Market Failure

The result of the failure of markets to achieve efficiency. Failure is normally the result of too much confidence in the free operation of the market (market fundamentalism), an exceptional reliance on the theory that the market is capable of correcting itself. This view was predominant during the 18th century and part of the 20th century, until the Great Depression of the 1930s challenged the presumption of the classical view of the free market.

Markets may be inefficient for a variety of distortionary reasons—a conspiracy or collusion to restrain trade, corruption, deception, adverse income distribution, ill-defined property rights, and externalities (which are the result of overallocation and underallocation of resources). When a market cannot function on its own accord, policy intervention may be required to aid its optimal performance. This is usually done by regulation, and fiscal and monetary policies.

To address the issue of market failure, governments have regulated wages, rental rates for housing, interest rates (by usury laws), environmental pollution, unemployment benefits, product quality, and business performance.

Unfortunately, there is no guarantee that policy intervention will have the desired effects when time sensitive adjustments are required, as in the case of the business cycle. Lags associated with untimely implementation (inside lags) and the unintended effects of timely implementation (outside lags) produce unwanted results.

When a reasonable determination is made that an activity must be expanded—inoculation or education, for example—but is not adequately provided by the market, it might be desirable for government to subsidize the activity in order to compensate for failure of the market or underallocation of resources. Conversely, when an activity creates harmful effects and there is overallocation of societal resources—pollution, let's say—it might make sense for regulation to discourage its expansion or proliferation. Policy may therefore have a useful social function that the market is not capable of providing.