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Market Failure

The concept of market failure refers to the numerous ways in which real markets fail to display the characteristics and performances of theoretical or perfect markets and/or to generate social outcomes that are analytically superior to those produced by other means of societal allocation. The modern conception of ideal market exchange and its perceived benefits dates at least to the classic work of Adam Smith in The Wealth of Nations (1776).

Characteristics of a Perfect Market

The concept of a “perfect market” is an abstraction. A perfect market is an exchange system featuring many buyers and sellers; actors who pursue rational self-interest with completely free choice and stable preferences; perfect information held by all the actors; goods that are all private in character in that their consumption can be excluded from consumption by other potential consumers; exchange among the buyers and sellers that is costless; actors who begin their market exchanges with resource endowments that can neither increase nor change in quality or capability over time nor have any special characters or values (but can be used only to fund the exchanges); actors who are solitary and self-contained in that they act as atomistic, disconnected entities with no internal complexity and no external, dependent relationships such as stakeholder ties; no technology effects such as those that would cause markets of different sizes to behave differently so that trading in goods at different scales produces different behaviors; no by-product costs or impacts from the exchange, so the market itself is selfcontained and has no memory or history, among other characteristics.

In contrast, real-world markets can violate any of these conditions. They can have few sellers and/or few buyers; consumers can be inconsistent in their choices and be influenced by other actors and historical patterns; false or incomplete product information can flood the market; buyers can collude with one another; the supply of goods can be joint, not private, in that once supplied to one consumer they are at the same time consumable by other consumers; there are many, and many kinds of, transactions costs in the market; actors can possess widely varying endowments of resources that can be transformed in quality and value by innovation and technology, yet for some actors may be too little or of such type or quality as to prevent those actors from using them to conduct any market exchanges or participate meaningfully in the market; production in the market produces unintended by-product effects not priced in the market; technology can cause rational market actors to collude and/or combine so that the market itself collapses into a single actor; information about all aspects of the market and its actors can be unevenly distributed and costly to elicit; market actors are often internally complex, as in firms, and intricately interdependent with stakeholders who affect or are affected by the actor, that is, the firm; and so on.

Pareto Optimality

Perfect markets are held to be desirable because they can produce the exchange condition that economists label Pareto optimality, after the Italian economist Vilfredo Pareto (1848–1923). In the exchanges leading to Pareto optimality, market participants have employed their endowments to make exchanges with other participants in response to their self-interest and their perfect knowledge of available exchanges. Participants are driven by the benefits of each exchange to continue to trade until they can no longer—either they have exhausted their endowment or, what is equivalent, there is no available trade that will make them better off. In other words, there is no trade available that will make at least one actor better off while leaving the other actors indifferent to the exchange. Such a condition is, in essence, the best of all possible worlds available to market participants at that position in the sense that they cannot move to any state where they would be better off. Movement toward that condition is also desirable—any trade that makes at least one actor better off while no other actor is harmed is a Pareto efficient transaction.

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