lack of information reduces the level of exports. Policymakers might choose to help promote commercial advice, subside the costs of that advice, or provide support and loans directly (see our business advice pages).

Information deficiencies can also lead to risk aversion.  For example, banks may choose not to lend to businesses operating in ‘new’ sectors as they do not have information to assess their business models.  Overcoming this market failure is the rationale for many access to finance interventions.

In other cases, the market failure occurs because people or firms ignore the wider effects of their actions on others. Economists refer to these wider effects as externalities. For example, innovation, particularly R&D, can be very expensive for a business, and success isn’t guaranteed. But, even if it was, some of the benefits of innovating tend to go to other firms and their customers as competitors learn from, and imitate, success. The result of these externalities is that – from the viewpoint of society as a whole – businesses will tend to under-invest in innovation (because they only care about the benefits to them, not to others). This can hold firms back from pursuing innovation. Policymakers may intervene with R&D subsidies or grants, by supporting clusters of innovative firms, etc. (see our resources on innovation).

Similar considerations, justify government’s getting involved in skills training – firms will tend to underinvest in training when newly trained workers can move to another firm. And sometimes governments will want to intervene to address negative externalities – e.g. imposing congestion charges to reduce congestion.

Another example is market control where a small number of firms dominate a market. Competition authorities worry about this a lot at the national level. While it might seem like less of an issue at the local level, it can be a problem – for example, when a specific firm accounts for a large proportion of local employment (see our guide to developing a local industrial strategy for more discussion).

Finally, the market tends to struggle to provide public goods – such as public parks and libraries – which are non-excludable (anyone can use them) and non-rival (one person using them, doesn’t stop other people from using them). The market provides some options, such as ticketed entry to private gardens and bookstores. But given these public goods often generate lots of benefits to society, the ‘right price’ for people using these services may often by ‘free’ (or at least below the market price). We have recently published a briefing to help policymakers think through the benefits and costs of public spaces.  

Why do we need to think about market failure?  

Market failures will happen as long as we have markets. From a policy perspective, it’s important to distinguish between outcomes we don’t like and outcomes that are caused by market failures. For example, a local business that struggles to get customers may need a better product, rather than support from a government (unless, for example, one of the market failures above explains why they don’t invest in producing a better product).

Policymakers may, however, step in to address that market failure if there is a clear wider benefit – we gave lots of examples above.

What to consider when thinking about market failures?

The benefits of intervening also need to be weighed against the costs. Sometimes fixing the problem may cost more than the benefits, especially once we recognise the risk of deadweight – government support for activities that would have happened anyway. For example, innovation grants may fund work that innovative firms would have decided was worth the risk – this is deadweight. If those grants encourage firms to establish a local innovation network that wouldn’t have happened otherwise, that would generate additionality (benefits that wouldn’t have happened without the intervention.

Beyond issues of additional and displacement, we also need to worry about government failure. Sometimes government policy may create the market failure in the first place – for example by overly restricting the supply of land for commercial and residential development.

While identifying the type of market failure can be tricky, it’s a useful way of thinking about “should local government intervene?” and helps to plan better interventions.

How can I learn more?

• In the Green Book, HM Treasury recommends considering market failures as part of the process of developing a rationale for intervention and generating a longlist of possible options
• The Department for Science, Innovation and Technology, has recently published a research report that sets out the case for investing in the space sector, which includes an analysis of the market failures that are currently leading to underinvestment.
• Levies are one approach to tacking underinvestment in skills. The Engineering Construction Industry Training Board is responsible for managing the levy in the engineering construction sector.  In this blog, they set out the market failure that leads to underinvestment in training by their sector and how the levy helps address this.
• The Grantham Institute sets out in this blog why economists often describe climate change as a market failure.

Up next

The next blog in our understanding key concepts in local economic growth series will be on agglomeration. Sign up to our newsletter to get an update on our next blogs, briefings and events.