Market Failure

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Market failure occurs in economics when the allocation of goods and services by a free market is not efficient. In such cases the pursuit of pure self-interest leads to results that can be improved upon from the societal point-of-view. The first known use of the term by economists was in 1958, but the concept has been traced back to the Victorian philosopher Henry Sidgwick.

A market failure can occur for three main reasons: if the market is monopolized (a small group of businesses hold significant market power), if production of the good or service results in an externality (a cost or benefit that affects an unaffiliated third party), or if the good or service is a ‘public good’ (a non-excludable good like air).

The existence of a market failure is often used as a justification for government intervention in a particular market. Economists are often concerned with the causes of market failure, and possible means to correct them. 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 failure. Thus, there is sometimes a choice between imperfect outcomes, i.e. imperfect market outcomes with or without government interventions. 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.

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, monopsonies, cartels, or monopolistic competition. 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. 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. Economists say that monopolies can maintain themselves where there are ‘barriers to entry.’

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. 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.

Natural monopoly, or the overlapping concepts of ‘practical’ and ‘technical’ monopoly, is an extreme case of failure of competition as a restraint on producers. The problem is described as one where the more of a product is made, the less the unit costs are. This means it only makes economic sense to have one producer.

The actions of agents can have externalities, which are innate to the methods of production, or other conditions important to the market. 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. If the firm also pollutes the atmosphere when it makes steel, however, and if it is not forced to pay for cleanup, then this cost will be borne not by the firm but by society. Hence, the market price for steel will fail to incorporate the full opportunity cost to society of producing. In this case, the market equilibrium in the steel industry will not be optimal. More steel will be produced than would occur were the firm to have to pay for all of its costs of production. Consequently, the marginal social cost of the last unit produced will exceed its marginal social benefit.

Common examples of an externality is environmental harm such as pollution or overexploitation of natural resources. Climate change is, in the words of the ‘Stern Review on the Economics of Climate Change,’ ‘the greatest example of market failure we have ever seen.’ Traffic congestion is also 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.

Information asymmetries and 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 (when buyers and sellers have asymmetric information the ‘bad’ products or services are more likely to be selected) and moral hazard (a party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party insulated from risk behaves differently from how it would if it were fully exposed).

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. 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.

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.

Economists such as Milton Friedman from the Chicago 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.

Advocates of laissez-faire capitalism, such as some economists of the Austrian School, argue that there is no such phenomenon as ‘market failures.’ 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.

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 necessarily inefficient, and so would not be considered a market failure by mainstream economics. 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.

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