Market failure is a term used by economists to describe the condition where the allocation of goods and services by a market is not efficient. The first known use of the term by economists was in 1958 [1], but the concept has been traced back to the Victorian philosopher Henry Sidgwick [2]. The belief that markets can fail is a common mainstream justification for government intervention in free markets[3] – however, not all economists believe that market failures occur, or that they are compelling arguments for government intervention, due to government failure[4]. Economists, especially macroeconomists, use many different models and theorems to analyze the causes of market failure, and possible means to correct such a failure when it occurs[5]. Such analysis plays an important role in many types of public policy decisions and studies.
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[edit] Causes of market failures
- See also: public goods, monopoly, monopsony, and oligopoly
In mainstream analysis, a market failure (relative to Pareto efficiency) can occur for three main reasons[6]. First, an agent in a market can gain market power, allowing them to block other mutually beneficial gains from trade from occurring. This can lead to inefficiency due to imperfect competition, which can take many different forms, such as monopolies, monopsonies, cartels, or monopolistic competition. Second, the actions of an agent can have "side effects" known as externalities, which are innate to the methods of production, or other conditions important to the market[6]. Finally, some markets can fail due to the nature of certain goods, or the nature of their exchange. For instance, goods can display the attributes of public goods or common-pool resources, while markets may have significant transaction costs, agency problems, or informational asymmetry[6]. In general, all of these situations can produce inefficiency, and a resulting market failure.
More fundamentally, the underlying cause of market failure is often a problem of property rights. As Hugh Gravelle and Ray Rees put it,
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[3].
As a result, an agent's control over the uses of their commodities can be imperfect, because the system of rights which defines that control is incomplete. Typically, this falls into two generalized rights – excludability and transferability. Excludability deals with the ability of an agent to control who uses their commodity, and for how long – and the related costs associated with doing so. Transferability reflects the right of an agent 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[3]. Considerations such as these form an important part of the work of institutional economics[7]. Nonetheless, views still differ on whether something is displaying these attributes is meaningful without the information provided by the market price system[8].
[edit] Interpretations and policy
The interpretation given above is the mainstream 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[4] – and specifically considers market failures absent considerations of the "public interest", or equity, citing definitional concerns[5]. This form of analysis has also been adopted by the Keynesian or new Keynesian schools in modern macroeconomics, applying it to Walrasian models of general equilibrium in order to deal with failures to attain full employment, or the non-adjustment of prices and wages.
Many social democrats and "New Deal liberals", have adopted this analysis for public policy, so they view market failures as a very common problem of any unregulated market system and therefore argue for extensive state intervention in the economy in order to ensure both efficiency and social justice (usually interpreted in terms of limiting avoidable inequalities in wealth and income). Both the democratic accountability of these regulations and the technocratic expertise of the economists play an important role here in shaping the kind and degree of intervention. Neoliberals follow a similar line, often focusing on "market-oriented solutions" to market failure: for example, they propose going beyond the common idea of having the government charge a fee for the right to pollute (internalizing the external cost, creating a disincentive to pollute) to allow polluters to sell the pollution permits.
[edit] Objections
- See also: government failure, Austrian school, and Marxian economics
Nonetheless, many heterodox schools disagree with the mainstream consensus. Advocates of laissez-faire capitalism, such as libertarians and economists of the Austrian School, argue that there is no such phenomena as "market failures," although the notions of market efficiency and perfect competition can be redefined as to include the analytical framework of the Austrian School (praxeology). Israel Kirzner states:
Efficiency for a social system means the efficiency with which it permits its individual members to achieve their individual goals[9].
The Austrian analysis focuses on the actions that individuals make, as to attain their goals or needs; inefficiency arises when means are chosen that are inconsistent with desired goals[10]. This definition of efficiency differs from that of Pareto efficiency, and forms the basis of the theoretical argument against the existence of market failures. However, providing that the conditions of the first welfare theorem are met, these two definitions agree, and give identical results.
The main objection that Austrians have against the concept of market failure is that it is a concept build on static equilibrium models that are conceived as approximations to reality, and these models are then compared to reality, and when reality differs from the results of an Pareto optimality model it is considered a market failure. However the Austrians argue that these equilibrium situations are only hypothetical constructs that don't exist in reality because of the incessant changes of the state of the market that makes impossible the establishment of equilibrium. In effect Austrians argue that the market always tends to eliminate its failures through the continuous market process of entrepreneur discovery that is brought by the profit motive, failures that the State cannot even determine, much less correct.
In addition, economists such as Milton Friedman, often from the Public Choice school, argue that market failure does not necessarily imply that government should attempt to solve market failures, because the costs of government failure might be worse than those of the market failure it attempts to fix. This failure of government is seen as the result of the inherent problems of democracy perceived by this school and also of the power of special-interest groups (rent seekers) both in the private sector and in the government bureaucracy. Conditions that many would regard as negative are often seen as an effect of subversion of the free market by coercive government intervention.
Finally, objections also exist on more fundamental bases, such as that of equity, or Marxian analysis. Colloquial uses of the term "market failure" reflect the notion of a market "failing" to provide some desired attribute different from efficiency – for instance, high levels of inequality can be considered a "market failure", yet are not Pareto inefficient, and so would not be considered a market failure by mainstream economics[6]. In addition, many Marxian economists would argue that the system of individual property rights is a fundamental problem in itself, and that resources should be allocated in another way entirely. This is different from concepts of "market failure" which focuses on specific situations – typically seen as "abnormal" – where markets have inefficient outcomes. Marxists, in contrast, would say that all 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 focus on what they believe to be more fundamental considerations such as class struggle or the process of commodification.
