Market Failure

Efficient Markets: The First and Second Welfare Theorems

Economists define market failure against a theoretical, ideally operating economy. When individuals are free to trade in a competitive marketplace where no externalities in production or consumption exist, the resulting distribution of resources in the economy is Pareto efficient: no person can be made better off without making some other person worse off. At this equilibrium, the price system has coordinated the activities of all market participants such that all resources have moved to their most highly valued uses. Work by Kenneth Arrow, Gerald Debreu, and Francis Bator in the 1950s provided formal proof of the conditions under which market equilibrium is Pareto efficient: the first fundamental theorem of welfare economics.

The first welfare theorem refers only to the efficiency of the equilibrium; it says nothing about whether the resulting allocations are fair or just. However, many potential allocations satisfy Pareto efficiency. The second welfare theorem shows that any efficient equilibrium is achievable through the operation of competitive markets with redistribution of individual endowments or wealth. Consequently, if one deems the results of a market process inequitable, economists would argue that any correction should be implemented via changes in endowments rather than through interventions in the workings of the price system. For example, if certain individuals were unable to afford decent housing, the second welfare theorem would suggest that the appropriate corrective measure, if someone desired it, is to increase those individuals' incomes (funded via a nondistortionary tax) rather than to provide targeted housing subsidies or impose price controls. Such policy would not work to correct any market failure; rather, it would work to select among efficient outcomes for reasons of equity.

When the conditions underlying the first welfare theorem fail to hold, we can expect market failure. Market failure consequently has a very precise meaning for economists, despite its often loose usage elsewhere: it requires a failure of the first welfare theorem rather than simple dissatisfaction with market outcomes.

When markets fail, government intervention may improve outcomes; however, one cannot guarantee such improvement. Economists define market failure relative to a norm of Pareto efficiency rather than in comparison with a potential policy intervention. For purposes of policy analysis, identification of market failure is not sufficient to require government intervention; rather, one should base policy intervention on sound comparative institutional analysis that balances the imperfections of markets and politics.

Ways Markets Fail: Competition, Externalities, and Public Goods

When markets are not competitive, market failure may result. A monopolist has an incentive to restrict output and raise price, creating deadweight losses. Where monopolists can engage in price discrimination, they reduce such losses. Antitrust policy works to mitigate losses due to lack of competition; however, the costs of such policy need careful weighing against potential benefits.

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