Science Fair Project Encyclopedia
In economics, a market failure is a case in which a market fails to efficiently provide or allocate goods and services. On the other hand, to many, market failures are situations where market forces do not serve the perceived "public interest". Here, the focus is on the economists' theories of market failure.
Economists use model-like theorems to explain such cases. The two main reasons that markets fail are (1) sub-optimal market structures and (2) the lack of internalization of costs or benefits in prices and thus into microeconomic decision-making in markets.
External costs and benefits
Examples of latter include:
- public goods and common property resources
- undefined property rights
- asymmetrical information
- market power
Strategies to reduce these imperfections require alternative, non-market, institutions, such as the centralized government or state, tradition, and/or community democracy. These are often studied in the field of collective action. See also Coase theorem.
Examples of sub-optimal market structures include:
- imperfect competition
- downward sloping longrun average cost curve, i.e. natural monopoly
- price discrimination
As could be expected, the issue of market failures (and how they should be addressed) is a source of dispute between different schools of economic thought.
Note that all the types of failures listed above refer to situations where markets create inefficiency. This follows the lead of the currently-dominant school of academic economics, i.e., the neoclassical (orthodox) school. In this perspective, if a certain result is Pareto efficient, then it is not considered a market failure, regardless of whether or not it serves the "public interest", however that may be defined. Therefore, in this view, it is possible for a result to go against the public interest even if market failure is not involved. For example, many would consider the existence of gross inequalities in the distribution of wealth and income to be against the public interest, but this situation can be Pareto efficient, in that no one person could be made better off without making some other person worse off. Redistribution aimed at reducing the degree of inequality would be inefficient under the Pareto definition.
Put another way, consider the old saw that "he who pays the piper calls the tune". Market failure involves the piper not playing the tune that that payer calls for – or playing it in the wrong way or poorly. This phrase also suggests, accurately, that markets serve those with the most wealth and income best, and those without such purchasing power worst; the working of markets reflects the pre-existing distribution of wealth. In the neoclassical view, the issue of the inequality of distribution of income and wealth left over from history is completely separate from that of market failure, at least in static analysis.
On the other hand, in dynamic analysis, if the operations of markets normally lead to increasing inequality of wealth ownership over time, many neoclassicals would see it as a result of market failure, e.g., the ability of those with the most wealth to use their economic power to increase their wealth. This phenomenon could reflect a lack of competition in markets or others from the list of market failures above.
Keynesian / Neo-Keynesian School
Modern macroeconomics, especially that of the Keynesian or new Keynesian varieties, applies the neoclassical view to interpret the failure to automatically attain full employment of resources (as with Say's Law) in terms of theories of market failure. Once modified to take market failure into account, the standard Walrasian model of general equilibrium usually produces Keynesian results. For new Keynesians, the main stress in on the non-adjustment of prices and (especially) wages.
Austrian and Public Choice Schools
Many advocates of laissez-faire capitalism, such as libertarians and economists of the Austrian School, often deny the existence of market failures altogether, or see them as small, irrelevant, or temporary. For example, the problem of externalities is often played down by terming them mere "neighborhood effects ".
Economists of the Public Choice school often argue that market failure does not necessarily imply that government should attempt to solve market failures, because the costs of government failure might be worse than those of the market failure it attempts to fix. This failure of government is seen as the result of the inherent problems of democracy perceived by this school and also of the power of special-interest groups (rent seekers) both in the private sector and in the government bureaucracy.
To these schools, a market failure is usually a failure to have markets. Alternatively, they would say that results that some might call "market failures" cannot be such if those results are not intended to be avoided by the establishment of markets. Moreover, conditions that many would regard as negative are often seen as an effect of subversion of the free market by coercive government intervention.
While some would dub a high degree of centralization of the wealth distribution in a small number of hands a "market failure", the laissez faire response would be that goal at distributing wealth evenly was never the purpose of establishing markets in the first place. But critics of laissez faire would ask who it was who determined the purpose of using markets. For example, in many cases, "privatization", i.e., the replacement of government programs by ones organized following market principles, simply reflects the political influence of businesses that see potential profit gains from marketization (i.e., rent-seeking) and the ideology of powerful organizations such as the International Monetary Fund. Instead of a government program, which in theory reflects the democratically-expressed will of the people, the result is sometimes a privately owned monopoly allied with the political insiders, the kind of crony capitalism that most economists, including the laissez faire schools oppose.
New liberal schools
Others, such as social democrats and "New Deal liberals", view market failures as a very common problem of any unregulated market system, and therefore argue for extensive state intervention in the economy, in order to ensure both efficiency and social justice (usually interpreted in terms of limiting inequalities in wealth and income). Both the democratic accountability of these regulations and the technocratic expertise of the economists play an important role here in shaping the kind and degree of intervention.
A major argument against this view is that these liberals have too much faith in the benevolence of the government and/or in the ability of citizens to control their government democratically. As noted, advocates of laissez faire point to a large number of examples of government failure, where the government interference in markets made matters worse. The social democrats and New Deal liberals would riposte that we should seek the best combination of markets and government, in light of the failures of both. Of course, to most economists, markets could not exist without government enforcement of individual property rights and contracts, so that the idea of a totally free market system is ridiculous.
In the current era, we sometimes see professed New Deal liberal intentions merged with laissez-faire ideas to form neoliberalism. In this vein, some propose "market-oriented solutions" to market failure: for example, they propose going beyond the common idea of having the government charge a fee for the right to pollute (internalizing the external cost, creating a disincentive to pollute) to allow polluters to sell the pollution permit. Often companies in other industries are willing to buy such permits, so that the government created an artificial market for pollution rights.
In general, Marxists would argue that the system of individual property rights is a fundamental problem in itself, and that resources should be allocated in another way (usually democratically or assigned by a central planner or planning board held democratically responsible to the people). This is different from concepts of "market failure" which focuses on specific situations – typically seen as "abnormal" – where markets have inefficient outcomes. Marxists, in contrast, would say that all markets have inefficient and democratically-unwanted outcomes.
That is, the Marxist school of economics sees market failure as an inherent feature of any capitalist economy. However, although Marxists argue for the abolition of capitalism, they often do not raise the issue of market failure in their arguments (preferring to concentrate on other aspects instead). They do not see the "perfect market" (one without failures) as reasonable goal. Further, they see capitalist exploitation, class conflict, and economic crises as existing even with "perfect" markets. The issues of wealth inequality and increases in its degree (discussed above) moves to center stage, along with the associated inequalities of social power.
Even when they do discuss the issue of market failure, Marxists note that government leaders and those who benefit from market failures (polluters, monopolists, etc.) often form alliances, so that the government is not a neutral purveyor of technocratic solutions in the name of the people. In this view, market failure and government failure normally go together. Only popular pressure on both the government and the companies benefiting from market failure can lead to success in reducing market failures.
- Phillip Longman, Washington Monthly, January/February 2005, "The Best Care Anywhere"  Veterans' Health versus private healthcare
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