Market failure

In economics, market failure is a situation in which the allocation of goods and services is not efficient. That is, there exists another conceivable outcome where an individual may be made better-off without making someone else worse-off. 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 time-inconsistent preferences,^[5] information asymmetries,^[6] non-competitive markets, principal–agent problems, externalities,^[7] or public goods.^[8] The existence of a market failure is often the reason that self-regulatory organizations, governments or supra-national institutions intervene in a particular market.^[9][10] Economists, especially microeconomists, are often concerned with the causes of market failure and possible means of correction.^[11] Such analysis plays an important role in many types of public policy decisions and studies. However, government policy interventions, such as taxes, subsidies, bailouts, wage and price controls, and regulations (including poorly implemented attempts to correct market failure), may also lead to an inefficient allocation of resources, sometimes called government failure.^[12]

Given the tension between, on the one hand, the undeniable costs to society caused by market failure, and on the other hand, the potential that attempts to mitigate these costs could lead to even greater costs from "government failure," 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. Most mainstream economists believe that there are circumstances (like building codes or endangered species) in which it is possible for government or other organizations to improve the inefficient market outcome. Several heterodox schools of thought disagree with this as a matter of principle.^[13]

Categories

Different economists have different views about what events are the sources of market failure. Mainstream economic analysis widely accepts a market failure (relative to Pareto efficiency) can occur for three main reasons: if the market is "monopolised" or a small group of businesses hold significant market power, if production of the good or service results in an externality, or if the good or service is a "public good".^[2]

The nature of the market

Agents 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,^[14] monopsonies, or monopolistic competition, if the agent does not implement perfect price discrimination. In a monopoly, the market equilibrium will no longer be Pareto optimal.^[14] The monopoly will use its market power to restrict output below the quantity at which the marginal social benefit is equal to the marginal social cost of the last unit produced, so as to keep prices and profits high.^[14] 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.

It is then a further question about what circumstances allow a monopoly to arise. In some cases, monopolies can maintain themselves where there are "barriers to entry" that prevent other companies from effectively entering and competing in an industry or market. Or there could exist significant First-mover advantages in the market that make it difficult for other firms to compete. In another way, a Natural monopoly is an extreme case of the failure of competition as a restraint on producers. A natural monopoly is a firm whose per-unit cost decreases as it increases output; in this situation it is most efficient (from a cost perspective) to have only a single producer of a good.

The nature of the goods

Non-excludability

Some markets can fail due to the nature of the goods being exchanged. For instance, goods can display the attributes of public goods^[14] or common goods, wherein sellers are unable to exclude non-buyers from using a product, as in the development of inventions that may spread freely once revealed. This can cause underinvestment because developers cannot capture enough of the benefits from success to make the development effort worthwhile. This can also lead to resource depletion in the case of common-pool resources, where, because use of the resource is rival but non-excludable, there is no incentive for users to conserve the resource. An example of this is a lake with a natural supply of fish: if people catch the fish faster than they can reproduce, then the fish population will dwindle until there are no fish left for future generations.

Externalities

A good or service could also have significant externalities,^[7][14] where gains or losses associated with the product, production or consumption of a product because it differs from the private cost. These externalities can be 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.^[14] 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.^[14] Hence, the market price for steel will fail to incorporate the full opportunity cost to society of producing.^[14] In this case, the market equilibrium in the steel industry will not be optimal.^[14] More steel will be produced than would occur were the firm to have to pay for all of its costs of production.^[14] Consequently, the marginal social cost of the last unit produced will exceed its marginal social benefit.^[14]

Traffic congestion is an example of market failure that incorporates both non-excludability and externality. Public roads are common resources that are available for the entire population's use (non-excludable), and act as a complement to cars (the more roads there are, the more useful cars become). Because there is very low cost but high benefit to individual drivers in using the roads, the roads become congested, decreasing their usefulness to society. Furthermore, driving can impose hidden costs on society through pollution (externality). Solutions for this include public transportation, congestion pricing, tolls, and other ways of making the driver include the social cost in the decision to drive.^[2]

Perhaps the best example of the inefficiency associated with common/public goods and externalities is the environmental harm caused by pollution and overexploitation of natural resources.^[2]

The nature of the exchange

Some markets can fail due to the nature of their exchange. Markets may have significant transaction costs, agency problems, or informational asymmetry.^[2][14] Such incomplete markets may result in economic inefficiency but also a possibility of improving efficiency through market, legal, and regulatory remedies. From contract theory, decisions in transactions where one party has more or better information than the other is an asymmetry. This creates an imbalance of power in transactions which can sometimes cause the transactions to go awry. Examples of this problem are adverse selection and moral hazard. Most commonly, information asymmetries are studied in the context of principal–agent problems. George Akerlof, Michael Spence, and Joseph E. Stiglitz developed the idea and shared the 2001 Nobel Prize in Economics.^[15]

Bounded rationality

In Models of Man, Herbert A. Simon points out that most people are only partly rational, and are emotional/irrational in the remaining part of their actions. In another work, he states "boundedly rational agents experience limits in formulating and solving complex problems and in processing (receiving, storing, retrieving, transmitting) information" (Williamson, p. 553, citing Simon). Simon describes a number of dimensions along which "classical" models of rationality can be made somewhat more realistic, while sticking within the vein of fairly rigorous formalization. These include:

• limiting what sorts of utility functions there might be.
• recognizing the costs of gathering and processing information.
• the possibility of having a "vector" or "multi-valued" utility function.

Simon suggests that economic agents employ the use of heuristics to make decisions rather than a strict rigid rule of optimization. They do this because of the complexity of the situation, and their inability to process and compute the expected utility of every alternative action. Deliberation costs might be high and there are often other, concurrent economic activities also requiring decisions.

Coase theorem

The Coase theorem, developed by Ronald Coase and labeled as such by George Stigler, states that private transactions are efficient as long as property rights exist, only a small number of parties are involved, and transactions costs are low. Additionally, this efficiency will take place regardless of who owns the property rights. This theory comes from a section of Coase's Nobel prize-winning work The Problem of Social Cost. While the assumptions of low transactions costs and a small number of parties involved may not always be applicable in real-world markets, Coase's work changed the long-held belief that the owner of property rights was a major determining factor in whether or not a market would fail.^[16]

Property rights as rights of control

Drawing heavily upon the Coase Theorem, Hugh Gravelle and Ray Rees argue that more fundamentally, the underlying cause of market failure is often a problem of property rights.

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.^[10]

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.^[10] Considerations such as these form an important part of the work of institutional economics.^[17] Nonetheless, views still differ on whether something displaying these attributes is meaningful without the information provided by the market price system.^[18]

Interpretations and policy examples

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^[19] – and specifically considers market failures absent considerations of the "public interest", or equity, citing definitional concerns.^[11] 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.

Policies to prevent market failure are already commonly implemented in the economy. For example, to prevent information asymmetry, members of the New York Stock Exchange agree to abide by its rules in order to promote a fair and orderly market in the trading of listed securities. The members of the NYSE presumably believe that each member is individually better off if every member adheres to its rules - even if they have to forego money-making opportunities that would violate those rules.

As an example of externalities, municipal governments enforce building codes and license tradesmen to mitigate the incentive to use cheaper (but more dangerous) construction practices, ensuring that the total cost of new construction includes the (otherwise external) cost of preventing future tragedies. The voters who elect municipal officials presumably feel that they are individually better off if everyone complies with the local codes, even if those codes may increase the cost of construction in their communities.

CITES is an international treaty to protect the world's common interest in preserving endangered species—a classic "public good"—against the private interests of poachers, developers and other market participants who might otherwise reap monetary benefits without bearing the known and unknown costs that extinction could create. Even without knowing the true cost of extinction, the signatory countries believe that the societal costs far outweigh the possible private gains that they have agreed to forego.

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.

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

Some advocates of laissez-faire capitalism, including many economists of the Austrian School, argue that there is no such phenomenon as "market failure". Israel Kirzner states that, "Efficiency for a social system means the efficiency with which it permits its individual members to achieve their individual goals."^[20] Inefficiency only arises when means are chosen by individuals that are inconsistent with their desired goals.^[21] 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.^[22]

Marxian

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

• Contract failure
• Criticism of capitalism
• Distortion (economics)
• Government failure
• Government success
• Public economics
• Social cost
• Tyranny of small decisions

References

External links

• Market Failures - in Price Theory, an intermediate text by David D. Friedman