Skip to main content icon/video/no-internet
icon backReturn to Entries

Market Failure

Markets are said to fail when they deliver an outcome that falls short of the socially optimal or Pareto optimal result. In particular, the economic theory of market failure seeks to account for inefficient outcomes in markets that otherwise conform to the assumptions about markets held by neoclassical economics (i.e., markets that feature perfect competition, symmetrical information, and completeness). When failure happens, less welfare is created than could be created given the available resources. The social task then becomes to correct the failure.

The theory of market failure is at the heart of several economic analyses that support government action (intervention) in markets for goods and services or that justify outright government production. Many social welfare programs find their theoretical justification in market failure or in other violations of the standard market assumptions.

Criticism of the market failure notion and of using government to remedy its effects has been articulated in the public choice school of economics. Public choice scholarship has had great impact on contemporary reforms of the public sector, replacing the Keynesian and welfare economics logics that drove much public service expansion. Recent reforms that replace governments with markets to challenge or remedy market failure have been the practical consequence of these critiques.

The Theory

The descriptions of market failure were developed in the middle of the twentieth century as part of a larger school of Keynesian welfare and macroeconomics. Important contributors include Arthur C. Pigou, Francis Bator, William Baumol, and Paul A. Samuelson.

The theorists were concerned with the correspondence between free market outcomes and social welfare optimization. In standard economics, the invisible hand or duality theorem holds that laissez-faire market performance and Pareto optimality go hand in hand. When consumers and producers respond to price signals, they make their own decisions about whether to buy or sell and how to produce the good. The aggregate of these choices is the same as the Pareto optimal or socially optimal distribution. Welfare economists were concerned with conditions under which this correspondence failed and sought to describe such conditions.

The interest in exceptions to the invisible hand theorem led to the study of violations of the standard market assumptions. These assumptions include perfect competition, perfect information, complete markets, and the absence of market failures. Markets fail under any of three conditions: production has increasing economies of scale; goods in the market are public; or production or consumption has externalities.

Increasing Economies of Scale

When producing one more of a good leads to a lower average cost of producing each good, production of the good has increasing economies of scale. Economists have found that when economies of scale increase regardless of how much is produced, few or no firms can survive as producers in the market. The standard concern with increasing economies of scale is that market forces will lead to monopoly production. Monopolies are sole providers of goods in a market, so they can charge any price they find suits their needs. Economists find that this leads to a suboptimal level of production and consumption. In addition, increasing scales may push all producers out of a market if none can charge enough to cover costs. In this case, production ceases even if it benefits society. Hence, markets fail under increasing economies of scale.

...

  • Loading...
locked icon

Sign in to access this content

Get a 30 day FREE TRIAL

  • Watch videos from a variety of sources bringing classroom topics to life
  • Read modern, diverse business cases
  • Explore hundreds of books and reference titles

Read next

More like this

Sage Recommends

We found other relevant content for you on other Sage platforms.

close

Have you created a personal profile? Login or create a profile so that you can save clips, playlists and searches

close
close
close Signed In to profile You are signed in as:
close
Logged in Institution Institution