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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 driven by the supply and demand In microeconomics, supply and demand is an economic model In econo ...
, market failure is a situation in which the allocation of
goods and services Goods are items that are usually (but not always) tangible According to the philosopher Piyush Mathur (2017), "''Tangibility is the property that a phenomenon exhibits if it has and/or transports mass and/or energy and/or momentum". Mathur, P ...
by a
free market In economics Economics () is a social science Social science is the branch A branch ( or , ) or tree branch (sometimes referred to in botany Botany, also called , plant biology or phytology, is the science of pl ...
is not
Pareto efficient Pareto efficiency or Pareto optimality is a situation where no individual or preference criterion can be better off without making at least one individual or preference criterion worse off or without any loss thereof. The concept is named after ...
, often leading to a net loss of
economic value In economics Economics () is a social science that studies the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods and services. Economics focuses on the beh ...
. 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 An economist is a professional and practitioner in the social science Social science is the branch The branches and leaves of a tree. A branch ( or , ) or ...
and
Robin Wells Robin Elizabeth Wells (born 1959) is an American economist. She is the co-author of several economics texts. Life and career Wells received her BA from the University of Chicago and her PhD from the University of California, Berkeley.Economics, 1 ...
(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
351–79
(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 Utilitarianism is a family of normative ethical theories that prescribe actions that maximize happiness and well-being Well-being, also known as ''wellness' ...

Henry Sidgwick
.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
58. 200
Online Working Paper.
/ref> Market failures are often associated with
public goods In economics Economics () is a social science Social science is the branch A branch ( or , ) or tree branch (sometimes referred to in botany Botany, also called , plant biology or phytology, is the science of pla ...
,
time-inconsistent preferences In economics, dynamic inconsistency or time inconsistency is a situation in which a decision-maker's preferences change over time in such a way that a preference can become inconsistent at another point in time. This can be thought of as there being ...
,
information asymmetries In contract theory In economics, contract theory studies how economic actors can and do construct contractual arrangements, generally in the presence of information asymmetry. Because of its connections with both agency (law), agency and incentives ...
, non-competitive markets,
principal–agent problem The principal–agent problem, in political science Political science is the scientific study of politics Politics (from , ) is the set of activities that are associated with making decisions In psychology, decision-making (also sp ...
s, or
externalities In economics Economics () is the social science that studies how people interact with value; in particular, the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods ...
. J.J. Laffont (2008). "externalities," ''
The New Palgrave Dictionary of Economics ''The New Palgrave Dictionary of Economics'' (2018), 3rd ed., is an twenty-volume reference work on economics Economics () is a social science that studies the Production (economics), production, distribution (economics), distribution, ...
'', 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 government ...
s, governments or supra-national institutions intervene in a particular
market Market may refer to: *Market (economics) *Market economy *Marketplace, a physical marketplace or public market Geography *Märket, an island shared by Finland and Sweden Art, entertainment, and media Films *Market (1965 film), ''Market'' (1965 ...
. 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 to solve relevant and real-world problems, guided by a conception and implemented by programs as a course of action created and/or enacted, typically by a government A government is th ...
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 In law Law is a system A system is a group of Interaction, interacting or interrelated elements that act accord ...
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 ...

subsidies
,
wage A wage is the distribution from an employer Employment is the relationship between two party (law), parties, usually based on a employment contract, contract where work is paid for, where one party, which may be a corporation, for profi ...
and
price controls Price controls are restrictions set in place and enforced by governments, on the prices that can be charged for goods and services in a market. The intent behind implementing such controls can stem from the desire to maintain affordability of goods ...
, and
regulation Regulation is the management of complex systems A complex system is a system A system is a group of interacting Interaction is a kind of action that occurs as two or more objects have an effect upon one another. The idea of a two-way e ...

regulation
s, may also lead to an inefficient allocation of resources, sometimes called
government failure Government failure, in the context of public economics Public economics (or economics of the public sector) is the study of government policy through the lens of economic efficiencyIn microeconomics, economic efficiency is, roughly speaking, a sit ...
. 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 Ancient Greek includes the forms of the Greek language Greek ( el, label=Modern Greek Modern Greek (, , or , ''Kiní Neoellinikí Glóssa''), generally referred to by speakers simply a ...
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 Natural resources are resource Resource refers to all the materials available in our environment which help us to satisfy our needs and wants. Resources can ...
s, disrupting fragile ecosystems, or biospheric waste absorption capacities. In none of these cases does the criterion of Pareto efficiency obtain.


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 individual or preference criterion can be better off without making at least one individual or preference criterion worse off or without any loss thereof. The concept is named after Vi ...
) can occur for three main reasons: if the market is " monopolised" or a small group of businesses hold significant
market power In economics Economics () is a social science Social science is the branch A branch ( or , ) or tree branch (sometimes referred to in botany Botany, also called , plant biology or phytology, is the science of plant ...
, if production of the good or service results in an
externality In economics Economics () is a social science Social science is the branch A branch ( or , ) or tree branch (sometimes referred to in botany Botany, also called , plant biology or phytology, is the science of plan ...

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 insuran ...
s in a market can gain
market power In economics Economics () is a social science Social science is the branch A branch ( or , ) or tree branch (sometimes referred to in botany Botany, also called , plant biology or phytology, is the science of plant ...
, allowing them to block other mutually beneficial
gains from tradeIn economics Economics () is the social science that studies how people interact with value; in particular, the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods and ...
from occurring. This can lead to inefficiency due to
imperfect competitionIn 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, resulting in market failure. The structure of a market can sign ...
, which can take many different forms, such as
monopolies A monopoly (from Greek#REDIRECT Greek Greek may refer to: Greece Anything of, from, or related to Greece Greece ( el, Ελλάδα, , ), officially the Hellenic Republic, is a country located in Southeast Europe. Its population is approxi ...

monopolies
, monopsonies, or
monopolistic competition Monopolistic competition is a type of imperfect competitionIn 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, ...
, 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 In theories of competition Competition arises whenever two or more parties strive for a common goal A goal is an idea of the future or desired result that a person or a group of people envision, Planning, plan and commit to achieve. Peop ...
" that prevent other companies from effectively entering and competing in an industry or market. Or there could exist significant
first-mover advantage In marketing strategyMarketing strategy is a process that can allow an organization to concentrate its limited resources on the greatest opportunities to increase sales and achieve a sustainable competitive advantage. Strategic planning involve ...
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 A monopoly (from Greek#REDIRECT Greek Greek may refer to: Greece Anything of, from, or related to Greece Greece ( el, Ελλάδα, , ), officially the Hellenic Republic, is a country located in Southea ...

natural monopoly
is a firm whose per-unit cost decreases as it increases output; in this situation it is most efficient (from a cost perspective) to have only a single producer of a good. Natural monopolies display so-called increasing returns to scale. It means that at all possible outputs
marginal cost In economics Economics () is a social science that studies the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods and services. Economics focuses on the behavio ...

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 Economics () is a social science Social science is the branch A branch ( or , ) or tree branch (sometimes referred to in botany Botany, also called , plant biology or phytology, is the science of pla ...
or
common good Common good Common good In philosophy Philosophy (from , ) is the study of general and fundamental questions, such as those about reason, Metaphysics, existence, Epistemology, knowledge, Ethics, values, Philosophy of mind, mind, and ...

common good
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 resource Natural resources are resource Resource refers to all the materials available in our environment which help us to satisfy our nee ...
in the case of
common-pool resourceIn economics Economics () is the social science that studies how people interact with value; in particular, the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods and ...
s, whereby the use of the resource is rival but non-excludable, there is no incentive for users to conserve the resource. An example of this is a lake with a natural supply of fish: if people catch the fish faster than the fish can reproduce, then the fish population will dwindle until there are no fish left for
future generations Future generations are the generations of people to come in the future, after the currently living generations of humans. The future generation is contrasted with current and past generations, and evoked in order to create thinking about interge ...
.


Externalities

A good or service could also have significant
externalities In economics Economics () is the social science that studies how people interact with value; in particular, the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods ...

externalities
, where gains or losses associated with the product, production or consumption of a product, differ from the private
cost In production Production may be: Economics and business * Production (economics) * Production, the act of manufacturing goods * Production, in the outline of industrial organization, the act of making products (goods and services) * Production ...

cost
. 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.
Traffic congestion Traffic congestion is a condition in transport that is characterised by slower speeds, longer trip times, and increased vehicular queueing Queue areas are places in which people queue ( first-come, first-served) for goods or services. Su ...

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 often something that completes something else, or at least adds to it in some useful way. Thus it may be: * Complement (linguistics), a word or phrase having a particular syntactic role ** Subject complement, a word or phrase addi ...
to cars (the more roads there are, the more useful cars become). Because there is very low cost but high benefit to individual drivers in using the roads, the roads become congested, decreasing their usefulness to society. Furthermore, driving can impose hidden costs on society through pollution (externality). Solutions for this include
public transport Public transport (also known as public transportation, public transit, mass transit, or simply transit) is a system of transport Transport (in British English), or transportation (in American English), is the Motion, movement of humans ...

public transport
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 In economics Economics () is a social science Social science is the branch ...
, tolls, and other ways of making the driver include the social cost 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 contaminant Contamination is the presence of a constituent, impurity, or some other undesirable element that spoils, corrupts, infects, makes unfit, or makes inferior a material, physical body, natural en ...

pollution
and
overexploitation Overexploitation, also called overharvesting, refers to harvesting a renewable resource File:Global Vegetation.jpg, Global vegetation A renewable resource, also known as a flow resource, is a natural resource which will replenish to replace th ...

overexploitation
of
natural resource Natural resources are resource Resource refers to all the materials available in our environment which help us to satisfy our needs and wants. Resources can broadly be classified upon their availability — they are classified into renewabl ...
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 (economics), market. Oliver E. Williamson defines transaction costs as the costs of running an economic system of companie ...
s, agency problems, or informational asymmetry. Such
incomplete markets In economics, incomplete markets are markets in which the number of Arrow–Debreu securities is less than the number of states of nature. In contrast with complete market In economics Economics () is the social science that studies how ...
may result in economic inefficiency, but also have a possibility of improving efficiency through market, legal, and regulatory remedies. From
contract theory In economics, contract theory studies how economic actors can and do construct contractual arrangements, generally in the presence of information asymmetry. Because of its connections with both agency (law), agency and incentives, contract theory ...
, decisions in transactions where one party has more or better
information Information is processed, organised and structured data Data (; ) are individual facts A fact is something that is truth, true. The usual test for a statement of fact is verifiability—that is whether it can be demonstrated to c ...

information
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 Economics () is a social science Social science is the branch A branch ( or , ) or tree branch (sometimes referred to in botany Botany, also called , plant biology or phytology, is the science of plant ...
and
moral hazard#REDIRECT Moral hazard In economics Economics () is the social science that studies how people interact with value; in particular, the Production (economics), production, distribution (economics), distribution, and Consumption (economi ...
. Most commonly, information asymmetries are studied in the context of
principal–agent problem The principal–agent problem, in political science Political science is the scientific study of politics Politics (from , ) is the set of activities that are associated with making decisions In psychology, decision-making (also sp ...
s.
George Akerlof George Arthur Akerlof (born June 17, 1940) is an American economist who is a university professor at the McCourt School of Public Policy at Georgetown University and Koshland Professor of Economics Emeritus at the University of California, Berkele ...

George Akerlof
,
Michael Spence Andrew Michael Spence (born November 7, 1943, Montclair, New Jersey Montclair () is a Township (New Jersey), township in Essex County, New Jersey, Essex County, New Jersey, United States. As of the 2010 United States Census, the township's po ...
, and developed the idea and shared the 2001 Nobel Prize in Economics.


Bounded rationality

In ''Models of Man'', Herbert A. Simon points out that most people are only partly
rational Rationality is the quality or state of being rational – that is, being based on or agreeable to reason Reason is the capacity of consciously making sense of things, applying logic Logic (from Ancient Greek, Greek: grc, wikt:λογι ...

rational
, 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. Th ...
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 processed, organised and structured data Data (; ) are individual facts A fact is something that is truth, true. The usual test for a statement of fact is verifiability—that is whether it can be demonstrated to c ...

information
" (, 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 Economics () is a social science Social science is the Branches of science, branch of science devoted to the study of society, societies and the Social relation, relationships among individuals within thos ...

utility
functions there might be. * recognizing the costs of gathering and processing information. * the possibility of having a "
vector Vector may refer to: Biology *Vector (epidemiology) In epidemiology Epidemiology is the study and analysis of the distribution (who, when, and where), patterns and risk factor, determinants of health and disease conditions in defined pop ...
" 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 Problem solving consists of using generic or ad hoc Ad hoc is a Latin phrase __NOTOC__ This is a list of Wikipedia articles of Latin phrases and their transla ...

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


Coase theorem

The
Coase theorem In law and economics, the Coase theorem () describes the Efficiency (economics), economic efficiency of an economic Economic system, allocation or outcome in the presence of externality, externalities. The theorem states that if trade in an extern ...
, developed by
Ronald Coase Ronald Harry Coase (; 29 December 1910 – 2 September 2013) was a British economist and author. He was the Clifton R. Musser Professor of Economics at the University of Chicago Law School, where he arrived in 1964 and remained for the rest of hi ...
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 Coas ...
''. 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 Ownership is the state or fact of exclusive right In Anglo-Saxon law Anglo-Saxon law (Old English Old English (, ), or Anglo-Saxon, is the earliest recorded form of the En ...
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 lease is a contract A contract is a legally binding document between at least two parties that defines and governs the rights and duties of the parties to an agreement. A contract is legally enforceable because it meets the requirements and ...
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 evolutionary Evolution is change in the Heredity, heritable Phenotypic trait, characteristics of biological populations over successive generations. These characteristics are ...
. 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 The business cycle, also known as the economic cycle or trade cycle, are the fluctuations of gross domestic product Gross domestic product (GDP) is a monetary Image:National-Debt-Gillray.jpeg, In a 1786 James Gillray caricature, the pl ...

business cycle
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 The mainstream is the prevalent current thought In their most common sense, the terms thought and thinking refer to conscious cognitive processes that can happen independently of sensory stimulation. Their most paradigmatic forms are judging, r ...
view of what market failures mean and of their importance in the economy. This analysis follows the lead of the
neoclassical Neoclassical or neo-classical may refer to: * Neoclassicism or New Classicism, any of a number of movements in the fine arts, literature, theatre, music, language, and architecture beginning in the 17th century ** Neoclassical architecture, an arc ...
school, and relies on the notion of
Pareto efficiency Pareto efficiency or Pareto optimality is a situation where no individual or preference criterion can be better off without making at least one individual or preference criterion worse off or without any loss thereof. The concept is named after Vi ...
, which can be in the "
public interest The public interest is "the welfare or well-being Well-being, also known as ''wellness'', ''prudential value'' or ''quality of life'', refers to what is intrinsically valuable relative ''to'' someone. So the well-being of a person is wha ...
", 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 differe ...
. This form of analysis has also been adopted by the Keynesian or
new Keynesian New Keynesian economics is a school of macroeconomics Macroeconomics (from the Greek prefix ''makro-'' meaning "large" + ''economics'') is a branch of economics Economics () is the social science that studies how people interact with va ...
schools in modern
macroeconomics Macroeconomics (from the Greek prefix ''makro-'' meaning "large" + ''economics'') is a branch of economics Economics () is a social science Social science is the branch A branch ( or , ) or tree branch (sometimes referred ...
, applying it to Walrasian models of
general equilibrium In economics Economics () is the social science that studies how people interact with value; in particular, the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods a ...
in order to deal with failures to attain
full employment Full employment is a situation in which there is no cyclical or deficient-demand unemployment. Full employment does not entail the disappearance of all unemployment, as other kinds of unemployment, namely structural A structure is an arrangement ...
, 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, Manhattan, Financial District of Lower Manhattan in New York City. It is by far the List of stock exchanges, world's largest s ...

NYSE
presumably believe that each member is individually better off if every member adheres to its rules – even if they have to forego money-making opportunities that would violate those rules. 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 A multilateral treaty is a treaty A treaty is a formal, leg ...

CITES
is an international treaty to protect the world's common interest in preserving endangered species – a classic "public good" – against the private interests of poachers, developers and other market participants who might otherwise reap monetary benefits without bearing the known and unknown costs that extinction could create. Even without knowing the true cost of extinction, the signatory countries believe that the societal costs far outweigh the possible private gains that they have agreed to forego. Some remedies for market failure can resemble other market failures. For example, the issue of systematic underinvestment in research is addressed by the
patent A patent is a type of intellectual property Intellectual property (IP) is a category of property Property is a system of rights that gives people legal control of valuable things, and also refers to the valuable things themselves. Depe ...

patent
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 An economist is a professional and practitioner in the social science Social science is the branch The branches and leaves of a tree. A branch ( ...

Milton Friedman
from the Chicago school and others from the
Public Choice Public choice, or public choice theory, is "the use of economic An economy (from Greek language, Greek οίκος – "household" and νέμoμαι – "manage") is an area of the Production (economics), production, Distribution (economics), ...
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 Public economics (or economics of the public sector) is the study of government policy through the lens of economic efficiencyIn microeconomics, economic efficiency is, roughly speaking, a sit ...
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 An economy (; ) is an area of the production Production may be: Economics and business * Production (economics) * Production, the act of manufacturing goods * Production, in the outline of indust ...
and in the government
bureaucracy The term bureaucracy () may refer both to a body of non-elected governing officials (bureaucrats A bureaucrat is a member of a bureaucracy and can compose the administration of any organization of any size, although the term usually connotes ...

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 use of threat A threat is a ''communicated'' intent to inflict harm or loss on another person. Intimidation is widely observed in animal behavior (particularly in a rituali ...
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 An economic system, or economic order, is a system A system is a group of interacting Interaction is a kind of action that occurs as two or more objects hav ...
''
capitalism Capitalism is an economic system An economic system, or economic order, is a system A system is a group of interacting Interaction is a kind of action that occurs as two or more objects have an effect upon one another. The idea o ...

capitalism
, including many economists of the
Austrian School The Austrian School is a heterodox In religion, heterodoxy (from Ancient Greek Ancient Greek includes the forms of the Greek language used in ancient Greece and the classical antiquity, ancient world from around 1500 BC to 300 BC. It ...
, 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 An economist is a practitioner in the social sciences, social science discipline of economics. The individual may also study, develo ...

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 Pareto efficiency or Pareto optimality is a situation where no individual or preference criterion can be better off without making at least one individual or preference criterion worse off or without any loss thereof. The concept is named after Vi ...
, 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 Welfare economics is a branch of economics that uses microeconomics, microeconomic techniques to evaluate well-being (welfare) at the aggregate (economy-wide) level. Attempting to apply th ...
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 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 than simply ...
driven by the
profit motive In economics Economics () is a social science Social science is the branch A branch ( or , ) or tree branch (sometimes referred to in botany Botany, also called , plant biology or phytology, is the science of plant ...
; 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
MarxianMarxian is a term generally used to refer to things related to Karl Marx other than Marxism. It can refer to: * Marxian economics * Marxist philosophy * Marxian class theory See also

* Marxism, which is usually referred to as "Marxist", rathe ...
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 Ecological economics, bioeconomics, ecolonomy, eco-economics, or ecol-econ is both a transdisciplinary Transdisciplinarity connotes a research strategy that crosses many disciplinary boundaries to create a holistic Holism (from Ancient Gre ...
, the concept of
externalities In economics Economics () is the social science that studies how people interact with value; in particular, the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods ...

externalities
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 Economics () is the social science that studies how people interact with value; in particular, the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods a ...
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 individual or preference criterion can be better off without making at least one individual or preference criterion worse off or without any loss thereof. The concept is named after Vi ...
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 Romanians, Romanian mathematician, statistician and economist. He is best known today for his 1971 Masterpiece, magnum opus ''The Entropy Law and the Ec ...
and
Herman Daly Herman Edward Daly (born July 21, 1938) is an American ecological Ecology (from el, οἶκος, "house" and el, -λογία, label=none, "study of") is the study of the relationships between living organisms, including humans, and their p ...
, 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 Ownership is the state or fact of exclusive right In Anglo-Saxon law Anglo-Saxon law (Old English Old English (, ), or Anglo-Saxon, is the earliest recorded form of the En ...
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 In economic science, the tragedy of the commons is a situation in which individual users, who have open access to a resource unhampered by shared social structures or formal rules that govern access and use, act independently according to their s ...
'. 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 Climate change includes both global warming driven by human emissions of greenhouse gas A greenhouse gas (sometimes abbreviated GHG) is a gas that Absorption (electromagnetic radiation), absorbs and Emission (electromagnetic radia ...
presents an overwhelming example of a 'tragedy of the commons'-type of ecological market failure: The Earth's
atmosphere An atmosphere (from the greek words ἀτμός ''(atmos)'', meaning 'vapour', and σφαῖρα ''(sphaira)'', meaning 'ball' or 'sphere') is a layer or a set of layers of gases surrounding a planet or other material body, that is held in ...
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 The world economy or the global economy is the economy An economy (; ) is an area of the production Production may be: Economics and business * Production (economics) * Production, the act of manufacturing goods * Production, in the outl ...
. Historically, the
fossil fuel A fossil fuel is a hydrocarbon In , a hydrocarbon is an consisting entirely of and . Hydrocarbons are examples of s. Hydrocarbons are generally colourless and hydrophobic with only weak odours. Because of their diverse molecular structure ...
dependence of the
Industrial Revolution The Industrial Revolution was the transition to new manufacturing processes in Great Britain, continental Europe Continental Europe or mainland Europe is the contiguous continent A continent is any of several large landmasse ...
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 are emissions of greenhouse gases A greenhouse gas (sometimes abbreviated GHG) is a gas that absorbs and emits radiant energy In physics Physics (from grc, φυσική (ἐπιστήμη), physikḗ ( ...
permits are bought and sold among market agents. The term '
uneconomic growth Uneconomic growth is economic growth Economic growth can be defined as the increase in the inflation-adjusted market value of the goods and services produced by an economics, economy over time. Statisticians conventionally measure such growt ...
' 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 individual or preference criterion can be better off without making at least one individual or preference criterion worse off or without any loss thereof. The concept is named after Vi ...
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 individual or preference criterion can be better off without making at least one individual or preference criterion worse off or without any loss thereof. The concept is named after Vi ...
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

*
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. ...
* Distortion (economics) * Government failure * Highest and best use * Public economics * Social cost * Tyranny of small decisions


References


External links


Market Failures
– in Price Theory, an intermediate text by David D. Friedman {{Authority control Market failure,