Market Failure: A situation in which the market economy equilibrium leads to inefficiency (the presence of a deadweight loss). This means that either too many or too few resources are being allocated to a specific endeavor, and that the outcome can be improved by introducing smart government regulation.
The two types of market failures discussed here will be externalities, and public goods.
Externality: When a market transaction occurring between two parties has an effect on a third party not involved in the transaction. Pollution and education are two types of externalities.
Negative externality: Social cost is higher than private cost.
Positive externality: Social benefit is higher than private benefit.
How the government can correct this market failure:
Through the introduction of special taxes, regulation, government owned industry, or subsidies.
Public goods: Goods that are non-rival, and non-excludable. Non-rival means that one person’s consumption of a good does not reduce the available amount to be consumed by another person (for example, an apple is rival because if I eat it you cannot eat it, but if I listen to the radio, you can also listen to the radio). Non-excludable means that someone cannot be stopped from consuming the good. For example, if there is a road, it is non-excludable because anyone can drive on it, but if I put up a toll booth, it becomes excludable because those who do not pay the toll cannot use it.
A common problem with the allocation of public goods is the free rider problem.
Free riders: individuals assume that others will pay for the good, so they do not pay and receive the benefits for free. If everyone becomes a free-rider, then the good is not provided and everyone loses. Typically public goods are underfunded because of the free-rider problem.
Examples of goods and services with public good aspects are parks, health care, and education.