Market failure

Market failure is a situation in which markets do not efficiently organize production or allocate goods and services to consumers. To economists, the term would normally be applied to situations where the inefficiency is particularly dramatic, or when it is suggested that non-market institutions (such as public policing and firefighting) would be more efficient and wealth-producing than their private alternatives.

On the other hand, many market failures are situations where market forces do not serve the perceived public interest. Here, the focus is on the economists' theories of market failure. Economists use model-like theorems to explain or understand such cases. The two main reasons that markets fail are:

the inadequate expression of costs or benefits in prices and thus into microeconomic decision-making in markets.
sub-optimal market structures.

The word "failure" here is not intended to mean an economic collapse, or a breakdown in market relations. Market failure is a claim that the market is failing to create maximum efficiency. It doesn't mean that the market has broken down or ceased to exist.

To understand the concept of market failure, it is first necessary to understand this key term:

public good: a good from which everyone can simultaneously obtain benefits. Public goods retain the characteristics of nonrivalry and nonexcludability. Nonrivalry means that one person's benefit does not reduce the benefit available to others, and nonexcludability means that there is no effective way of excluding individuals from the benefit of the good, once it comes into existence (thereby creating the free-rider problem). Due to the free-rider problem, a public good is not profitable to provide by a private firm. Examples of public goods include national defense, street lighting, and environmental regulations.

In terms of market failure, due to nonrivalry and nonexcludability, private firms cannot profitably produce a public good. If, then, society still demands the good, it is the responsibility of the government to provide it---of course, the government can provide it only when funded by taxes.

Noncompetition

Examples of sub-optimal market structures include:

imperfect competition
price discrimination
- price skimming
markets with asymmetric information - see also The Market for Lemons
externalities

note: monopolies with downward sloping long-run average cost curves - i.e. a natural monopoly - may not be sub-optimal

Interpretations

As could be expected, the issue of market failures (and how they should be addressed) is a source of dispute between different schools of economic thought.

Neoclassical School

Note that all the types of failures listed above refer to situations where markets create inefficiency. This follows the lead of the currently-dominant school of academic economics, the neoclassical (orthodox) school. In this perspective, if a certain result is Pareto efficient, then it is not considered a market failure, regardless of whether or not it serves the "public interest", however that may be defined. For example, many would consider the existence of gross inequalities in the distribution of wealth and income to be against the public interest. But it would not be a market failure, as this situation can be Pareto efficient, in that no one person could be made better off without making some other person worse off.

In the neoclassical view, the issue of the inequality of distribution of income and wealth left over from history is completely separate from that of market failure, at least in static analysis. On the other hand, in dynamic analysis, if the operations of markets normally lead to increasing inequality of wealth ownership over time, many neoclassicals would see it as an indication of market failure. This phenomenon could reflect a lack of competition in markets or others from the list of market failures above.

Keynesian/Neo-Keynesian School

Modern macroeconomics, especially that of the Keynesian or new Keynesian varieties, applies the neoclassical view to interpret the failure to automatically attain full employment of resources (as with Say's Law) in terms of theories of market failure. Once modified to take market failure into account, the standard Walrasian model of general equilibrium usually produces Keynesian results. For new Keynesians, the main stress in on the non-adjustment of prices and (especially) wages.

Austrian and Public Choice Schools

Many advocates of laissez-faire capitalism, such as libertarians and economists of the Austrian School, argue that there is no such concept as a market failure ^*. It is argued that their perceived existence is actually the result of government regulations, or see them as small, irrelevant, or temporary. For example, the problem of externalities is often played down by terming them mere "neighborhood effects".

Economists of the Public Choice school often 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 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.

To these schools, a market failure is usually a failure to have markets. Alternatively, they would say that results that some might call "market failures" cannot be such if those results are not intended to be avoided by the establishment of markets. Moreover, conditions that many would regard as negative are often seen as an effect of subversion of the free market by coercive government intervention.

While some would dub a high degree of centralization of the wealth distribution in a small number of hands a "market failure", the laissez faire response would be that the goal of distributing wealth evenly was never the purpose of establishing markets in the first place. But critics of laissez faire would ask who it was who determined the purpose of using markets. For example, in many cases, "privatization", i.e., the replacement of government programs by ones organized following market principles, simply reflects the political influence of businesses that see potential profit gains from marketization (i.e., rent-seeking). Instead of a government program, which in theory reflects the democratically-expressed will of the people, the result is sometimes a privately owned monopoly allied with the political insiders, the kind of crony capitalism that most economists, including the laissez faire schools oppose. In turn, the laissez-faire schools would argue the presence of government involvement in that 'privatizaton' in the first place and deem its status as a market 'reform' dubious. The debate remains over how the market and the political or public sphere should be separated, if possible at all.

New liberal schools

Others, such as social democrats and "New Deal liberals", view market failures as a very common problem of any unregulated market system, and therefore argue for extensive state intervention in the economy, in order to ensure both efficiency and social justice (usually interpreted in terms of limiting 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.

A major argument against this view is that these liberals have too much faith in the benevolence of the government and/or in the ability of citizens to control their government democratically. As noted, advocates of laissez faire point to a large number of examples of government failure, where the government interference in markets made matters worse. The social democrats and New Deal liberals would riposte that we should seek the best combination of markets and government, in light of the failures of both. To most economists, markets could not exist without government enforcement of individual property rights and contracts, so to them the idea of a totally free market system is self-contradictory. Of course, other economists note that many drugs are bought and sold not only without government enforcement of contracts and private property rights, but in the face of energetic government efforts to stop the drug market operating at all (see illegal drug trade), implying that a totally free market system can, at least under some conditions, occur.

In the current era, we sometimes see professed New Deal liberal intentions merged with laissez-faire ideas to form neoliberalism. In this vein, some propose "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 permit. Often companies in other industries are willing to buy such permits, so that the government created an artificial market for pollution rights.

Marxist School

In general, Marxists would argue that the system of individual property rights is a fundamental problem in itself, and that resources should be allocated in another way (usually democratically or assigned by a central planner or planning board held democratically responsible to the people). 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 all markets have inefficient and democratically-unwanted outcomes.

That is, the Marxist school of economics sees market failure as an inherent feature of any capitalist economy. However, although Marxists argue for the abolition of capitalism, they often do not raise the issue of market failure in their arguments (preferring to concentrate on other aspects instead). They do not see the "perfect market" (one without failures) as reasonable goal. Further, they see capitalist exploitation, class conflict, and economic crises as existing even with "perfect" markets. The issues of wealth inequality and increases in its degree (discussed above) moves to center stage, along with the associated inequalities of social power.

Even when they do discuss the issue of market failure, Marxists note that government leaders and those who benefit from market failures (polluters, monopolists, etc.) often form alliances, so that the government is not a neutral purveyor of technocratic solutions in the name of the people. In this view, market failure and government failure normally go together. Only popular pressure on both the government and the companies benefiting from market failure can lead to success in reducing market failures.

External links

Phillip Longman, Washington Monthly, January/February 2005, "The Best Care Anywhere" ^* Veterans' Health versus private healthcare
Folvary, Fred E. and Klein B. Klein, The Half-Life of Policy Rationales How New Technology Affects Old Policy Issues Argues that "Applications of market-failure theory may be found to have a technological "half life," after which their validity disolves"