Market failure
Encyclopedia
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 a market participant 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. 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
.
Market failures are often associated with information asymmetries
, non-competitive markets
, principal–agent problems, externalities, or public goods. The existence of a market failure is often used as a justification for government intervention in a particular market
. Economists, especially microeconomists
, are often concerned with the causes of market failure, and possible means to correct such a failure when it occurs. 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. 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.
) 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
".
s in a market can gain market power
, allowing them to block other mutually beneficial gains from trade
s from occurring. This can lead to inefficiency due to imperfect competition
, which can take many different forms, such as monopolies
, monopsonies, cartel
s, or monopolistic competition
, if the agent does not implement perfect price discrimination. In a monopoly, the market equilibrium will no longer be Pareto optimal. 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
".
, 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.
, 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.
s 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 the use of this resource, 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
.
Traffic congestion
is an example of market failure, since driving can impose hidden costs on other drivers and society. Solutions for this include public transport
ation, congestion pricing
, toll road
s and toll bridge
s, and other ways of making the driver include the social cost in the decision to drive.
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:
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.
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.
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. Considerations such as these form an important part of the work of institutional economics
. Nonetheless, views still differ on whether something displaying these attributes is meaningful without the information provided by the market price system.
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
– and specifically considers market failures absent considerations of the "public interest
", or equity
, citing definitional concerns. This form of analysis has also been adopted by the Keynesian or new Keynesian
schools in modern macroeconomics
, applying it to Walras
ian 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.
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.
capitalism
, such as some economists of the Austrian School
, argue that there is no such phenomenon as "market failures". Israel Kirzner
states that: "Efficiency for a social system means the efficiency with which it permits its individual members to achieve their individual goals". Inefficiency only arises when means are chosen by individuals that are inconsistent with their desired goals. 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.
, 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. 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.
Free market
A free market is a competitive market where prices are determined by supply and demand. However, the term is also commonly used for markets in which economic intervention and regulation by the state is limited to tax collection, and enforcement of private ownership and contracts...
is not efficient. That is, there exists another conceivable outcome where a market participant 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. 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
Henry Sidgwick
Henry Sidgwick was an English utilitarian philosopher and economist. He was one of the founders and first president of the Society for Psychical Research, a member of the Metaphysical Society, and promoted the higher education of women...
.
Market failures are often associated with information asymmetries
Information asymmetry
In economics and contract theory, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other. This creates an imbalance of power in transactions which can sometimes cause the transactions to go awry, a kind of market failure...
, non-competitive markets
Market structure
In economics, market structure .* Monopolistic competition, also called competitive market, where there are a large number of firms, each having a small proportion of the market share and slightly differentiated products.* Oligopoly, in which a market is dominated by a small number of firms that...
, principal–agent problems, externalities, or public goods. The existence of a market failure is often used as a justification for government intervention in a particular market
Market
A market is one of many varieties of systems, institutions, procedures, social relations and infrastructures whereby parties engage in exchange. While parties may exchange goods and services by barter, most markets rely on sellers offering their goods or services in exchange for money from buyers...
. Economists, especially microeconomists
Microeconomics
Microeconomics is a branch of economics that studies the behavior of how the individual modern household and firms make decisions to allocate limited resources. Typically, it applies to markets where goods or services are being bought and sold...
, are often concerned with the causes of market failure, and possible means to correct such a failure when it occurs. Such analysis plays an important role in many types of public policy
Public policy (law)
In private international law, the public policy doctrine or ordre public concerns the body of principles that underpin the operation of legal systems in each state. This addresses the social, moral and economic values that tie a society together: values that vary in different cultures and change...
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
Government failure
Government failure is the public sector analogy to market failure and occurs when a government intervention causes a more inefficient allocation of goods and resources than would occur without that intervention...
. 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
Pareto efficiency
Pareto efficiency, or Pareto optimality, is a concept in economics with applications in engineering and social sciences. The term is named after Vilfredo Pareto, an Italian economist who used the concept in his studies of economic efficiency and income distribution.Given an initial allocation of...
. Mainstream neoclassical and Keynesian economists believe that it may be possible for a government to improve the inefficient market outcome, while several heterodox
Heterodox economics
"Heterodox economics" refers to approaches or to schools of economic thought that are considered outside of "mainstream economics". Mainstream economists sometimes assert that it has little or no influence on the vast majority of academic economists in the English speaking world. "Mainstream...
schools of thought disagree with this.
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 efficiencyPareto efficiency
Pareto efficiency, or Pareto optimality, is a concept in economics with applications in engineering and social sciences. The term is named after Vilfredo Pareto, an Italian economist who used the concept in his studies of economic efficiency and income distribution.Given an initial allocation of...
) can occur for three main reasons: if the market is "monopolised" or a small group of businesses hold significant market power
Market power
In economics, market power is the ability of a firm to alter the market price of a good or service. In perfectly competitive markets, market participants have no market power. A firm with market power can raise prices without losing its customers to competitors...
, if production of the good or service results in an externality
Externality
In economics, an externality is a cost or benefit, not transmitted through prices, incurred by a party who did not agree to the action causing the cost or benefit...
, or if the good or service is a "public good
Public good
In economics, a public good is a good that is non-rival and non-excludable. Non-rivalry means that consumption of the good by one individual does not reduce availability of the good for consumption by others; and non-excludability means that no one can be effectively excluded from using the good...
".
Monopolies
AgentAgent (economics)
In economics, an agent is an actor and decision maker in a model. Typically, every agent makes decisions by solving a well or ill defined optimization/choice problem. The term agent can also be seen as equivalent to player in game theory....
s in a market can gain market power
Market power
In economics, market power is the ability of a firm to alter the market price of a good or service. In perfectly competitive markets, market participants have no market power. A firm with market power can raise prices without losing its customers to competitors...
, allowing them to block other mutually beneficial gains from trade
Gains from trade
Gains from trade in economics refers to net benefits to agents from allowing an increase in voluntary trading with each other. In technical terms, it is the increase of consumer surplus plus producer surplus from lower tariffs or otherwise liberalizing trade...
s from occurring. This can lead to inefficiency due to imperfect competition
Imperfect competition
In economic theory, imperfect competition is the competitive situation in any market where the conditions necessary for perfect competition are not satisfied...
, which can take many different forms, such as monopolies
Monopoly
A monopoly exists when a specific person or enterprise is the only supplier of a particular commodity...
, monopsonies, cartel
Cartel
A cartel is a formal agreement among competing firms. It is a formal organization of producers and manufacturers that agree to fix prices, marketing, and production. Cartels usually occur in an oligopolistic industry, where there is a small number of sellers and usually involve homogeneous products...
s, or monopolistic competition
Monopolistic competition
Monopolistic competition is imperfect competition where many competing producers sell products that are differentiated from one another...
, if the agent does not implement perfect price discrimination. In a monopoly, the market equilibrium will no longer be Pareto optimal. 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
Social cost
Social cost, in economics, is generally defined in opposition to "private cost". In economics, theorists model individual decision-making as measurement of costs and benefits...
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
Barriers to entry
In theories of competition in economics, barriers to entry are obstacles that make it difficult to enter a given market. The term can refer to hindrances a firm faces in trying to enter a market or industry - such as government regulation, or a large, established firm taking advantage of economies...
".
Public goods
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 problemsPrincipal-agent problem
In political science and economics, the principal–agent problem or agency dilemma treats the difficulties that arise under conditions of incomplete and asymmetric information when a principal hires an agent, such as the problem of potential moral hazard and conflict of interest, in as much as the...
, or informational asymmetry
Information asymmetry
In economics and contract theory, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other. This creates an imbalance of power in transactions which can sometimes cause the transactions to go awry, a kind of market failure...
. 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
Natural monopolyNatural monopoly
A monopoly describes a situation where all sales in a market are undertaken by a single firm. A natural monopoly by contrast is a condition on the cost-technology of an industry whereby it is most efficient for production to be concentrated in a single form...
, 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.
Externalities
The actions of agentAgent (economics)
In economics, an agent is an actor and decision maker in a model. Typically, every agent makes decisions by solving a well or ill defined optimization/choice problem. The term agent can also be seen as equivalent to player in game theory....
s can have externalities
Externality
In economics, an externality is a cost or benefit, not transmitted through prices, incurred by a party who did not agree to the action causing the cost or benefit...
, 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 the use of this resource, 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
Social cost
Social cost, in economics, is generally defined in opposition to "private cost". In economics, theorists model individual decision-making as measurement of costs and benefits...
of the last unit produced will exceed its marginal social benefit.
Common examples of an externality is environmental harm such as pollution
Pollution
Pollution is the introduction of contaminants into a natural environment that causes instability, disorder, harm or discomfort to the ecosystem i.e. physical systems or living organisms. Pollution can take the form of chemical substances or energy, such as noise, heat or light...
or overexploitation
Overexploitation
Overexploitation, also called overharvesting, refers to harvesting a renewable resource to the point of diminishing returns. Sustained overexploitation can lead to the destruction of the resource...
of natural resources
Natural Resources
Natural Resources is a soul album released by Motown girl group Martha Reeves and the Vandellas in 1970 on the Gordy label. The album is significant for the Vietnam War ballad "I Should Be Proud" and the slow jam, "Love Guess Who"...
.
Traffic congestion
Traffic congestion
Traffic congestion is a condition on road networks that occurs as use increases, and is characterized by slower speeds, longer trip times, and increased vehicular queueing. The most common example is the physical use of roads by vehicles. When traffic demand is great enough that the interaction...
is an example of market failure, since driving can impose hidden costs on other drivers and society. Solutions for this include public transport
Public transport
Public transport is a shared passenger transportation service which is available for use by the general public, as distinct from modes such as taxicab, car pooling or hired buses which are not shared by strangers without private arrangement.Public transport modes include buses, trolleybuses, trams...
ation, congestion pricing
Congestion pricing
Congestion pricing or congestion charges is a system of surcharging users of a transport network in periods of peak demand to reduce traffic congestion. Examples include some toll-like road pricing fees, and higher peak charges for utilities, public transport and slots in canals and airports...
, toll road
Toll road
A toll road is a privately or publicly built road for which a driver pays a toll for use. Structures for which tolls are charged include toll bridges and toll tunnels. Non-toll roads are financed using other sources of revenue, most typically fuel tax or general tax funds...
s and toll bridge
Toll bridge
A toll bridge is a bridge over which traffic may pass upon payment of a toll, or fee.- History :The practice of collecting tolls on bridges probably harks back to the days of ferry crossings where people paid a fee to be ferried across stretches of water. As boats became impractical to carry large...
s, and other ways of making the driver include the social cost in the decision to drive.
Bounded rationality
In Models of Man, Herbert SimonHerbert Simon
Herbert Alexander Simon was an American political scientist, economist, sociologist, and psychologist, and professor—most notably at Carnegie Mellon University—whose research ranged across the fields of cognitive psychology, cognitive science, computer science, public administration, economics,...
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
Information
Information in its most restricted technical sense is a message or collection of messages that consists of an ordered sequence of symbols, or it is the meaning that can be interpreted from such a message or collection of messages. Information can be recorded or transmitted. It can be recorded as...
" (Williamson
Oliver E. Williamson
Oliver Eaton Williamson is an American economist, professor at the University of California, Berkeley and recipient of the Nobel Memorial Prize in Economic Sciences....
, 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 utilityUtilityIn economics, utility is a measure of customer satisfaction, referring to the total satisfaction received by a consumer from consuming a good or service....
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.
Information asymmetry
Information asymmetries and incomplete marketsIncomplete markets
In economics, incomplete markets refers to markets in which the number of Arrow–Debreu securities is less than the number of states of nature...
may result in economic inefficiency but also a possibility of improving efficiency through market, legal, and regulatory remedies. From contract theory
Contract theory
In economics, contract theory studies how economic actors can and do construct contractual arrangements, generally in the presence of asymmetric information. Because of its connections with both agency and incentives, contract theory is often categorized within a field known as Law and economics...
, decisions in transactions where one party has more or better information
Information
Information in its most restricted technical sense is a message or collection of messages that consists of an ordered sequence of symbols, or it is the meaning that can be interpreted from such a message or collection of messages. Information can be recorded or transmitted. It can be recorded as...
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
Adverse selection
Adverse selection, anti-selection, or negative selection is a term used in economics, insurance, statistics, and risk management. It refers to a market process in which "bad" results occur when buyers and sellers have asymmetric information : the "bad" products or services are more likely to be...
and moral hazard
Moral hazard
In economic theory, moral hazard refers to a situation in which 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 to the risk.Moral hazard...
. Most commonly, information asymmetries are studied in the context of principal–agent problems. George Akerlof
George Akerlof
George Arthur Akerlof is an American economist and Koshland Professor of Economics at the University of California, Berkeley. He won the 2001 Nobel Prize in Economics George Arthur Akerlof (born June 17, 1940) is an American economist and Koshland Professor of Economics at the University of...
, Michael Spence
Michael Spence
Andrew Michael Spence is an American economist and recipient of the 2001 Nobel Memorial Prize in Economic Sciences, along with George A. Akerlof and Joseph E. Stiglitz, for their work on the dynamics of information flows and market development. He conducted this research while at Harvard University...
, and Joseph E. Stiglitz
Joseph E. Stiglitz
Joseph Eugene Stiglitz, ForMemRS, FBA, is an American economist and a professor at Columbia University. He is a recipient of the Nobel Memorial Prize in Economic Sciences and the John Bates Clark Medal . He is also the former Senior Vice President and Chief Economist of the World Bank...
developed the idea.
Property right as right of control
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
Leasing
Leasing is a process by which a firm can obtain the use of a certain fixed assets for which it must pay a series of contractual, periodic, tax deductible payments....
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. Considerations such as these form an important part of the work of institutional economics
Institutional economics
Institutional economics focuses on understanding the role of the evolutionary process and the role of institutions in shaping economic behaviour. Its original focus lay in Thorstein Veblen's instinct-oriented dichotomy between technology on the one side and the "ceremonial" sphere of society on the...
. Nonetheless, views still differ on whether something displaying these attributes is meaningful without the information provided by the market price system.
Interpretations and policy
The above causes represent the mainstreamMainstream economics
Mainstream economics is a loose term used to refer to widely-accepted economics as taught in prominent universities and in contrast to heterodox economics...
view of what market failures mean and of their importance in the economy. This analysis follows the lead of the neoclassical
Neoclassical economics
Neoclassical economics is a term variously used for approaches to economics focusing on the determination of prices, outputs, and income distributions in markets through supply and demand, often mediated through a hypothesized maximization of utility by income-constrained individuals and of profits...
school, and relies on the notion of Pareto efficiency
Pareto efficiency
Pareto efficiency, or Pareto optimality, is a concept in economics with applications in engineering and social sciences. The term is named after Vilfredo Pareto, an Italian economist who used the concept in his studies of economic efficiency and income distribution.Given an initial allocation of...
– and specifically considers market failures absent considerations of the "public interest
Public interest
The public interest refers to the "common well-being" or "general welfare." The public interest is central to policy debates, politics, democracy and the nature of government itself...
", or equity
Equity (economics)
Equity is the concept or idea of fairness in economics, particularly as to taxation or welfare economics. More specifically it may refer to equal life chances regardless of identity, to provide all citizens with a basic minimum of income/goods/services or to increase funds and commitment for...
, citing definitional concerns. This form of analysis has also been adopted by the Keynesian or new Keynesian
New Keynesian economics
New Keynesian economics is a school of contemporary macroeconomics that strives to provide microeconomic foundations for Keynesian economics. It developed partly as a response to criticisms of Keynesian macroeconomics by adherents of New Classical macroeconomics.Two main assumptions define the New...
schools in modern macroeconomics
Macroeconomics
Macroeconomics is a branch of economics dealing with the performance, structure, behavior, and decision-making of the whole economy. This includes a national, regional, or global economy...
, applying it to Walras
Walras
Walras is surname of:* Auguste Walras , French school administrator and economist* Léon Walras * Walras' law...
ian models of general equilibrium
General equilibrium
General equilibrium theory is a branch of theoretical economics. It seeks to explain the behavior of supply, demand and prices in a whole economy with several or many interacting markets, by seeking to prove that a set of prices exists that will result in an overall equilibrium, hence general...
in order to deal with failures to attain full employment
Full employment
In macroeconomics, full employment is a condition of the national economy, where all or nearly all persons willing and able to work at the prevailing wages and working conditions are able to do so....
, or the non-adjustment of prices and wages.
Many social democrats and "New Deal liberals
New liberalism
New Liberalism is a book by Matthew Kalkman that examines the evolution of Liberalism from its early beginnings to its potential future incarnations. The author argues that New Liberalism is the next step in this evolution: the notion that, in order for a society to be maintained and to evolve, it...
", have adopted this analysis for public policy
Public policy (law)
In private international law, the public policy doctrine or ordre public concerns the body of principles that underpin the operation of legal systems in each state. This addresses the social, moral and economic values that tie a society together: values that vary in different cultures and change...
, 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
Efficiency (economics)
In economics, the term economic efficiency refers to the use of resources so as to maximize the production of goods and services. An economic system is said to be more efficient than another if it can provide more goods and services for society without using more resources...
and social justice
Social justice
Social justice generally refers to the idea of creating a society or institution that is based on the principles of equality and solidarity, that understands and values human rights, and that recognizes the dignity of every human being. The term and modern concept of "social justice" was coined by...
(usually interpreted in terms of limiting avoidable inequalities in wealth and income). Both the democratic accountability of these regulations and the technocratic
Technocracy (bureaucratic)
Technocracy is a form of government where technical experts are in control of decision making in their respective fields. Economists, engineers, scientists, health professionals, and those who have knowledge, expertise or skills would compose the governing body...
expertise of the economists play an important role here in shaping the kind and degree of intervention. Neoliberals
Neoliberalism
Neoliberalism is a market-driven approach to economic and social policy based on neoclassical theories of economics that emphasizes the efficiency of private enterprise, liberalized trade and relatively open markets, and therefore seeks to maximize the role of the private sector in determining the...
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.
Public choice
Economists such as Milton FriedmanMilton Friedman
Milton Friedman was an American economist, statistician, academic, and author who taught at the University of Chicago for more than three decades...
from the Chicago school and others from the Public Choice
Public choice theory
In economics, public choice theory is the use of modern economic tools to study problems that traditionally are in the province of political science...
school, argue that market failure does not necessarily imply that government should attempt to solve market failures, because the costs of government failure
Government failure
Government failure is the public sector analogy to market failure and occurs when a government intervention causes a more inefficient allocation of goods and resources than would occur without that intervention...
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
Private sector
In economics, the private sector is that part of the economy, sometimes referred to as the citizen sector, which is run by private individuals or groups, usually as a means of enterprise for profit, and is not controlled by the state...
and in the government bureaucracy
Bureaucracy
A bureaucracy is an organization of non-elected officials of a governmental or organization who implement the rules, laws, and functions of their institution, and are occasionally characterized by officialism and red tape.-Weberian bureaucracy:...
. Conditions that many would regard as negative are often seen as an effect of subversion of the free market by coercive
Coercion
Coercion is the practice of forcing another party to behave in an involuntary manner by use of threats or intimidation or some other form of pressure or force. In law, coercion is codified as the duress crime. Such actions are used as leverage, to force the victim to act in the desired way...
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
Advocates of laissez-faireLaissez-faire
In economics, laissez-faire describes an environment in which transactions between private parties are free from state intervention, including restrictive regulations, taxes, tariffs and enforced monopolies....
capitalism
Capitalism
Capitalism is an economic system that became dominant in the Western world following the demise of feudalism. There is no consensus on the precise definition nor on how the term should be used as a historical category...
, such as some economists of the Austrian School
Austrian School
The Austrian School of economics is a heterodox school of economic thought. It advocates methodological individualism in interpreting economic developments , the theory that money is non-neutral, the theory that the capital structure of economies consists of heterogeneous goods that have...
, argue that there is no such phenomenon as "market failures". Israel Kirzner
Israel Kirzner
Israel Meir Kirzner is a leading economist in the Austrian School.-Early life:The son of a well-known rabbi and Talmudist, Kirzner was born in London, England and came to the United States via South Africa.-Education:After studying with the University of Cape Town, South Africa in 1947-48 and...
states that: "Efficiency for a social system means the efficiency with which it permits its individual members to achieve their individual goals". Inefficiency only arises when means are chosen by individuals that are inconsistent with their desired goals. This definition of efficiency differs from that of Pareto efficiency
Pareto efficiency
Pareto efficiency, or Pareto optimality, is a concept in economics with applications in engineering and social sciences. The term is named after Vilfredo Pareto, an Italian economist who used the concept in his studies of economic efficiency and income distribution.Given an initial allocation of...
, 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
Entrepreneurship
Entrepreneurship is the act of being an entrepreneur, which can be defined as "one who undertakes innovations, finance and business acumen in an effort to transform innovations into economic goods". This may result in new organizations or may be part of revitalizing mature organizations in response...
driven by the profit motive; something the government has great difficulty detecting, or correcting.
Marxian
Finally, objections also exist on more fundamental bases, such as that of equityJustice
Justice is a concept of moral rightness based on ethics, rationality, law, natural law, religion, or equity, along with the punishment of the breach of said ethics; justice is the act of being just and/or fair.-Concept of justice:...
, or Marxian analysis
Marxian economics
Marxian economics refers to economic theories on the functioning of capitalism based on the works of Karl Marx. Adherents of Marxian economics, particularly in academia, distinguish it from Marxism as a political ideology and sociological theory, arguing that Marx's approach to understanding the...
. 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
Pareto efficiency
Pareto efficiency, or Pareto optimality, is a concept in economics with applications in engineering and social sciences. The term is named after Vilfredo Pareto, an Italian economist who used the concept in his studies of economic efficiency and income distribution.Given an initial allocation of...
, and so would not be considered a market failure by mainstream
economics. In addition, many Marxian
Marxian economics
Marxian economics refers to economic theories on the functioning of capitalism based on the works of Karl Marx. Adherents of Marxian economics, particularly in academia, distinguish it from Marxism as a political ideology and sociological theory, arguing that Marx's approach to understanding the...
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.
External links
- A discussion of market failure
- http://www.daviddfriedman.com/Academic/Price_Theory/PThy_Chapter_18/PThy_Chap_18.htmlMarket Failures - in Price Theory: An Intermediate Text by David D. FriedmanDavid D. FriedmanDavid Director Friedman is an American economist, author, and Right-libertarian theorist. He is known as a leader in anarcho-capitalist political theory, which is the subject of his most popular book, The Machinery of Freedom...
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