What constitutes market failure in microeconomics?

Market failure in microeconomics occurs when the allocation of goods and services by a free market is not efficient.

In more detail, market failure is a situation where the forces of supply and demand do not lead to an optimal allocation of resources, resulting in a loss of economic and social welfare. This inefficiency can occur due to a variety of reasons, including externalities, public goods, imperfect information, and market power.

Externalities are costs or benefits that affect a party who did not choose to incur that cost or benefit. For example, pollution from a factory can negatively impact the health of people living nearby, even though they did not choose to be exposed to it. This is a negative externality. On the other hand, a positive externality could be the benefit received by individuals when their neighbours vaccinate their children, reducing the risk of disease spread.

Public goods are non-excludable and non-rivalrous, meaning they are available to all and one person's use does not diminish another's. Examples include street lighting or national defence. The free market may fail to provide these goods as there is no incentive for firms to produce them, as they cannot exclude non-payers. This leads to the 'free-rider' problem.

Imperfect information can also lead to market failure. If buyers and sellers do not have complete information to make decisions, they may make choices that lead to inefficiency. For instance, a buyer may purchase a product that is harmful to their health because they were not aware of its risks.

Market power, where a single buyer or seller can influence prices, can also lead to market failure. Monopolies, for example, can set prices higher than in competitive markets, leading to allocative inefficiency.

In all these cases, the market fails to achieve an efficient outcome, and there may be a case for government intervention to correct the market failure. This could be through regulation, taxation, subsidies, or direct provision of goods and services. However, government intervention also carries the risk of government failure, where intervention leads to an even worse outcome. Therefore, the decision to intervene must be carefully considered.