Market failure

From CEOpedia

Market failure is a situation in which the allocation of goods and services by a free market is not Pareto efficient, leading to a net loss of economic value due to externalities, public goods, information asymmetry, or market power (Stiglitz J.E. 2000, p.77)[1]. The factory pollutes the river, imposing costs on downstream fishermen that its prices don't reflect. The lighthouse guides all ships, whether they paid for it or not. The used car seller knows about the engine problems; the buyer doesn't. In each case, markets alone fail to achieve efficient outcomes.

Market failure provides the economic rationale for government intervention. Without some correction mechanism, too much pollution gets produced, too few public goods get supplied, and information imbalances distort transactions. Arthur Pigou formalized much of this thinking in his 1920 Economics of Welfare, and the concept remains central to policy debates about regulation, taxation, and public provision.

Types of market failure

Several distinct mechanisms cause markets to fail:

Externalities

Third-party effects. Externalities occur when transactions affect parties not directly involved—and these effects aren't reflected in prices[2].

Negative externalities. Pollution is the textbook example. A factory's emissions impose health and environmental costs on nearby residents. Since the factory doesn't pay these costs, it produces more than the socially optimal amount. Other examples: traffic congestion, noise, secondhand smoke.

Positive externalities. Education benefits not just the student but society through higher productivity, lower crime, and better civic participation. Vaccination protects not just the vaccinated individual but those around them. Because these benefits aren't captured by producers or consumers, too little gets produced.

Market outcome. With negative externalities, markets overproduce. With positive externalities, markets underproduce. Either way, the outcome is inefficient[3].

Public goods

Non-excludable. Once provided, public goods are available to everyone—you can't exclude non-payers. National defense protects all citizens whether they paid taxes or not.

Non-rival. One person's consumption doesn't reduce availability for others. The lighthouse beam guides my ship without diminishing its usefulness to yours.

Free rider problem. If people can enjoy benefits without paying, they won't pay voluntarily. Private markets therefore undersupply public goods—or don't provide them at all.

Examples. Clean air, street lighting, basic research, public parks. Each exhibits non-excludability and non-rivalry to varying degrees[4].

Information asymmetry

Unequal knowledge. When one party knows more than another, markets can break down. The seller knows the car's history; the buyer doesn't.

Adverse selection. In insurance markets, those most likely to need coverage are most eager to buy it. If insurers can't distinguish high-risk from low-risk customers, they price for average risk—driving low-risk customers away and raising average risk further. George Akerlof's "market for lemons" paper (1970) formalized this dynamic.

Moral hazard. Once insured, people may take more risks. The insured driver may be less careful. The bank backed by government guarantees may take excessive risks[5].

Market power

Imperfect competition. When firms have pricing power—monopolies, oligopolies, or monopolistic competitors—they restrict output below competitive levels and charge prices above marginal cost.

Deadweight loss. The gap between what would be produced under competition and what's actually produced represents lost value—transactions that would benefit both buyers and sellers don't occur.

Barriers to entry. Patents, economies of scale, network effects, and regulatory barriers can sustain market power over time.

Solutions to market failure

Various interventions address market failures:

Pigovian taxes and subsidies

Taxing negative externalities. Arthur Pigou proposed taxing activities that generate negative externalities by an amount equal to the external cost. A carbon tax makes polluters face the full social cost of emissions[6].

Subsidizing positive externalities. Education subsidies, research grants, and vaccination programs encourage activities with positive externalities.

Price correction. The idea is to adjust prices to reflect true social costs and benefits, letting corrected markets achieve efficient outcomes.

Regulation

Command and control. Direct regulation mandates or prohibits behaviors—emission standards, safety requirements, disclosure rules.

Quantity limits. Cap-and-trade systems limit total pollution while allowing trading of permits.

Information requirements. Mandatory disclosure addresses information asymmetry—nutritional labels, financial reporting, product safety information.

Public provision

Government supply. For pure public goods, government provision may be necessary. National defense, basic research, and public health infrastructure are typically provided publicly.

Government production. Sometimes government produces services directly (public schools). Other times it finances private provision (Medicare, housing vouchers).

Property rights

Coase theorem. Ronald Coase argued that if property rights are well-defined and transaction costs are low, private bargaining can resolve externalities without government intervention. The polluter and victims can negotiate an efficient outcome[7].

Limitations. In practice, transaction costs are often high, especially with many affected parties. Property rights solutions work better for localized problems.

Criticisms and complications

Market failure analysis has limitations:

Government failure. Government interventions can fail too—through capture by special interests, bureaucratic inefficiency, or unintended consequences. The cure may be worse than the disease.

Measurement difficulties. Quantifying external costs, optimal public goods provision, or information gaps is challenging. Policies based on imprecise estimates may miss the mark[8].

Dynamic effects. Static efficiency analysis may miss dynamic considerations. Monopoly profits might fund innovation. Regulations might stifle entrepreneurship.

Political economy. Once government intervenes, political forces shape outcomes. Concentrated interests (polluters, regulated industries) may influence policy more than diffuse interests (consumers, taxpayers).


Market failure — recommended articles
Microeconomics — Public policy — Externalities — Public goods

References

Footnotes

  1. ↑ Stiglitz J.E. (2000), Economics of the Public Sector, p.77
  2. ↑ Pigou A.C. (1920), Economics of Welfare, pp.134-156
  3. ↑ Stiglitz J.E. (2000), Economics of the Public Sector, pp.89-102
  4. ↑ Coase R.H. (1960), Problem of Social Cost, pp.12-24
  5. ↑ Akerlof G.A. (1970), Market for Lemons, pp.489-495
  6. ↑ Pigou A.C. (1920), Economics of Welfare, pp.178-192
  7. ↑ Coase R.H. (1960), Problem of Social Cost, pp.34-42
  8. ↑ Stiglitz J.E. (2000), Economics of the Public Sector, pp.145-167

Author: Sławomir Wawak

Retrieved from "https://ceopedia.org/index.php?title=Market_failure&oldid=6636"