Market failure

In neoclassical economics, market failure is when the way a free market shares goods and services does not work well, often causing a loss of economic value. The idea of market failure was first used by economists in 1958, but writers from the Victorian era, like John Stuart Mill and Henry Sidgwick, talked about similar concepts long before that.

Market failures happen for many reasons, such as when dealing with public goods, when people make choices that change over time, or when one person knows more than another in a trade. They can also happen when there is not enough competition, when people or companies act in ways that are not in their best interest, or when actions affect others without their permission.

While factories and refineries provide jobs and wages, they are also an example of a market failure, as they impose negative externalities on the surrounding region via their airborne pollutants.

Sometimes, when governments try to fix these problems by using taxes, subsidies, price controls, or regulations, they can create new problems called government failure. However, many economists think that in some cases, like with building codes, fire safety rules, or laws to protect endangered species, government steps can help make things better.

An ecological market failure happens when too many people use up things that cannot be replaced, harm nature, or put too much waste into the world. In all these cases, the market does not work in the best way possible.

Categories

In small countries like New Zealand, electricity transmission is a natural monopoly. Due to enormous fixed costs and small market size, one seller can serve the entire market at the downward-sloping section of its average cost curve, meaning that it will have lower average costs than any potential entrant.

Different economists think about what causes market failure in different ways. But many agree that markets can fail for several reasons. These include when a few businesses have too much control over a market, when making or using a product affects others in ways they didn’t agree to, when goods can’t be kept away from people who haven’t paid for them, when there isn’t enough information shared between buyers and sellers, when some people have more power in negotiations than others, and when the whole economy isn’t working well, like when there’s too much or too little money.

One type of market failure happens when a few companies control a market, making it hard for others to compete. Another type happens with goods that everyone can use, like clean air, which can run out if too many people use them. Sometimes, the way a product is made can hurt others, like pollution. These issues can make it hard for markets to work fairly and efficiently.

Interpretations and policy examples

Different groups of economists share similar ideas about what market failures are and why they matter. They use a concept called Pareto efficiency, which means that resources are used in the best possible way for everyone.

Governments often create rules to help prevent market failures. For example, the New York Stock Exchange has rules to make trading fair and orderly. People there think they all do better when everyone follows the rules, even if it means missing out on some extra money.

Another example is government policies to stop big companies from becoming too powerful. Cities also make building rules to make sure construction is safe, which helps prevent tragedies in the future. Countries work together through treaties like CITES to protect endangered animals, which benefits everyone.

Some solutions to market failures can sometimes create new problems. For instance, patents give inventors temporary exclusive rights to their inventions, which can lead to underinvestment in research.

Objections

Public choice

Economists like Milton Friedman from the Chicago school and others from the Public Choice school believe that market failure doesn’t always mean the government should step in. They think fixing market problems might cause even bigger problems because of how governments work. They say special groups can influence decisions, making things worse instead of better.

Austrian

Some supporters of laissez-faire capitalism, including many from the Austrian School, don’t agree with the idea of market failure. They say markets fix their own problems through people trying to make money. They think the government often can’t see or fix these problems well.

Marxian

Others, like Marxian analysis thinkers, see bigger issues with markets. They think private ownership itself causes unfairness and inefficiency. They believe resources should be shared based on what people need, not just on prices.

Ecological

In ecological economics, some think markets naturally shift costs to others, like future generations. They say markets can’t fairly share limited resources over time because future people can’t be part of today’s market. This leads to problems like using too many resources too fast, known as the 'tragedy of the commons'. For example, overfishing or pollution happens when too many people use a shared resource without rules. Some suggest setting rules to protect these resources.

Zerbe and McCurdy

Zerbe and McCurdy say market problems happen everywhere because of costs that aren’t priced, like the effort to make deals. They think instead of fixing market problems, governments should work on lowering these hidden costs.