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. Market failure can be viewed as a scenario in which individuals' pursuit of self-interest leads to unsatisfactory results for the society.^[1] The first known use of the term by economists was in 1958,^[2] but the concept has been traced back to the Victorian philosopher Henry Sidgwick.^[3]

The belief that markets can have inefficient outcomes is a common mainstream justification for government intervention in free markets.^[4] Economists, especially microeconomists, use many different models and theorems to analyze the causes of market failure, and possible means to correct such a failure when it occurs.^[5] 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, which has been called government failure.^[6] Thus, there is often a choice between imperfect outcomes, i.e. imperfect market outcomes and imperfect government outcomes.

Causes

See also: public goods, monopoly, monopsony, oligopoly, and externality

In mainstream analysis, a market failure (relative to Pareto efficiency) can occur for three main reasons.^[1]

• First, an agent in a market can gain market power, allowing them to block other mutually beneficial gains from trade from occurring. This can lead to inefficiency due to imperfect competition, which can take many different forms, such as monopolies, monopsonies, cartels, or monopolistic competition, if the agent does not implement perfect price discrimination.
• Second, the actions of an agent can have externalities, which are innate to the methods of production, or other conditions important to the market.^[1]
• 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 or common-pool resources, while markets may have significant transaction costs, agency problems, or informational asymmetry.^[1] In general, all of these situations can produce inefficiency, and a resulting market failure.

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.^[4]

As a result, an agent's 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 an agent to control who uses their commodity, and for how long – and the related costs associated with doing so. Transferability reflects the right of an agent 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.^[4] Considerations such as these form an important part of the work of institutional economics.^[7] Nonetheless, views still differ on whether something is displaying these attributes is meaningful without the information provided by the market price system.^[8]

There are many examples cited by economists as examples of market failure. For instance, traffic congestion is considered an example, since driving can impose hidden costs on other drivers and society, whereas use of public transportation or other ways of avoiding driving would be more beneficial to society as a whole.^[1] Other common examples of market failure include environmental problems such as pollution or overexploitation of natural resources.^[1]

Interpretations and policy

This interpretation is 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^[6] – and specifically considers market failures absent considerations of the "public interest", or equity, citing definitional concerns^[5]. 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.

Objections

See also: government failure, Austrian school, and Marxian economics

Austrian

Many heterodox schools disagree with the mainstream consensus. Advocates of laissez-faire capitalism, such as libertarians, Objectivists, and economists of the Austrian School, argue that there is no such phenomenon as "market failures," - that is, when private businesses in the free market fail, this is not an instance of "market failure", but rather an instance of the market eliminating failure.

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.^[9] 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 also object to the principle of market failure on the grounds that it is an equilibrium concept, which cannot occur in reality due to incessant changes in the state of the market. 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 .^[10]

Austrians would respond to the above examples of traffic congestion and pollution by pointing out market distortions caused by government that stifle or prohibit private road construction and dismiss liability for damaging private property against its owner's will.

Public choice

In addition, economists such as Milton Friedman, often 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.

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.^[1] 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

An example of Market failure is in the case of monopolistic control of a service or goods provision. In this case the monopoly means the ability of the provider to control and set the prices according to his wish and not according to the interaction with other stakeholders in the market.

The Austrian objection to this would be that there can never exist a monopoly under the free market, since the initiation of physical force would not be permitted. Any attempt to set prices above market value would create exposure to competition, or push consumers to switch to a substitute good or service.

References

External links

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