Market failure
In neoclassical economics, market failure is a situation in which the allocation of goods and services by a free market is not Pareto efficient, often leading to a net loss of economic value.[1] [2][3] The first known use of the term by economists was in 1958,[4] but the concept has been traced back to the Victorian philosopher Henry Sidgwick.[5] Market failures are often associated with public goods,[6] time-inconsistent preferences,[7] information asymmetries,[8] non-competitive markets, principal–agent problems, or externalities.[9]
The existence of a market failure is often the reason that self-regulatory organizations, governments or supra-national institutions intervene in a particular market.[10][11] Economists, especially microeconomists, are often concerned with the causes of market failure and possible means of correction.[12] Such analysis plays an important role in many types of public policy decisions and studies.
However, government policy interventions, such as taxes, subsidies, wage and price controls, and regulations, may also lead to an inefficient allocation of resources, sometimes called government failure.[13] Most mainstream economists believe that there are circumstances (like building codes fire safety regulations or endangered species) in which it is possible for government or other organizations to improve the inefficient market outcome. Several heterodox schools of thought disagree with this as a matter of ideology.[14][15] An ecological market failure exists when human activity in a market economy is exhausting critical non-renewable resources, disrupting fragile ecosystems, or overloading biospheric waste absorption capacities. In none of these cases does the criterion of Pareto efficiency obtain.[16]
Interpretations and policy examples[edit]
The above causes represent the mainstream view of what market failures mean and of their importance in the economy. This analysis follows the lead of the neoclassical school, and relies on the notion of Pareto efficiency,[32] which can be in the "public interest", as well as in interests of stakeholders with equity.[12] This form of analysis has also been adopted by the Keynesian or new Keynesian schools in modern macroeconomics, applying it to Walrasian models of general equilibrium in order to deal with failures to attain full employment, or the non-adjustment of prices and wages.
Policies to prevent market failure are already commonly implemented in the economy. For example, to prevent information asymmetry, members of the New York Stock Exchange agree to abide by its rules in order to promote a fair and orderly market in the trading of listed securities. The members of the NYSE presumably believe that each member is individually better off if every member adheres to its rules – even if they have to forego money-making opportunities that would violate those rules.
A simple example of policies to address market power is government antitrust policies. As an additional example of externalities, municipal governments enforce building codes and license tradesmen to mitigate the incentive to use cheaper (but more dangerous) construction practices, ensuring that the total cost of new construction includes the (otherwise external) cost of preventing future tragedies. The voters who elect municipal officials presumably feel that they are individually better off if everyone complies with the local codes, even if those codes may increase the cost of construction in their communities.
CITES is an international treaty to protect the world's common interest in preserving endangered species – a classic "public good" – against the private interests of poachers, developers and other market participants who might otherwise reap monetary benefits without bearing the known and unknown costs that extinction could create. Even without knowing the true cost of extinction, the signatory countries believe that the societal costs far outweigh the possible private gains that they have agreed to forego.
Some remedies for market failure can resemble other market failures. For example, the issue of systematic underinvestment in research is addressed by the patent system that creates artificial monopolies for successful inventions.