Market failure

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Market failure is a concept within economic theory wherein the allocation of goods and services by a free market is not efficient. That is, there exists another conceivable outcome where market participants' overall gains from the new outcome would outweigh their losses (even if some participants lose under the new arrangement). Market failures can be viewed as scenarios where individuals' pursuit of pure self-interest leads to results that are not efficient – that can be improved upon from the societal point-of-view.^[1][2] The first known use of the term by economists was in 1958,^[3] but the concept has been traced back to the Victorian philosopher Henry Sidgwick.^[4]

Market failures are often associated with information, non-competitive markets, externalities,^[5] or public goods. The existence of a market failure is often used as a justification for government intervention in a particular market.^[6][7] Economists, especially microeconomists, are often concerned with the causes of market failure, and possible means to correct such a failure when it occurs.^[8] Such analysis plays an important role in many types of public policy decisions and studies. However, some types of government policy interventions, such as taxes, subsidies, bailouts, wage and price controls, and regulations, including attempts to correct market failure, may also lead to an inefficient allocation of resources, (sometimes called government failures).^[9] Thus, there is sometimes a choice between imperfect outcomes, i.e. imperfect market outcomes with or without government interventions. But either way, if a market failure exists the outcome is not pareto efficient. Mainstream neoclassical and Keynesian economists believe that it may be possible for a government to improve the inefficient market outcome, while several heterodox schools of thought disagree with this.^[10]

Causes

According to mainstream economic analysis, a market failure (relative to Pareto efficiency) can occur for three main reasons.^[2]

• First, agents in a market can gain market power, allowing them to block other mutually beneficial gains from trades from occurring. This can lead to inefficiency due to imperfect competition, which can take many different forms, such as monopolies,^[11] monopsonies, cartels, or monopolistic competition, if the agent does not implement perfect price discrimination. In a monopoly, the market equilibrium will no longer be Pareto optimal.^[11] The monopoly will use its market power to restrict output below the quantity at which the Marginal social benefit (MSB) is equal to the Marginal social cost (MSC) of the last unit produced, so as to keep prices and profits high.^[11] An issue for this analysis is whether a situation of market power or monopoly is likely to persist if unaddressed by policy, or whether competitive or technological change will undermine it over time.
• Second, the actions of agents can have externalities,^[5][11] which are innate to the methods of production, or other conditions important to the market.^[2] For example, when a firm is producing steel, it absorbs labor, capital and other inputs, it must pay for these in the appropriate markets, and these costs will be reflected in the market price for steel.^[11] If the firm also pollutes the atmosphere when it makes steel, however, and if it is not forced to pay for the use of this resource, then this cost will be borne not by the firm but by society.^[11] Hence, the market price for steel will fail to incorporate the full opportunity cost to society of producing.^[11] In this case, the market equilibrium in the steel industry will not be optimal.^[11] More steel will be produced than would occur were the firm to have to pay for all of its costs of production.^[11] Consequently, the MSC of the last unit produced will exceed its MSB.^[11]
• Finally, some markets can fail due to the nature of certain goods, or the nature of their exchange. For instance, goods can display the attributes of public goods^[11] or common-pool resources, while markets may have significant transaction costs, agency problems, or informational asymmetry.^[2][11] In general, all of these situations can produce inefficiency, and a resulting market failure. A related issue can be the inability of a seller to exclude non-buyers from using a product anyway, as in the development of inventions that may spread freely once revealed. This can cause underinvestment, such as where a researcher cannot capture enough of the benefits from success to make the research effort worthwhile.

More fundamentally, the underlying cause of market failure is often a problem of property rights. As Hugh Gravelle and Ray Rees put it,

A market is an institution in which individuals or firms exchange not just commodities, but the rights to use them in particular ways for particular amounts of time. [...] Markets are institutions which organize the exchange of control of commodities, where the nature of the control is defined by the property rights attached to the commodities.^[7]

As a result, agents' control over the uses of their commodities can be imperfect, because the system of rights which defines that control is incomplete. Typically, this falls into two generalized rights – excludability and transferability. Excludability deals with the ability of agents to control who uses their commodity, and for how long – and the related costs associated with doing so. Transferability reflects the right of agents to transfer the rights of use from one agent to another, for instance by selling or leasing a commodity, and the costs associated with doing so. If a given system of rights does not fully guarantee these at minimal (or no) cost, then the resulting distribution can be inefficient.^[7] Considerations such as these form an important part of the work of institutional economics.^[12] Nonetheless, views still differ on whether something displaying these attributes is meaningful without the information provided by the market price system.^[13]

Traffic congestion is an example of market failure, since driving can impose hidden costs on other drivers and society. Solutions for this include public transportation, congestion pricing, toll roads and toll bridges, and other ways of making the driver include the social cost in the decision to drive.^[2] Other common examples of market failure include environmental problems such as pollution or overexploitation of natural resources.^[2]

Interpretations and policy

The above causes represent the mainstream view of what market failures mean and of their importance in the economy. This analysis follows the lead of the neoclassical school, and relies on the notion of Pareto efficiency^[14] – and specifically considers market failures absent considerations of the "public interest", or equity, citing definitional concerns.^[8] This form of analysis has also been adopted by the Keynesian or new Keynesian schools in modern macroeconomics, applying it to Walrasian models of general equilibrium in order to deal with failures to attain full employment, or the non-adjustment of prices and wages.

Many social democrats and "New Deal liberals", have adopted this analysis for public policy, so they view market failures as a very common problem of any unregulated market system and therefore argue for state intervention in the economy in order to ensure both efficiency and social justice (usually interpreted in terms of limiting avoidable inequalities in wealth and income). Both the democratic accountability of these regulations and the technocratic expertise of the economists play an important role here in shaping the kind and degree of intervention. Neoliberals follow a similar line, often focusing on "market-oriented solutions" to market failure: for example, they propose going beyond the common idea of having the government charge a fee for the right to pollute (internalizing the external cost, creating a disincentive to pollute) to allow polluters to sell the pollution permits.

Some remedies for market failure can resemble other market failures. For example, the issue of systematic underinvestment in research is addressed by the patent system that creates artificial monopolies for successful inventions. Antitrust enforcement against large firms may limit their ability to cut prices or offer other benefits to customers that smaller firms can't match, perhaps causing directly the price increases that were feared from market power in the first place.

Objections

Public choice

Economists such as Milton Friedman from the Chicago school and others from the Public Choice school, argue that market failure does not necessarily imply that government should attempt to solve market failures, because the costs of government failure might be worse than those of the market failure it attempts to fix. This failure of government is seen as the result of the inherent problems of democracy and other forms of government perceived by this school and also of the power of special-interest groups (rent seekers) both in the private sector and in the government bureaucracy. Conditions that many would regard as negative are often seen as an effect of subversion of the free market by coercive government intervention. Beyond philosophical objections, a further issue is the practical difficulty that any single decision maker may face in trying to understand (and perhaps predict) the numerous interactions that occur between producers and consumers in any market.

Austrian

Many heterodox schools disagree with the mainstream consensus. Advocates of laissez-faire capitalism, such as economists of the Austrian School, argue that there is no such phenomenon as "market failures," although the notions of market efficiency and perfect competition can be redefined as to include the analytical framework of the Austrian School (praxeology) . Israel Kirzner states:

Efficiency for a social system means the efficiency with which it permits its individual members to achieve their individual goals,^[15]

The Austrian analysis focuses on the actions that individuals make, as to attain their goals or needs; inefficiency arises when means are chosen that are inconsistent with desired goals.^[16] This definition of efficiency differs from that of Pareto efficiency, and forms the basis of the theoretical argument against the existence of market failures. However, providing that the conditions of the first welfare theorem are met, these two definitions agree, and give identical results. Austrians argue that the market tends to eliminate its inefficiencies through the process of entrepreneurship driven by the profit motive; something the government has great difficulty detecting, or correcting.^[17]

Marxian

Finally, objections also exist on more fundamental bases, such as that of equity, or Marxian analysis. Colloquial uses of the term "market failure" reflect the notion of a market "failing" to provide some desired attribute different from efficiency – for instance, high levels of inequality can be considered a "market failure", yet are not Pareto inefficient, and so would not be considered a market failure by mainstream economics.^[2] In addition, many Marxian economists would argue that the system of individual property rights is a fundamental problem in itself, and that resources should be allocated in another way entirely. This is different from concepts of "market failure" which focuses on specific situations – typically seen as "abnormal" – where markets have inefficient outcomes. Marxists, in contrast, would say that markets have inefficient and democratically-unwanted outcomes – viewing market failure as an inherent feature of any capitalist economy – and typically omit it from discussion, preferring to ration finite goods not exclusively through a price mechanism, but based upon need as determined by society expressed through the community.

See also

• Distortions (economics)
• Social cost
• Tyranny of small decisions

References

External links

• A discussion of market failure
• Market Failures - in Price Theory: An Intermediate Text by David D. Friedman