Market Failure
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In
neoclassical economics Neoclassical economics is an approach to economics in which the production, consumption and valuation (pricing) of goods and services are observed as driven by the supply and demand model. According to this line of thought, the value of a good ...
, market failure is a situation in which the allocation of
goods and services Goods are items that are usually (but not always) tangible, such as pens, physical books, salt, apples, and hats. Services are activities provided by other people, who include architects, suppliers, contractors, technologists, teachers, doc ...
by a
free market In economics, a free market is an economic system in which the prices of goods and services are determined by supply and demand expressed by sellers and buyers. Such markets, as modeled, operate without the intervention of government or any ot ...
is not
Pareto efficient Pareto efficiency or Pareto optimality is a situation where no action or allocation is available that makes one individual better off without making another worse off. The concept is named after Vilfredo Pareto (1848–1923), Italian civil engin ...
, often leading to a net loss of
economic value In economics, economic value is a measure of the benefit provided by a good or service to an economic agent. It is generally measured through units of currency, and the interpretation is therefore "what is the maximum amount of money a speci ...
. 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.
Paul Krugman Paul Robin Krugman ( ; born February 28, 1953) is an American economist, who is Distinguished Professor of Economics at the Graduate Center of the City University of New York, and a columnist for ''The New York Times''. In 2008, Krugman was th ...
and
Robin Wells Robin Elizabeth Wells (born 1959) is an American economist. She is the co-author of several economics texts, mostly with her husband Paul Krugman. Life and career Wells received her BA from the University of Chicago and her PhD from the Universit ...
(2006). ''Economics'', New York, Worth Publishers.
The first known use of the term by economists was in 1958, Francis M. Bator (1958). "The Anatomy of Market Failure," ''Quarterly Journal of Economics'', 72(3) pp
351–379
(press +).
but the concept has been traced back to the Victorian philosopher
Henry Sidgwick Henry Sidgwick (; 31 May 1838 – 28 August 1900) was an English utilitarian In ethical philosophy, utilitarianism is a family of normative ethical theories that prescribe actions that maximize happiness and well-being for all affected i ...
.Steven G. Medema (2007). "The Hesitant Hand: Mill, Sidgwick, and the Evolution of the Theory of Market Failure," ''History of Political Economy'', 39(3),
p. 331
358. 200
Online Working Paper.
Market failures are often associated with
public goods In economics, a public good (also referred to as a social good or collective good)Oakland, W. H. (1987). Theory of public goods. In Handbook of public economics (Vol. 2, pp. 485-535). Elsevier. is a good that is both non-excludable and non-riv ...
, time-inconsistent preferences,
information asymmetries In contract theory and economics, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other. Information asymmetry creates an imbalance of power in transactions, which ca ...
, non-competitive markets, principal–agent problems, or
externalities In economics, an externality or external cost is an indirect cost or benefit to an uninvolved third party that arises as an effect of another party's (or parties') activity. Externalities can be considered as unpriced goods involved in either co ...
. J.J. Laffont (2008). "externalities," ''
The New Palgrave Dictionary of Economics ''The New Palgrave Dictionary of Economics'' (2018), 3rd ed., is a twenty-volume reference work on economics published by Palgrave Macmillan. It contains around 3,000 entries, including many classic essays from the original Inglis Palgrave Diction ...
'', 2nd Ed
Abstract.
/ref> The existence of a market failure is often the reason that
self-regulatory organization A self-regulatory organization (SRO) is an organization that exercises some degree of regulatory authority over an industry or profession. The regulatory authority could exist in place of government regulation, or applied in addition to governmen ...
s, governments or supra-national institutions intervene in a particular
market Market is a term used to describe concepts such as: *Market (economics), system in which parties engage in transactions according to supply and demand *Market economy *Marketplace, a physical marketplace or public market Geography *Märket, an ...
. Economists, especially microeconomists, are often concerned with the causes of market failure and possible means of correction. Such analysis plays an important role in many types of
public policy Public policy is an institutionalized proposal or a decided set of elements like laws, regulations, guidelines, and actions to solve or address relevant and real-world problems, guided by a conception and often implemented by programs. Public p ...
decisions and studies. However, government policy interventions, such as
tax A tax is a compulsory financial charge or some other type of levy imposed on a taxpayer (an individual or legal entity) by a governmental organization in order to fund government spending and various public expenditures (regional, local, or n ...
es,
subsidies A subsidy or government incentive is a form of financial aid or support extended to an economic sector (business, or individual) generally with the aim of promoting economic and social policy. Although commonly extended from the government, the ter ...
,
wage A wage is payment made by an employer to an employee for work done in a specific period of time. Some examples of wage payments include compensatory payments such as ''minimum wage'', '' prevailing wage'', and ''yearly bonuses,'' and remune ...
and price controls, and
regulation Regulation is the management of complex systems according to a set of rules and trends. In systems theory, these types of rules exist in various fields of biology and society, but the term has slightly different meanings according to context. Fo ...
s, may also lead to an inefficient allocation of resources, sometimes called
government failure Government failure, in the context of public economics, is an economic inefficiency caused by a government intervention, if the inefficiency would not exist in a true free market. The costs of the government intervention are greater than the bene ...
. 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 In religion, heterodoxy (from Ancient Greek: , "other, another, different" + , "popular belief") means "any opinions or doctrines at variance with an official or orthodox position". Under this definition, heterodoxy is similar to unorthodoxy, w ...
schools of thought disagree with this as a matter of ideology. An ''ecological'' market failure exists when human activity in a market economy is exhausting critical
non-renewable resource A non-renewable resource (also called a finite resource) is a natural resource that cannot be readily replaced by natural means at a pace quick enough to keep up with consumption. An example is carbon-based fossil fuels. The original organic mat ...
s, disrupting fragile ecosystems, or overloading biospheric waste absorption capacities. In none of these cases does the criterion of Pareto efficiency obtain. It is critical to create checks on human activities that cause societal negative externalities.


Categories

Different economists have different views about what events are the sources of market failure. Mainstream economic analysis widely accepts that a market failure (relative to
Pareto efficiency Pareto efficiency or Pareto optimality is a situation where no action or allocation is available that makes one individual better off without making another worse off. The concept is named after Vilfredo Pareto (1848–1923), Italian civil engi ...
) can occur for three main reasons: if the market is " monopolised" or a small group of businesses hold significant
market power In economics, market power refers to the ability of a firm to influence the price at which it sells a product or service by manipulating either the supply or demand of the product or service to increase economic profit. In other words, market powe ...
, if production of the good or service results in an externality (external costs or benefits), or if the good or service is a " public good"


Nature of the market

Agent Agent may refer to: Espionage, investigation, and law *, spies or intelligence officers * Law of agency, laws involving a person authorized to act on behalf of another ** Agent of record, a person with a contractual agreement with an insuranc ...
s in a market can gain
market power In economics, market power refers to the ability of a firm to influence the price at which it sells a product or service by manipulating either the supply or demand of the product or service to increase economic profit. In other words, market powe ...
, allowing them to block other mutually beneficial
gains from trade In economics, gains from trade are the net benefits to economic agents from being allowed an increase in voluntary trading with each other. In technical terms, they are the increase of consumer surplus plus producer surplus from lower tariffs ...
from occurring. This can lead to inefficiency due to
imperfect competition In economics, imperfect competition refers to a situation where the characteristics of an economic market do not fulfil all the necessary conditions of a perfectly competitive market. Imperfect competition will cause market inefficiency when it hap ...
, which can take many different forms, such as
monopolies A monopoly (from Greek el, μόνος, mónos, single, alone, label=none and el, πωλεῖν, pōleîn, to sell, label=none), as described by Irving Fisher, is a market with the "absence of competition", creating a situation where a speci ...
,
monopsonies In economics, a monopsony is a market structure in which a single buyer substantially controls the market as the major purchaser of goods and services offered by many would-be sellers. The Microeconomics, microeconomic theory of monopsony assumes ...
, or
monopolistic competition Monopolistic competition is a type of imperfect competition such that there are many producers competing against each other, but selling products that are differentiated from one another (e.g. by branding or quality) and hence are not perfec ...
, if the agent does not implement perfect price discrimination. 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 advantage In marketing strategy, first-mover advantage (FMA) is the competitive advantage gained by the initial ("first-moving") significant occupant of a market segment. First-mover advantage enables a company or firm to establish strong brand recognitio ...
s in the market that make it difficult for other firms to compete. Moreover, monopoly can be a result of geographical conditions created by huge distances or isolated locations. This leads to a situation where there are only few communities scattered across a vast territory with only one supplier. Australia is an example that meets this description. A
natural monopoly A natural monopoly is a monopoly in an industry in which high infrastructural costs and other barriers to entry relative to the size of the market give the largest supplier in an industry, often the first supplier in a market, an overwhelming adv ...
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. Natural monopolies display so-called increasing returns to scale. It means that at all possible outputs marginal cost needs to be below average cost if average cost is declining. One of the reasons is the existence of fixed costs, which must be paid without considering the amount of output, what results in a state where costs are evenly divided over more units leading to the reduction of cost per unit.


Nature of the goods


Non-excludability

Some markets can fail due to the nature of the goods being exchanged. For instance, some goods can display the attributes of
public goods In economics, a public good (also referred to as a social good or collective good)Oakland, W. H. (1987). Theory of public goods. In Handbook of public economics (Vol. 2, pp. 485-535). Elsevier. is a good that is both non-excludable and non-riv ...
or
common good In philosophy, economics, and political science, the common good (also commonwealth, general welfare, or public benefit) is either what is shared and beneficial for all or most members of a given community, or alternatively, what is achieved by c ...
s, wherein sellers are unable to exclude non-buyers from using a product, as in the development of inventions that may spread freely once revealed, such as developing a new method of harvesting. 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 Resource depletion is the consumption of a resource faster than it can be replenished. Natural resources are commonly divided between renewable resources and non-renewable resources (see also mineral resource classification). Use of either ...
in the case of
common-pool resource In economics, a common-pool resource (CPR) is a type of good consisting of a natural or human-made resource system (e.g. an irrigation system or fishing grounds), whose size or characteristics makes it costly, but not impossible, to exclude potenti ...
s, whereby the use of the resource is
rival A rivalry is the state of two people or groups engaging in a lasting competitive relationship. Rivalry is the "against each other" spirit between two competing sides. The relationship itself may also be called "a rivalry", and each participant o ...
but
non-excludable In economics, a good, service or resource are broadly assigned two fundamental characteristics; a degree of excludability and a degree of rivalry. Excludability is defined as the degree to which a good, service or resource can be limited to only p ...
, 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 the fish can reproduce, then the fish population will dwindle until there are no fish left for
future generations Future generations are cohorts of hypothetical people not yet born. Future generations are contrasted with current and past generations, and evoked in order to encourage thinking about intergenerational equity. The moral patienthood of future g ...
.


Externalities

A good or service could also have significant
externalities In economics, an externality or external cost is an indirect cost or benefit to an uninvolved third party that arises as an effect of another party's (or parties') activity. Externalities can be considered as unpriced goods involved in either co ...
, where gains or losses associated with the product, production or consumption of a product, differ from the private
cost In production, research, retail, and accounting, a cost is the value of money that has been used up to produce something or deliver a service, and hence is not available for use anymore. In business, the cost may be one of acquisition, in whic ...
. These gains or losses are imposed on a third-party that didn't take part in the original market transaction. These externalities can be innate to the methods of production or other conditions important to the market. “The Problem of Social Cost” illuminates a different path towards social optimum showing the Pigouvian tax is not the only way towards solving externalities. It is hard to say who discovered externalities first since many classical economists saw the importance of education or a lighthouse, but it was Alfred Marshall who wanted to explore this more. He wondered why long-run supply curve under perfect competition could be decreasing so he founded “external economies” (). Externalities can be positive or negative depending on how a good/service is produced or what the good/service provides to the public. Positive externalities tend to be goods like vaccines, schools, or advancement of technology. They usually provide the public with a positive gain. Negative externalities would be like noise or air pollution. Coase shows this with his example of the case Sturges v. Bridgman it pertained a confectioner and doctor. The confectioner had lived there many years and soon the doctor several years into residency decides to build a consulting room; it is right by the confectioner’s kitchen which releases vibrations from his grinding of pestle and mortar ( ). The doctor wins the case by a claim of nuisance so the confectioner would have to cease from using his machine. Coase argues there could have been bargains instead the confectioner could have paid the doctor to continue the source of income from using the machine hopefully it is more than what the Doctor is losing ( ). Vice versa the doctor could have paid the confectioner to cease production since he is prohibiting a source of income from the confectioner. Coase used a few more examples similar in scope dealing with social cost of an externality and the possible resolutions. 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 A complement is something that completes something else. Complement may refer specifically to: The arts * Complement (music), an interval that, when added to another, spans an octave ** Aggregate complementation, the separation of pitch-clas ...
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 In microeconomic theory, the opportunity cost of a particular activity is the value or benefit given up by engaging in that activity, relative to engaging in an alternative activity. More effective it means if you chose one activity (for exampl ...
on society through pollution (externality). Solutions for this include
public transport Public transport (also known as public transportation, public transit, mass transit, or simply transit) is a system of transport for passengers by group travel systems available for use by the general public unlike private transport, typi ...
ation,
congestion pricing Congestion pricing or congestion charges is a system of surcharging users of public goods that are subject to congestion through excess demand, such as through higher peak charges for use of bus services, electricity, metros, railways, tele ...
, tolls, and other ways of making the driver include the
social cost Social cost in neoclassical economics is the sum of the private costs resulting from a transaction and the costs imposed on the consumers as a consequence of being exposed to the transaction for which they are not compensated or charged. In other w ...
in the decision to drive. Perhaps the best example of the inefficiency associated with common/public goods and externalities is the environmental harm caused by
pollution Pollution is the introduction of contaminants into the natural environment that cause adverse change. Pollution can take the form of any substance (solid, liquid, or gas) or energy (such as radioactivity, heat, sound, or light). Pollutants, the ...
and overexploitation of
natural resource Natural resources are resources that are drawn from nature and used with few modifications. This includes the sources of valued characteristics such as commercial and industrial use, aesthetic value, scientific interest and cultural value. ...
s.


Nature of the exchange

Some markets can fail due to the nature of their exchange. Markets may have significant
transaction cost In economics and related disciplines, a transaction cost is a cost in making any economic trade when participating in a market. Oliver E. Williamson defines transaction costs as the costs of running an economic system of companies, and unlike pro ...
s, agency problems, or informational asymmetry. Such
incomplete markets In economics, incomplete markets are markets in which there does not exist an Arrow–Debreu security for every possible state of nature. In contrast with complete markets, this shortage of securities will likely restrict individuals from transferr ...
may result in economic inefficiency, but also have 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 Information is an abstract concept that refers to that which has the power to inform. At the most fundamental level information pertains to the interpretation of that which may be sensed. Any natural process that is not completely random ...
than the other is considered "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 In economics, insurance, and risk management, adverse selection is a market situation where buyers and sellers have different information. The result is that participants with key information might participate selectively in trades at the expe ...
and
moral hazard In economics, a moral hazard is a situation where an economic actor has an incentive to increase its exposure to risk because it does not bear the full costs of that risk. For example, when a corporation is insured, it may take on higher risk ...
. Most commonly, information asymmetries are studied in the context of principal–agent problems.
George Akerlof George Arthur Akerlof (born June 17, 1940) is an American economist and a university professor at the McCourt School of Public Policy at Georgetown University and Koshland Professor of Economics Emeritus at the University of California, Berkeley. ...
, Michael Spence, and
Joseph E. Stiglitz Joseph Eugene Stiglitz (; born February 9, 1943) is an American New Keynesian economist, a public policy analyst, and a full professor at Columbia University. He is a recipient of the Nobel Memorial Prize in Economic Sciences (2001) and the ...
developed the idea and shared the 2001 Nobel Prize in Economics.


Bounded rationality

In ''Models of Man'',
Herbert A. Simon Herbert Alexander Simon (June 15, 1916 – February 9, 2001) was an American political scientist, with a Ph.D. in political science, whose work also influenced the fields of computer science, economics, and cognitive psychology. His primary ...
points out that most people are only partly
rational Rationality is the quality of being guided by or based on reasons. In this regard, a person acts rationally if they have a good reason for what they do or a belief is rational if it is based on strong evidence. This quality can apply to an abi ...
, and are emotional/
irrational Irrationality is cognition, thinking, talking, or acting without inclusion of rationality. It is more specifically described as an action or opinion given through inadequate use of reason, or through emotional distress or cognitive deficiency. T ...
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 is an abstract concept that refers to that which has the power to inform. At the most fundamental level information pertains to the interpretation of that which may be sensed. Any natural process that is not completely random ...
" ( 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 As a topic of economics, utility is used to model worth or value. Its usage has evolved significantly over time. The term was introduced initially as a measure of pleasure or happiness as part of the theory of utilitarianism by moral philosoph ...
functions there might be. * recognizing the costs of gathering and processing information. * the possibility of having a "
vector Vector most often refers to: *Euclidean vector, a quantity with a magnitude and a direction *Vector (epidemiology), an agent that carries and transmits an infectious pathogen into another living organism Vector may also refer to: Mathematic ...
" or "multi-valued" utility function. Simon suggests that economic agents employ the use of
heuristics A heuristic (; ), or heuristic technique, is any approach to problem solving or self-discovery that employs a practical method that is not guaranteed to be optimal, perfect, or rational, but is nevertheless sufficient for reaching an immediate, ...
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 In law and economics, the Coase theorem () describes the economic efficiency of an economic allocation or outcome in the presence of externalities. The theorem states that if trade in an externality is possible and there are sufficiently low tra ...
, developed by
Ronald Coase Ronald Harry Coase (; 29 December 1910 – 2 September 2013) was a British economist and author. Coase received a bachelor of commerce degree (1932) and a PhD from the London School of Economics, where he was a member of the faculty until 1951. ...
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 "The Problem of Social Cost" (1960) by Ronald Coase, then a faculty member at the University of Virginia, is an article dealing with the economic problem of externalities. It draws from a number of English legal cases and statutes to illustrate Co ...
''. 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 The right to property, or the right to own property (cf. ownership) is often classified as a human right for natural persons regarding their possessions. A general recognition of a right to private property is found more rarely and is typically h ...
was a major determining factor in whether or not a market would fail. The Coase theorem points out when one would expect the market to function properly even when there are externalities.
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 goods and services 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 Institutional economics focuses on understanding the role of the Sociocultural evolution, evolutionary process and the role of institutions in shaping Economy, economic Human behavior, behavior. Its original focus lay in Thorstein Veblen's instin ...
. Nonetheless, views still differ on whether something displaying these attributes is meaningful without the information provided by the market price system.


Business cycles

Macroeconomic
business cycle Business cycles are intervals of expansion followed by recession in economic activity. These changes have implications for the welfare of the broad population as well as for private institutions. Typically business cycles are measured by examin ...
s are a part of the market. They are characterized by constant downswings and upswings which influence economic activity. Therefore, this situation requires some kind of government intervention.


Interpretations and policy examples

The above causes represent the
mainstream Mainstream may refer to: Film * ''Mainstream'' (film), a 2020 American film Literature * ''Mainstream'' (fanzine), a science fiction fanzine * Mainstream Publishing, a Scottish publisher * ''Mainstream'', a 1943 book by Hamilton Basso Mu ...
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 Pareto efficiency or Pareto optimality is a situation where no action or allocation is available that makes one individual better off without making another worse off. The concept is named after Vilfredo Pareto (1848–1923), Italian civil engi ...
, which can be in the "
public interest The public interest is "the welfare or well-being of the general public" and society. Overview Economist Lok Sang Ho in his ''Public Policy and the Public Interest'' argues that the public interest must be assessed impartially and, therefor ...
", as well as in interests of stakeholders with
equity Equity may refer to: Finance, accounting and ownership * Equity (finance), ownership of assets that have liabilities attached to them ** Stock, equity based on original contributions of cash or other value to a business ** Home equity, the dif ...
. This form of analysis has also been adopted by the
Keynesian Keynesian economics ( ; sometimes Keynesianism, named after British economist John Maynard Keynes) are the various macroeconomic theories and models of how aggregate demand (total spending in the economy) strongly influences economic output an ...
or
new Keynesian New Keynesian economics is a school of 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 macroec ...
schools in modern macroeconomics, applying it to Walrasian models of
general equilibrium In economics, general equilibrium theory attempts to explain the behavior of supply, demand, and prices in a whole economy with several or many interacting markets, by seeking to prove that the interaction of demand and supply will result in an ov ...
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 The New York Stock Exchange (NYSE, nicknamed "The Big Board") is an American stock exchange in the Financial District of Lower Manhattan in New York City. It is by far the world's largest stock exchange by market capitalization of its liste ...
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. A simple example of policies to address market power is government antitrust policies. As an additional 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 CITES (shorter name for the Convention on International Trade in Endangered Species of Wild Fauna and Flora, also known as the Washington Convention) is a multilateral treaty to protect endangered plants and animals from the threats of interna ...
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 A patent is a type of intellectual property that gives its owner the legal right to exclude others from making, using, or selling an invention for a limited period of time in exchange for publishing an enabling disclosure of the invention."A ...
system that creates artificial monopolies for successful inventions.


Objections


Public choice

Economists such as
Milton Friedman Milton Friedman (; July 31, 1912 – November 16, 2006) was an American economist and statistician who received the 1976 Nobel Memorial Prize in Economic Sciences for his research on consumption analysis, monetary history and theory and the ...
from the Chicago school and others from the
Public Choice Public choice, or public choice theory, is "the use of economic tools to deal with traditional problems of political science". Gordon Tullock, 9872008, "public choice," ''The New Palgrave Dictionary of Economics''. . Its content includes the s ...
school, argue that market failure does not necessarily imply that the government should attempt to solve market failures, because the costs of
government failure Government failure, in the context of public economics, is an economic inefficiency caused by a government intervention, if the inefficiency would not exist in a true free market. The costs of the government intervention are greater than the bene ...
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 The private sector is the part of the economy, sometimes referred to as the citizen sector, which is owned by private groups, usually as a means of establishment for profit or non profit, rather than being owned by the government. Employment The ...
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 Coercion () is compelling a party to act in an involuntary manner by the use of threats, including threats to use force against a party. It involves a set of forceful actions which violate the free will of an individual in order to induce a desi ...
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 ''Laissez-faire'' ( ; from french: laissez faire , ) is an economic system in which transactions between private groups of people are free from any form of economic interventionism (such as subsidies) deriving from special interest groups ...
''
capitalism Capitalism is an economic system based on the private ownership of the means of production and their operation for profit. Central characteristics of capitalism include capital accumulation, competitive markets, price system, priva ...
, including many economists of the
Austrian School The Austrian School is a heterodox school of economic thought that advocates strict adherence to methodological individualism, the concept that social phenomena result exclusively from the motivations and actions of individuals. Austrian schoo ...
, argue that there is no such phenomenon as "market failure".
Israel Kirzner Israel Meir Kirzner (also Yisroel Mayer Kirzner ; born February 13, 1930) is a British-born American economist closely identified with the Austrian School. Early life and education The son of a well-known rabbi and Talmudist, Kirzner was born i ...
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 or Pareto optimality is a situation where no action or allocation is available that makes one individual better off without making another worse off. The concept is named after Vilfredo Pareto (1848–1923), Italian civil engi ...
, and forms the basis of the theoretical argument against the existence of market failures. However, providing that the conditions of the
first welfare theorem There are two fundamental theorems of welfare economics. The first states that in economic equilibrium, a set of complete markets, with complete information, and in perfect competition, will be Pareto optimal (in the sense that no further exchang ...
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 is the creation or extraction of economic value. With this definition, entrepreneurship is viewed as change, generally entailing risk beyond what is normally encountered in starting a business, which may include other values t ...
driven by the profit motive; something the government has great difficulty detecting, or correcting.


Marxian

Objections also exist on more fundamental bases, such as 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 private 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.


Ecological

In ecological economics, the concept of
externalities In economics, an externality or external cost is an indirect cost or benefit to an uninvolved third party that arises as an effect of another party's (or parties') activity. Externalities can be considered as unpriced goods involved in either co ...
is considered a misnomer, since market agents are viewed as making their incomes and profits by systematically 'shifting' the social and ecological costs of their activities onto other agents, including future generations. Hence, externalities is a ''modus operandi'' of the market, not a failure: The market cannot exist without constantly 'failing'. The fair and even allocation of non-renewable resources over time is a market failure issue of concern to ecological economics. This issue is also known as 'intergenerational fairness'. It is argued that the
market mechanism In economics, the market mechanism is a mechanism by which the use of money exchanged by buyers and sellers with an open and understood system of value and time trade-offs in a market tends to optimize distribution of goods and services in at ...
fails when it comes to allocating the Earth's finite mineral stock fairly and evenly among present and future generations, as future generations are not, and cannot be, present on today's market. In effect, today's market prices do not, and cannot, reflect the preferences of the yet unborn. This is an instance of a market failure passed unrecognized by most mainstream economists, as the concept of
Pareto efficiency Pareto efficiency or Pareto optimality is a situation where no action or allocation is available that makes one individual better off without making another worse off. The concept is named after Vilfredo Pareto (1848–1923), Italian civil engi ...
is entirely static (timeless). Imposing government restrictions on the general level of activity in the economy may be the only way of bringing about a more fair and even intergenerational allocation of the mineral stock. Hence,
Nicholas Georgescu-Roegen Nicholas Georgescu-Roegen (born Nicolae Georgescu, 4 February 1906 – 30 October 1994) was a Romanian mathematician, statistician and economist. He is best known today for his 1971 ''The Entropy Law and the Economic Process'', in which he argu ...
and Herman Daly, the two leading theorists in the field, have both called for the imposition of such restrictions: Georgescu-Roegen has proposed a minimal bioeconomic program, and Daly has proposed a comprehensive steady-state economy. However, Georgescu-Roegen, Daly, and other economists in the field agree that on a finite Earth, geologic limits will inevitably strain most fairness in the longer run, regardless of any present government restrictions: ''Any'' rate of extraction and use of the finite stock of non-renewable mineral resources will diminish the remaining stock left over for future generations to use. Another ecological market failure is presented by the overutilisation of an otherwise renewable resource at a point in time, or within a short period of time. Such overutilisation usually occurs when the resource in question has poorly defined (or non-existing)
property rights The right to property, or the right to own property (cf. ownership) is often classified as a human right for natural persons regarding their possessions. A general recognition of a right to private property is found more rarely and is typically h ...
attached to it while too many market agents engage in activity simultaneously for the resource to be able to sustain it all. Examples range from over-fishing of fisheries and over-grazing of pastures to over-crowding of recreational areas in congested cities. This type of ecological market failure is generally known as the '
tragedy of the commons Tragedy (from the grc-gre, τραγῳδία, ''tragōidia'', ''tragōidia'') is a genre of drama based on human suffering and, mainly, the terrible or sorrowful events that befall a main character. Traditionally, the intention of tragedy i ...
'. In this type of market failure, the principle of Pareto efficiency is violated the utmost, as ''all'' agents in the market are left worse off, while nobody are benefitting. It has been argued that the best way to remedy a 'tragedy of the commons'-type of ecological market failure is to establish enforceable property rights politically – only, this may be easier said than done. The issue of
anthropogenic global warming In common usage, climate change describes global warming—the ongoing increase in global average temperature—and its effects on Earth's climate system. Climate change in a broader sense also includes previous long-term changes to E ...
presents an overwhelming example of a 'tragedy of the commons'-type of ecological market failure: The Earth's atmosphere may be regarded as a 'global common' exhibiting poorly defined (non-existing) property rights, and the waste absorption capacity of the atmosphere with regard to carbon dioxide is presently being heavily overloaded by a large volume of emissions from the world economy. Historically, the fossil fuel dependence of the
Industrial Revolution The Industrial Revolution was the transition to new manufacturing processes in Great Britain, continental Europe, and the United States, that occurred during the period from around 1760 to about 1820–1840. This transition included going f ...
has unintentionally thrown mankind out of ecological equilibrium with the rest of the Earth's biosphere (including the atmosphere), and the market has failed to correct the situation ever since. Quite the opposite: The unrestricted market has been exacerbating this global state of ecological ''dis''-equilibrium, and is expected to continue doing so well into the foreseeable future. This particular market failure may be remedied to some extent at the political level by the establishment of an international (or regional) cap and trade property rights system, where
carbon dioxide emission Greenhouse gas emissions from human activities strengthen the greenhouse effect, contributing to climate change. Most is carbon dioxide from burning fossil fuels: coal, oil, and natural gas. The largest emitters include coal in China and larg ...
permits are bought and sold among market agents. The term '
uneconomic growth Uneconomic growth is economic growth that reflects or creates a decline in the quality of life. The concept is used in human development theory, welfare theory, and ecological economics. It is usually attributed to ecological economist Her ...
' describes a pervasive ecological market failure: The ecological costs of further economic growth in a so-called 'full-world economy' like the present world economy may exceed the immediate social benefits derived from this growth.


Chang's criticism

Chang states that "it is (implicitly) assumed the state knows everything and can do everything.” Thus, this implies several assumptions about government in relation to market failures. There are three main statements. First of all, government representatives are able to evaluate the scope of market failures and to what extent it differs from efficient outcome. Secondly, having acquired the aforementioned knowledge they have capacity to re-establish market efficiency. Lastly, there has arisen an idea according to which decisions of policy-makers are not influenced by self-interest, but they are driven by altruism.


Lipsey and Lancaster's criticism

Lipsey and Lancaster came up with the theory of the so-called the “second best.” They refuse Chang's theory and state that is it not possible to restore
Pareto optimality Pareto efficiency or Pareto optimality is a situation where no action or allocation is available that makes one individual better off without making another worse off. The concept is named after Vilfredo Pareto (1848–1923), Italian civil engine ...
even if policy makers possess the sufficient knowledge, intervene efficiently and altruism serves as stimulus for their decisions. On the other hand, the “second best” theory holds that when market failure occurs in one branch of the economy, it should be feasible to increase social welfare in another branch of the economy by violating
Pareto efficiency Pareto efficiency or Pareto optimality is a situation where no action or allocation is available that makes one individual better off without making another worse off. The concept is named after Vilfredo Pareto (1848–1923), Italian civil engi ...
instead of restoring Pareto efficiency by government intervention.


Zerbe and McCurdy

Zerbe and McCurdy connected criticism of market failure paradigm to transaction costs. Market failure paradigm is defined as follows: "A fundamental problem with the concept of market failure, as economists occasionally recognize, is that it describes a situation that exists everywhere.” Transaction costs are part of each market exchange, although the price of transaction costs is not usually determined. They occur everywhere and are unpriced. Consequently, market failures and externalities can arise in the economy every time transaction costs arise. There is no place for government intervention. Instead, government should focus on the elimination of both transaction costs and costs of provision.


See also

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Contract failure Contract failure describes a situation in which the consumer of a good or service is unable to evaluate its quality, thus incentivizing the producer to produce a lower quality good or service. Such behavior creates suboptimal economic conditions. ...
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Distortion (economics) In signal processing, distortion is the alteration of the original shape (or other characteristic) of a signal. In communications and electronics it means the alteration of the waveform of an information-bearing signal, such as an audio signal ...
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Highest and best use Highest and Best Use, or highest or best use (HBU), is a concept that originated with early economists such as Irving Fisher (1867-1947), who conceptualized the idea of maximum productivity. One of the earliest citations of the term is found in th ...
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Public economics Public economics ''(or economics of the public sector)'' is the study of government policy through the lens of economic efficiency and equity. Public economics builds on the theory of welfare economics and is ultimately used as a tool to improve s ...
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Tyranny of small decisions The tyranny of small decisions is a phenomenon explored in an essay of the same name, published in 1966 by the American economist Alfred E. Kahn. The article describes a situation in which a number of decisions, individually small and insignifican ...
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Tragedy of the commons Tragedy (from the grc-gre, τραγῳδία, ''tragōidia'', ''tragōidia'') is a genre of drama based on human suffering and, mainly, the terrible or sorrowful events that befall a main character. Traditionally, the intention of tragedy i ...
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Tragedy of the anticommons The tragedy of the anticommons is a type of coordination breakdown, in which a commons does not emerge, even when general access to resources or infrastructure would be a social good. It is a mirror-image of the older concept of tragedy of the co ...


References


Further reading

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External links


Market Failures
– in Price Theory, an intermediate text by
David D. Friedman David Director Friedman (born February 12, 1945) is an American economist, physicist, legal scholar, and anarcho-capitalist theorist. Although he studied chemistry and physics and not law or economics, he is known for his textbook writings on m ...
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