Market Failure

Definition of Market Failure This occurs when there is an inefficient allocation of resources in a free
market. Market failure can occur due to a variety of reasons, such as monopoly (higher prices and less
output), negative externalities (over-consumed) and public goods (usually not provided in a free market)

Types of market failure:

Positive externalities – Goods/services which give benefit to a third party, e.g. less congestion from
cycling

Negative externalities – Goods/services which impose cost on a third party, e.g. cancer from passive
smoking

Merit goods – People underestimate the benefit of good, e.g. education

Demerit goods – People underestimate the costs of good, e.g. smoking

Public Goods – Goods which are non-rival and non-excludable – e.g. police, national defence.

Monopoly Power – when a firm controls the market and can set higher prices.

Inequality – unfair distribution of resources in free market

Factor Immobility – E.g. geographical / occupational immobility

Agriculture – Agriculture is often subject to market failure – due to volatile prices and externalities.

Information failure – where there is a lack of information to make an informed choice.

Principal-agent problem – Two agents with different objectives and information asymmetries

Key Terms in Market Failure

Externalities: These occur when a third party is affected by the decisions and actions of others.

Social benefit: the total benefit to society =

Private Marginal Benefit (PMB) + External Marginal Benefit (XMB)

Social Cost: is the total cost to society =

Private Marginal Cost (PMC) + External Marginal Cost (XMC

 Social Efficiency: This occurs when resources are utilised in the most efficient way. This will occur at an
output where social marginal cost (SMC) = Social Marginal Benefit. (SMB)

Overcoming Market Failure

Tax on Negative Externalities – e.g. Petrol tax

Carbon Tax e.g. tax on CO2 emissions

Subsidy on positive externalities – why government may subsidies public transport

Laws and Regulations – Simple and effective ways to regulate demerit goods, like a ban on smoking
advertising.

Buffer stocks – aim to stabilise prices

Government failure – why government intervention may not always improve the situation

Market failure and behavioural economics

Behavioural economics examines how individuals often act in a non-rational manner – contrary to the
expectation of conventional economic models. These types of ‘irrational behaviour’ can lead to a type of
market failure where people make poor choices. For example.

Irrational exuberance – people getting carried away by good news leading to boom and bust.

Introduction

Definitions and Basics

Definition: Market failure, from Answers.com

An economic term that encompasses a situation where, in any given market, the
quantity of a product demanded by consumers does not equate to the quantity
supplied by suppliers. This is a direct result of a lack of certain economically ideal
factors, which prevents equilibrium....
Externalities, by Bryan Caplan, from the Concise Encyclopedia of Economics
Positive externalities are benefits that are infeasible to charge to provide; negative
externalities are costs that are infeasible to charge to not provide. Ordinarily, as
Adam Smith explained, selfishness leads markets to produce whatever people
want; to get rich, you have to sell what the public is eager to buy. Externalities
undermine the social benefits of individual selfishness. If selfish consumers do
 not have to pay producers for benefits, they will not pay; and if selfish producers
are not paid, they will not produce. A valuable product fails to appear. The
problem, as David Friedman aptly explains, "is not that one person pays for what
someone else gets but that nobody pays and nobody gets, even though the good is
worth more than it would cost to produce."...

Research and development is a standard example of a positive externality, air

pollution of a negative externality....
Public Goods and Externalities, by Tyler Cowen, from the Concise Encyclopedia of
Economics
Most economic arguments for government intervention are based on the idea that
the marketplace cannot provide public goods or handle externalities. Public
health and welfare programs, education, roads, research and development,
national and domestic security, and a clean environment all have been labeled
public goods....

Externalities occur when one person's actions affect another person's well-being
and the relevant costs and benefits are not reflected in market prices. A positive
externality arises when my neighbors benefit from my cleaning up my yard. If I
cannot charge them for these benefits, I will not clean the yard as often as they
would like. (Note that the free-rider problem and positive externalities are two
sides of the same coin.) A negative externality arises when one person's actions
harm another. When polluting, factory owners may not consider the costs that
pollution imposes on others....
Markets can fail if there are no property rights and negotiation is costly. The Coase
Theorem: Ronald H. Coase, biography from the Concise Encyclopedia of Economics
"The Problem of Social Cost," Coase's other widely cited article (661 citations
between 1966 and 1980), was even more path-breaking. Indeed, it gave rise to the
field called law and economics. Economists b.c. (Before Coase) of virtually all
political persuasions had accepted British economist Arthur Pigou's idea that if,
say, a cattle rancher's cows destroy his neighboring farmer's crops, the
government should stop the rancher from letting his cattle roam free or should at
least tax him for doing so. Otherwise, believed economists, the cattle would
continue to destroy crops because the rancher would have no incentive to stop
them.

But Coase challenged the accepted view. He pointed out that if the rancher had no
legal liability for destroying the farmer's crops, and if transaction costs were zero,
the farmer could come to a mutually beneficial agreement with the rancher under
which the farmer paid the rancher to cut back on his herd of cattle. This would
happen, argued Coase, if the damage from additional cattle exceeded the rancher's
net returns on these cattle. If for example, the rancher's net return on a steer was
two dollars, then the rancher would accept some amount over two dollars to give
up the additional steer. If the steer was doing three dollars' worth of harm to the
crops, then the farmer would be willing to pay the rancher up to three dollars to
get rid of the steer. A mutually beneficial bargain would be struck....
 Public Goods, by Tyler Cowen, from the Concise Encyclopedia of Economics
Public goods have two distinct aspects: nonexcludability and nonrivalrous
consumption. "Nonexcludability" means that the cost of keeping nonpayers from
enjoying the benefits of the good or service is prohibitive. If an entrepreneur
stages a fireworks show, for example, people can watch the show from their
windows or backyards. Because the entrepreneur cannot charge a fee for
consumption, the fireworks show may go unproduced, even if demand for the
show is strong....
Protectionism, by Jagdish Bhagwati, from the Concise Encyclopedia of Economics
Underlying both cases is the assumption that free markets determine prices and
that there are no market failures. But market failures can occur. A market failure
arises, for example, when polluters do not have to pay for the pollution they
produce. But such market failures or "distortions" can arise from governmental
action as well. Thus, governments may distort market prices by, for example,
subsidizing production, as European governments have done in aerospace, as
many other governments have done in electronics and steel, and as all wealthy
countries' governments do in agriculture. Or governments may protect intellectual
property inadequately, leading to underproduction of new knowledge; they may
also overprotect it. In such cases, production and trade, guided by distorted prices,
will not be efficient....
Market-clearing vs. sticky prices: New Keynesian Economics, by N. Gregory Mankiw,
from the Concise Encyclopedia of Economics
The primary disagreement between new classical and new Keynesian economists
is over how quickly wages and prices adjust. New classical economists build their
macroeconomic theories on the assumption that wages and prices are flexible.
They believe that prices "clear" markets—balance supply and demand—by
adjusting quickly. New Keynesian economists, however, believe that market-
clearing models cannot explain short-run economic fluctuations, and so they
advocate models with "sticky" wages and prices. New Keynesian theories rely
on this stickiness of wages and prices to explain why involuntary unemployment
exists and why monetary policy has such a strong influence on economic
activity....

In the News and Examples

Is defense a public good? Defense, from the Concise Encyclopedia of Economics

National defense is a public good. That means two things. First, consumption of
the good by one person does not reduce the amount available for others to
consume. Thus, all people in a nation must "consume" the same amount of
national defense (the defense policy established by the government). Second, the
benefits a person derives from a public good do not depend on how much that
person contributes toward providing it. Everyone benefits, perhaps in differing
amounts, from national defense, including those who do not pay taxes. Once the
 government organizes the resources for national defense, it necessarily defends all
residents against foreign aggressors....
Is education a public good? An Education in Market Failure, by Morgan Rose.
The most fundamental question raised by the school choice controversy is broader
than education itself. Before we can confront the subject of the state's role in
education, we first ought to address the proper role and justification for
government intervention in market activities in general....

One rationale that economists often use involves externalities and the problems
that markets can have in coping with them. It might be clearer to explain what
externalities are by first explaining why they sometimes cause problems for
markets...
Is the Occupy Wall Street movement about market failures, government failures, or both?
Makers vs. Takers at Occupy Wall Street, a LearnLiberty video at Youtube.
The Occupy Wall Street protests have popularized the distinction between the
lowest 99% and the highest 1% of income earners. Prof. Chris Coyne suggests
that a distinction between makers and the takers is a better way to understand the
problems that the protesters decry....
Cathy O'Neil on Wall St and Occupy Wall Street. EconTalk podcast.
Cathy O'Neil, data scientist and blogger at mathbabe.org, talks with EconTalk
host Russ Roberts about her journey from Wall Street to Occupy Wall Street. She
talks about her experiences on Wall Street that ultimately led her to join the
Occupy Wall Street movement. Along the way, the conversation includes a look
at the reliability of financial modeling, the role financial models played in the
crisis, and the potential for shame to limit dishonest behavior in the financial
sector and elsewhere.
Is smoking an example of a market failure? The Economics of Smoking, by Pierre
Lemieux
After the economists' analytical assault, the case for smoking regulations seemed
pretty thin in the early 1990s. Then, a new argument was proposed by World
Bank economist Howard Barnum. It relied on welfare economics, a field of
neoclassical economic theory designed to show that "market failures," created by
external costs or other types of "externalities" (phenomena that bypass the
market), prevent free markets from maximizing social welfare. The welfare-
economics argument against smoking has since been refined by other economists
working with the World Bank, and has provided the intellectual basis for the
Bank's 1999 report on the smoking "epidemic."...

The argument runs as follows. Smoking is not like other consumption choices,
and the economic presumption of market efficiency does not apply. This is
because, as the World Bank puts it, "many smokers are not fully aware of the high
probability of disease and premature death," and because of the addictive nature
of tobacco.
Global warming and market failure. The Economics of Climate Change, by Robert P.
Murphy
 If the physical science of manmade global warming is correct, then policymakers
are confronted with a massive negative externality. When firms or individuals
embark on activities that contribute to greater atmospheric concentrations of
greenhouse gases, they do not take into account the potentially large harms that
their actions impose on others. As Chief Economist of the World Bank Nicholas
Stern stated in his famous report, climate change is "the greatest example of
market failure we have ever seen."...
Monopoly and market failure. Monopoly, by George Stigler, from the Concise
Encyclopedia of Economics
A famous theorem in economics states that a competitive enterprise economy will
produce the largest possible income from a given stock of resources. No real
economy meets the exact conditions of the theorem, and all real economies will
fall short of the ideal economy--a difference called "market failure."...
Externalities, a LearnLiberty video.
Sean Mullholland explains pollution, a negative externality, and three possible
solutions: taxation, government regulation, and property rights.
The Failure of Market Failure. Part I. The Problem of Contract Enforcement, by Anthony
de Jasay
Received wisdom advances two broad reasons why government is entitled to
impose its will on its subjects, and why the subjects owe it obedience, provided its
will is exercised according to certain (constitutional) rules. One reason is rooted
in production, the other in distribution--the two aspects of social cooperation.
Ordinary market mechanisms produce and distribute the national income, but this
distribution is disliked by the majority of the subjects (notably because it is 'too
unequal') and it is for government to redistribute it (making it more equal or bend
it in other ways, a function that its partisans prefer to call 'doing social justice').
However, the market is said to be deficient even at the task of producing the
national income in the first place. Government is needed to overcome market
failure. A society of rational individuals would grasp this and readily mandate the
government to do what was needful (e.g. by taxation, regulation and policing) to
put this right....
The Failure of Market Failure. Part II. The Public Goods Dilemma, by Anthony de Jasay
Public goods are freely accessible to all members of a given public, each being
able to benefit from it without paying for it. The reason standard theory puts
forward for this anomaly is that public goods are by their technical character non-
excludable. There is no way to exclude a person from access to such a good if it is
produced at all. Examples cited include the defence of the realm, the rule of law,
clean air or traffic control. If all can have it without contributing to its cost,
nobody will contribute and the good will not be produced. This, in a nutshell, is
the public goods dilemma, a form of market failure which requires taxation to
overcome it. Its solution lies outside the economic calculus; it belongs to
politics....
Moral externalities and markets. Satz on Markets. EconTalk podcast.
Debra Satz, Professor of Philosophy at Stanford University, talks with EconTalk
host Russ Roberts about her book, Why Some Things Should Not Be For Sale:
 The Moral Limits of the Market. Satz argues that some markets are noxious and
should not be allowed to operate freely. Topics discussed include organ sales,
price spikes after natural disasters, the economic concept of efficiency and
utilitarianism. The conversation includes a discussion of the possible limits of
political intervention and whether it would be good to allow voters to sell their
votes....
Is price gouging justifiable? Munger on John Locke, Prices, and Hurricane Sandy.
EconTalk Podcast.
Mike Munger of Duke University talks with EconTalk host Russ Roberts about
the gas shortage following Hurricane Sandy and John Locke's view of the just
price. Drawing on a short, obscure essay of Locke's titled "Venditio," Munger
explores Locke's views on markets, prices, and morality.

A Little History: Primary Sources and References

John Maynard Keynes, biography from the Concise Encyclopedia of Economics

... Why shouldn't government, thought Keynes, fill the shoes of business by
investing in public works and hiring the unemployed? The General Theory
advocated deficit spending during economic downturns to maintain full
employment.
Coase on Externalities, the Firm, and the State of Economics. EconTalk Podcast, May
2012.
Nobel Laureate Ronald Coase of the University of Chicago talks with EconTalk
host Russ Roberts about his career, the current state of economics, and the
Chinese economy. Coase, born in 1910, reflects on his youth, his two great
papers, "The Nature of the Firm" and "The Problem of Social Cost". At the end of
conversation he discusses his new book on China, How China Became Capitalist
(co-authored with Ning Wang), and the future of the Chinese and world
economies.
Did Markets Fail in Post-Soviet Economies?, a LearnLiberty video.
Prof. Pavel Yakovlev argues that capitalism, to the extent that it has been tried,
has improved post-Soviet economies.

Advanced Resources

The Demand and Supply of Public Goods, by James M. Buchanan.

People are observed to demand and to supply certain goods and services through
market institutions. They are observed to demand and to supply other goods and
services through political institutions. The first are called private goods; the
second are called public goods....

Neoclassical economics provides a theory of the demand for and the supply of
private goods. But what does "theory" mean in this context? This question can
best be answered by examining the things that theory allows us to do. Explanation
 is the primary function of theory, here as everywhere else. For the private-goods
world, economic theory enables us to take up the familiar questions: What goods
and services shall be produced? How shall resources be organized to produce
them? How shall final goods and services be distributed? Note, however, that
theory here does not provide the basis for specific forecasts. Instead, it allows us
to develop an explanation of the structure of the system, the inherent logical
structure of the decision processes. With its help we understand and explain how
such decisions get made, not what particular pattern of outcome is specifically
chosen....
The Reason of Rules: Constitutional Political Economy, by Geoffrey Brennan and James
M. Buchanan.
Since we are ourselves professional economists, we have been particularly
mystified by the reluctance of our profession to adopt what we have called the
constitutional perspective. Economists in this century have been greatly
concerned with "market failure," which was the central focus of the theoretical
welfare economists that dominated economic thought during the middle decades
of the century. This market-failure emphasis extended to both micro- and macro-
levels of analysis. Scholars working at either of these levels showed no reluctance
in proffering advice to governments on detailed market correctives and
macroeconomic management. In retrospect, post-public choice, it seems strange
that these scholars so rarely showed a willingness to apply their analytic apparatus
to institutions other than the market; they paid almost no attention to politics and
political institutions. Once a policy recommendation seemed to have emerged
from their market-failure analytics, there was no subsequent analysis aimed at
proving that persons in their political roles, as either principals or agents, would
somehow behave as the economists' precepts dictated. Implicitly, economists
seemed locked into the presumption that political authority is vested in a group of
moral superpersons, whose behavior might be described by an appropriately
constrained social welfare function. Initial cursory attempts by a few public-
choice pioneers to inject a bit of practical realism into our models of individual
behavior in politics were subjected to charges of ideological bias. The myth of the
benign despot seems to have considerable staying power, a phenomenon that we
examine specifically in Chapter 3....

What is 'Market Failure'

Market failure describes any situation where the individual incentives for rational behavior do
not lead to rational outcomes for the group. Put another way, each individual makes the correct
decision for him/herself, but those prove to be the wrong decisions for the group. In traditional
microeconomics, this is shown as a steady state disequilibrium in which the quantity supplied
does not equal the quantity demanded.

BREAKING DOWN 'Market Failure'

A market failure occurs whenever the individuals in a group end up worse off than if they had
not acted in perfectly rational self-interest. Such a group either incurs too many costs or receives
too few benefits. Even though the concept seems simple, it can be misleading and easy to
misidentify.

Contrary to what the name implies, market failure does not describe inherent imperfections in the
market economy — there can be market failures in government activity, too. One noteworthy
example is rent seeking by special interest groups. Special interest groups can gain a large
benefit by lobbying for small costs on everyone else (such as through a tariff). When each small
group imposes its costs, the whole group is worse off than if no lobbying had taken place.

Additionally, not every bad outcome from market activity counts as a market failure. Nor does a
market failure imply that private market actors cannot solve the problem. On the flip side, not all
market failures have a potential solution, even with prudent regulation or extra public awareness.

Common Types of Market Failure

Commonly cited market failures include externalities, monopoly privileges, information
asymmetries and factor immobility. One easy-to-illustrate market failure is the “public good
problem.” Public goods are goods or services which, if produced, the producer cannot limit its
consumption to paying customers.

Public goods create market failures if some consumers decide to not pay but use the good
anyway. National Defense is one such public good because each citizen receives similar benefits
regardless of how much they pay. It is very difficult to privately produce the optimal amount of
national defense. Since governments cannot use a competitive price system to determine the
correct level of national defense, this may be a market failure with no pure solution.

Solutions to Market Failures

There are many potential solutions for market failures. Asymmetrical information is often solved
by intermediaries or ratings agencies — investors rely on Moody’s and Standard & Poor’s to
inform about securities risk; Underwriter’s Laboratories LLC performs the same task for
electronics. Negative externalities, such as pollution, are solved with tort lawsuits that increase
opportunity costs for the polluter. Tech companies that receive positive externalities from tech-
educated graduates can subsidize computer education through scholarships.

If businesses hire too few teenagers or immigrants after a minimum wage increase, the
government can create exceptions for younger or less-skilled workers. The 1978 Airline
Deregulation Act solved the underproduction of cheap air travel by allowing new price and
business competition. One popular public good, radio broadcasts, elegantly solved the non-
excludable problem by packaging periodic paid advertisements with the free broadcast.

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