Market failure

Market failure is the inability of an economy or market to allocate its resources efficiently. Market failures can occur due to externalities, market power (such as monopolies or monopsonies), asymmetric information, or common-pool resources/public goods. Outcomes in a market that are Pareto efficient can still be considered market failures if total welfare is not maximized. It is almost universally agreed that there are cases where government intervention can improve or correct market failures. However, there is much debate by economists over when, how, and to what extent governments should intervene. Nobel Prize winning economist Joseph Stiglitz has noted that government intervention in markets achieves outcomes that are best aligned with public interests when the government processes are "open, transparent, [and] democratic." Non-governmental solutions to market failures also exist.

Causes of Market Failure

Externalities

An externality is an economic side-effect - the effects of an economic activity on others, which are not captured in the price of the activity.

A widely used example of an externality is pollution: pollution is an unavoidable byproduct in many industries, and in the absence of regulation, most polluting firms will do little, if anything, to control their pollution, because abating pollution often incurs costs and reduces profits. But pollution can have detrimental effects on local, regional, and even world populations and ecosystems, so the cost to society of pollution is usually nontrivial and this societal cost is not something that the firm pays. Pollution is an example of a negative externality, but there are also positive externalities. An example of a positive externality is when a homeowner invests time and money to beautify his or her yard to increase the property value; the values of neighboring properties will increase because the neighborhood is a nicer place to live.

When a government decides to intervene to correct an externality (known as "internalizing" the externality), it has a number of options. One option is to clearly define property rights, as described in the Coase theorem. Alternatively, behaviors that cause negative externalities are often taxed while behaviors that cause positive externalities are often subsidized. Even though these methods can be sound economic policy, they can be controversial. Other solutions, each with their own pros and cons, include a cap-and-trade system (e.g. the one implemented in the U.S. to control sulfur dioxide pollution), government provision (e.g. public school), and oughtright criminilization of an activity.

Market Power

When an economic agent in a market has market power as the result of an imperfectly competitive market, a market failure can occur. Monopolies (one seller of a good or service) and oligopolies (few sellers) can take advantage of their control of finite resources or other barriers to entry in a market in order to charge prices that are much higher than the cost of production. This puts consumers at a disadvantage. On the other hand, monopsonies (one buyer of a good or service) and oligopsonies (few buyers) can take advantage of their situation by playing sellers off each other to artificially drive down prices and make demands that increase suppliers' costs.

Monopsonies and oligopsonies are not often given much attention by regulators, but most countries, including the U.S., have strong antitrust laws to prevent monopolies. It is a consensus among economists that unregulated natural monopolies can have negative effects on a market, however economist Milton Friedman has argued that laws against monopolies do more harm than good and these problems can be better solved with free trade.

Asymmetric Information

Asymmetric information is where one party in a transaction has more complete or more accurate information than another party. This is significant because an important assumption of competitive free market theory is often that all who participate in the market have perfect information about everything affecting their decisions. Classic examples of asymmetric information include the used car market, where sellers often have better information about the quality of the car than buyers, and the health insurance industry, where buyers of insurance have better information about their health and their risk factors than insurance companies do. Proponents of health care reform point to this type of market failure as an important underlying cause for rising insurance costs that needs to be addressed.

Common-pool Resources and Public Goods

Common-pool resources and public goods are both non-excludable, meaning that people using them cannot prevent others from using them. Using a public good does not reduce its availability for consumption by others, but common-pool resources can be depleted and/or overcrowded.

The free rider problem, where someone benefits without paying, is common with public goods. Because this can lead to underproduction/underdevelopment of public goods (and services), the government often provides such goods or services (e.g. national defense, public parks, the internet). Economist Ronald Coase has argued that some public goods can be effectively privatized.

The tragedy of the commons can be the result of a common-pool resource being exploited by many parties acting in their own self-interest. Privatization of a common-pool resource - with singular ownership - can eliminate the likelihood that a resource will be overexploited (exploited at a rate that does not maximize total benefits) or depleted, but there are often significant logistical issues with this. Political scientist Elinor Ostrom has developed design principles for common-pool resource management, which include clearly defined boundaries and rules regarding appropriation and revision of resources, effective monitoring, and sanctions for violators. These principles can be used by governments or by a group of interested parties creating a community organization.