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Information on the concept of market failure

Market failure is a concept within economic theory wherein the allocation of goods and services by a free market is not efficient. That is, there exists another conceivable outcome where market participants’ overall gains from that outcome would outweigh their losses (even if some participants lose under the new arrangement).

Market failures can be viewed as scenarios where individuals’ pursuit of pure self-interest leads to results that are not efficient-that can be improved upon from the societal point-of-view.

The first known use of the term by economists was in 1958, but the concept has been traced back to the Victorian philosopher Henry Sidgwick Market failures are often associated with information, non­competitive markets, externalities, or public goods.

The existence of a market failure is often used as a justification for government intervention in a particular market Economists, especially micro economists, are often concerned with the causes of market failure, and possible means to correct such a failure when it occurs. Such analysis plays an important role in many types of public policy decisions and studies.

However, some types of government policy interventions, such as taxes, subsidies, bailouts, wage and price controls, and regulations, including attempts to correct market failure, may also lead to an inefficient allocation of resources, (sometimes called government failures). Thus, there is sometimes a choice between imperfect outcomes, i.e. imperfect market outcomes with or without government interventions.

But either way, if a market failure exists the outcome is not Pareto efficient. Mainstream neoclassical and Keynesian economists believe that it may be possible for a government to improve the inefficient market outcome, while several heterodox schools of thought disagree with this.

According to mainstream economic analysis, a market failure (relative to Pareto efficiency) can occur for three main reasons:

First, agents in a market can gain market power, allowing them to block other mutually beneficial gains from trades from occurring.

This can lead to inefficiency due to imperfect competition, which can take many different forms, such as monopolies, monopolies, cartels, or monopolistic competition, if the agent does not implement perfect price discrimination. In a monopoly, the market equilibrium will no longer be Pareto optimal.

The monopoly will use its market power to restrict output below the quantity at which the marginal social benefit is equal to the marginal social cost of the last unit produced, so as to keep prices and profits high.

An issue for this analysis is whether a situation of market power or monopoly is likely to persist if unaddressed by policy, or whether competitive or technological change will undermine it over time.

Second, the actions of agents can have externalities, which are innate to the methods of production, or other conditions important to the market. For example, when a firm is producing steel, it absorbs labour, capital and other inputs, it must pay for these in the appropriate markets, and these costs will be reflected in the market price for steel.

If the firm also pollutes the atmosphere when it makes steel, however, and if it is not forced to pay for the use of this resource, then this cost will be borne not by the firm but by society.

Hence, the market price for steel will fail to incorporate the full opportunity cost to society of producing. In this case, the market equilibrium in the steel industry will not be optimal. More steel will be produced than would occur were the firm to have to pay for all of its costs of production.

Consequently, the marginal social cost of the last unit produced will exceed its marginal social benefit. Finally, some markets can fail due to the nature of certain goods, or the nature of their exchange.

For instance, goods can display the attributes of public goods or common-pool resources, while markets may have significant transaction costs, agency problems, or informational asymmetry. In general, all of these situations can produce inefficiency, and a resulting market failure.

A related issue can be the inability of a seller to exclude non-buyers from using a product anyway, as in the development of inventions that may spread freely once revealed. This can cause underinvestment, such as where a researcher cannot capture enough of the benefits from success to make the research effort worthwhile.

More fundamentally, the underlying cause of market failure is often a problem of property rights. As Hugh Gravelle and Ray Rees put it, a market is an institution in which individuals or firms exchange not just commodities, but the rights to use them in particular ways for particular amounts of time.

Markets are institutions which organise the exchange of control of commodities, where the nature of the control is defined by the property rights attached to the commodities. As a result, agents control over the uses of their commodities can be imperfect, because the system of rights which defines that control is incomplete.

Typically, this falls into two generalised rights excludability and transferability. Excludability deals with the ability of agents to control that uses their commodity and for how long and the related costs associated with doing so.

Transferability reflects the right of agents to transfer the rights of use from one agent to another, for instance by selling or leasing a commodity, and the costs associated with doing so. If a given system of rights does not fully guarantee these at minimal (or no) cost, then the j resulting distribution can be inefficient.

Considerations such as these form an important part of the work of institutional economics. Nonetheless, views still differ on whether something displaying these attributes is meaningful without the information provided by the market price system.

Traffic congestion is an example of market failure, since driving can impose hidden costs on other drivers and society.

Solutions for this include public transportation, congestion pricing, toll roads and toll bridges, and other ways of making the driver include the social cost in the decision to drive. Other common examples of market failure include environmental problems such as pollution or over exploitation of natural resources.