Market Failure

Market failure can be seen along a continuum. There is a wider and a narrower definition: the wider and imprecise one implying lack of output or even utter skepticism concerning the performance and functioning of markets and the narrower one limiting the term to deficiencies of the market. In this entry, the description of market failure and its basic model is followed by a discussion of market failures resulting from a wide variety of factors including asymmetrical information, monopolies, and external effects. Next, the entry examines public goods deficiencies as the narrower category of market failure. The last section discusses the distinction between market failure and economic crises.

With the worldwide financial and economic crisis that began in 2008, market failure has become a renewed focus of public discussion. Yet there is no need to let the state do what the market can do better—for example, organize free exchange relationships and produce consumer goods. Time-dependent public opinion creates shifts to and from more advocacy of state economic activities in creating an extended infrastructure for transport and goods such as public health and education and, nowadays, a heavy control and regulation of the financial sector. Irrespective of such tendencies, the “golden path”—apart from producing the “social goods proper” (see below)—is a combination of an effective judicial infrastructure respecting individual rights and property rights, market competition, the supervision of free access to markets, and avoidance of misuses by monopolies.

Market failure denotes situations where the result of market transactions is not equivalent to a Pareto optimal allocation. With such an allocation, no individual position could be improved while diminishing that of another person. Market failure thus implies a nonoptimal use of scarce resources. In neoclassical theorizing, which focuses on allocation issues rather than issues of distribution, market failure as a pure deficit in allocation stems from factors such as lack of information, external effects, market power, or the character of public goods, also called collective goods.

A basic causal model of market failure is presented in Figure 1. Market power is a background factor to informational asymmetry (as are other factors omitted here). Market power has a direct effect on market failure and an indirect one via external effects. As argued by Richard Musgrave (1959), the failure to produce public goods is the key component of market failure. The first three factors are instances of market deficiencies that can be healed to some extent by appropriate institutional devices. Public goods, by definition, cannot be created in a market since citizens cannot be excluded from consumption and are thus not willing to pay, therefore private production fails to emerge. One could also argue that the lack of public goods production is a cause for market failure just as much as a consequence. We leave this debate unresolved here, with just a line between the two variables to indicate the different nature of the variable “public goods” compared with the other three causal variables, which, in turn, could also be consequences of market failure.

Public goods, just as much as “public bads,” are characterized by nonrivalry in consumption and by the lack of excludability—that is, the ability to exclude others from consuming a good (e.g., security of a country). Partially, this is a case of positive externality. Free riding is tempting when potential consumers cannot be excluded from consuming the good without paying. A lack of effective demand is the result. Here the state can organize the provision of such public goods, yet often without sufficient information as to the adequate amount of such a good. Gathering such information is costly, however. Also the limitation of public goods would in itself be Pareto inefficient. Neoclassical economists argue that the state should interfere only in cases of market failure but not beyond and not for political goals.

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