Market failure

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Market failure is a term used to describe a situation in which markets do not efficiently allocate goods and services. To economists, the term would normally be applied to situations where the inefficiency is particularly dramatic, or when it is suggested that non-market institutions (such as public policing and firefighting) would be more efficient and welfare-enhancing than market solutions.

On the other hand, the term "market failure" is also often used to describe situations where market forces do not serve the perceived public interest. In this article, however, the focus is on market failure as defined by mainstream economics. Economists use model-like theorems to explain or understand such cases. The two main reasons that markets fail are:

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

The existence of a market failure in any economic activity is often used as an argument that the activity in question should not be directed by market forces. This generally leads to a debate on the question of what - if anything - should be used to replace markets. The most common response to a market failure in the present day is to use the government to produce certain goods and services. However, government intervention may cause nonmarket failure by the intervention itself causing externalities. Economist Milton Friedman argued that the safest thing to do is to not intervene, saying that inefficiencies resolve themselves if given the opportunity, and that intervention is extremely difficult to reverse. His position was that intervention to correct market failures leads to unforseen negative consequences that are usually worse than the problem they were intended to correct.

Contents 1 Types of Market Failures 2 Public goods 3 Interpretations 3.1 Neoclassical School 3.2 Keynesian/Neo-Keynesian School 3.3 Austrian and Public Choice Schools 3.4 New liberal schools 3.5 Marxist School 4 References 5 See also 6 External links

[edit] Types of Market Failures

• Imperfect competition / Market power
  • Monopoly*
  • Monopsony
  • Oligopoly
  • Cartel
  • Oligopsony
  • Monopolistic competition
  • Price discrimination
  • Price skimming

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

• Externality
  • Inadequate expression of costs or benefits in prices and economic decision-making
  • Pure Public goods (nonrivalrous & nonexcludable) --> Free Riders, Underprovision
  • Common-pool resource (rivalrous & nonexcludable) --> Tragedy of the Commons, Free Riders, Overuse

• Transaction cost
  • Search, Measurement, Inventory, and Decision Making Costs
  • Bargaining and Communication Costs
  • Market Regulation, Policing, Property Rights & Contract Enforcement, and Litigation Costs
  • Constrained choice sets (consumption choices are non-continuous)

• Imperfect Information / Information asymmetry
  • Incomplete markets
  • Adverse selection - people who are high risk are more likely to buy insurance
  • Moral hazard - behave recklessly if insured
  • Quality uncertainty - see also The Market for Lemons

• Organizational Failures
  • Principal-agent problem & Split Incentives Problem
  • Force of Habit Rules
  • Lack of Organizational learning

[edit] Public goods

Main article: public goods

It is necessary to understand this key term:

• public good: a good (or service, so more accurately "a product") for which the benefits of its consumption cannot easily be restricted, say to those who pay for it. National defense is a common example. Public goods have the characteristics of non-rivalry and non-excludability. Non-rivalry means that one person's benefit does not reduce the benefit available to others, and non-excludability means that there is no effective way of excluding individuals from the benefit of the good, once it comes into existence (thereby creating the free-rider problem). A public good whose consumption entails a free-rider problem is unlikely to be sufficiently profitable for a private firm to produce. Examples of public goods that are claimed must be provided by the state because of non-excludability include national defense, street lighting, and environmental regulations. A private lighthouse would be an example of a public good that is produced even though its use is non-excludable.

In terms of market failure, non-rivalry and non-excludability means that profit-seeking firms may not find it worthwhile to produce public goods. Therefore provision would have to be undertaken by the government (although the government could pay a private firm to produce a public good). However, views differ on which public goods, if any, should be provided by government and funded by taxation. There are also those that question whether it can be determined whether something is actually a public good without the information provided by the market price system.^[1]

A nonrivalrous public good is one where the ability to consume a good or service is not decreased by other people consuming it. An example of a nonrivalrous public good would be a movie at a theater. If a theater has vacant seats that would have been filled if ticket prices were lower, this may be seen as market failure.^[2] Others could be let in and those who paid would still be able to watch the movie. This may be seen as an inefficient distribution of resources, which may be seen as justifying state-operated movie theaters or subsidies to theaters in order to keep prices low in order to more efficiently provide what is believed to be in the public interest. However like all perceived market failures, what is seen as market failure by one may not be market failure to another because whether resources are distributed efficiently depends on prior conceptions on what the distribution should be.

[edit] Interpretations

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

[edit] Neoclassical School

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

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

[edit] 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.

[edit] Austrian and Public Choice Schools

Many advocates of laissez-faire capitalism, such as libertarians and economists of the Austrian School, argue that there is no such concept as "market failure," 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.[3]

”

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.^[4]

Economists of the Public Choice school often argue that market failure does not necessarily imply that government should attempt to solve market failures, because the costs of government failure might be worse than those of the market failure it attempts to fix. This failure of government is seen as the result of the inherent problems of democracy perceived by this school and also of the power of special-interest groups (rent seekers) both in the private sector and in the government bureaucracy.

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

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

[edit] New liberal schools

Main article: Social liberalism

Others, such as social democrats and "New Deal liberals", view market failures as a very common problem of any unregulated market system, and therefore argue for extensive state intervention in the economy, in order to ensure both efficiency and social justice (usually interpreted in terms of limiting inequalities in wealth and income). Both the democratic accountability of these regulations and the technocratic expertise of the economists play an important role here in shaping the kind and degree of intervention.

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

In the current era, we sometimes see professed New Deal liberal intentions merged with laissez-faire ideas to form neoliberalism. In this vein, some propose "market-oriented solutions" to market failure: for example, they propose going beyond the common idea of having the government charge a fee for the right to pollute (internalizing the external cost, creating a disincentive to pollute) to allow polluters to sell the pollution permit. Often companies in other industries are willing to buy such permits, so that the government created an artificial market for pollution rights.

[edit] Marxist School

In general, Marxists would argue that the system of individual property rights is a fundamental problem in itself, and that resources should be allocated in another way (usually democratically or assigned by a central planner or planning board held democratically responsible to the people). This is different from concepts of "market failure" which focuses on specific situations – typically seen as "abnormal" – where markets have inefficient outcomes. Marxists, in contrast, would say that all markets have inefficient and democratically-unwanted outcomes.

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

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

[edit] References

1. ^ Machan, R. Tibor, Some Skeptical Reflections on Research and Development, Hoover Press
2. ^ Cowen, Tyler, Public Goods and Market Failures, Transaction Publishers 1992, p. 4
3. ^ Israel Kirzner (1963). Market Theory and the Price System. Princeton. N.J.: D. Van Nostrand Company, 35. 
4. ^ Roy E. Cordato (1980). "The Austrian Theory of Efficiency and the Role of Government". The Journal of Libertarian Studies 4 (4): 393-403. 

[edit] See also

• Externality
• Government failure
• Microeconomics
• Nonmarket failure
• Social cost
• Tragedy of the anticommons

[edit] External links

• Phillip Longman, Washington Monthly, January/February 2005, "The Best Care Anywhere" [1] Veterans' Health versus private healthcare
• Folvary, Fred E. and Klein B. Klein, The Half-Life of Policy Rationales How New Technology Affects Old Policy Issues Argues that "Applications of market-failure theory may be found to have a technological "half life," after which their validity dissolves"

Topics in microeconomics
Scarcity • Opportunity cost • Supply and demand • Elasticity • Economic surplus • Economic shortage • Aggregation of individual demand to total, or market, demand • Consumer theory • Production, costs, and pricing • Market form • Welfare economics • Market failure