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.[1][2] The first known use of the term by
economists was in 1958,[3] but the concept has been traced back to the Victorian philosopher
Henry Sidgwick.[4]

Market failures are often associated with information, non-competitive markets, externalities,[5]
or public goods. The existence of a market failure is often used as a justification for government
intervention in a particular market.[6][7] Economists, especially microeconomists, are often
concerned with the causes of market failure, and possible means to correct such a failure when it
occurs.[8] 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).[9]
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.[10]

Contents
[hide]

• 1 Causes
• 2 Interpretations and policy
• 3 Objections
o 3.1 Public choice
o 3.2 Austrian
o 3.3 Marxian
• 4 See also
• 5 References

• 6 External links

[edit] Causes
See also: public goods, monopoly, monopsony, oligopoly, oligopsony, and externality

According to mainstream economic analysis, a market failure (relative to Pareto efficiency) can
occur for three main reasons.[2]
 • 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,[11]
monopsonies, 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.[11] 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.[11] 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,[5][11] which are innate to the methods
of production, or other conditions important to the market.[2] For example, when a firm is
producing steel, it absorbs labor, 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.[11] 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.[11] Hence, the market price for steel will fail to incorporate the full opportunity
cost to society of producing.[11] In this case, the market equilibrium in the steel industry
will not be optimal.[11] More steel will be produced than would occur were the firm to
have to pay for all of its costs of production.[11] Consequently, the marginal social cost of
the last unit produced will exceed its marginal social benefit.[11]
• 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[11] or common-
pool resources, while markets may have significant transaction costs, agency problems,
or informational asymmetry.[2][11] 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 organize the exchange of control of commodities, where the nature of the control is
defined by the property rights attached to the commodities.[7]

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
generalized rights – excludability and transferability. Excludability deals with the ability of
agents to control who 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 resulting distribution can be inefficient.[7] Considerations such as these form an important part
of the work of institutional economics.[12] Nonetheless, views still differ on whether something
displaying these attributes is meaningful without the information provided by the market price
system.[13]

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.[2] Other common examples of market failure include environmental problems such as
pollution or overexploitation of natural resources.[2]

Market failure is a situation which occurs when resources are not allocated effectively or
efficiently. This concept in economics can take a number of forms and appear in a variety of
situations, and it is often viewed as something which needs to be corrected through intervention,
usually on the part of the government, when it appears in the real world. For example, when
fisheries experience market failure, the government is expected to step in with policy decisions
which will resolve the issue.

When market failure occurs, it means that the system is not Pareto efficient. Pareto efficiency
refers to a situation in which any improvement to one area would cause a corresponding harm to
someone else. For example, if a fried potato franchise lowers the price on its product, bringing
about an improvement for consumers, it would also have to lower the price it pays to potato
farmers, thereby causing harm. When a system reaches Pareto efficiency, it means that it is
operating at optimum level, with everything in balance.

There are a number of factors which can contribute to market failure. Monopolies are a common
cause, as the lack of competition over the market for a particular good or service is eliminated
when a company holds a monopoly. Externalities can also become an issue which contributes to
market failure, as the end cost of goods and services may fail to take externalities such as wages
and impact on the environment into account. Some public goods are also viewed as a form of
market failure.

Gross inequalities in society can also lead to a market failure, as can a variety of other factors. In
all cases, market failure is characterized by the fact that there is a better and more efficient way
of doing things, but that this method is not being used. When public goods are used as an
example of market failure, for example, people may argue that privately funded firefighting
might be more effective than services paid for by the government.

Governments can intervene to address this issue in a variety of ways, including through bailouts,
legislation, policy changes, controls on wages, and taxation. One of the issues with government
intervention is that it can also contribute directly to market failure and make the problem worse
by failing to allocate resources appropriately. Knowing how and when to intervene is a difficult
decision which can be complicated by political and social issues which may influence people and
institutions involved in decision making.
The Causes of Market Failure A market fails because it cannot take account of all parties
who are affected by a particular transaction or economic process. Such failures abound, and they
appear in a wide range of complexity. Take a simple instance: A suburbanite purchases a power
mower. The seller gets a fair price for the mower and the buyer obtains the necessary amount of
utility from the expenditure. Neither buyer nor seller, though, considers the "costs" imposed on
the neighbors, who must now suffer the noise and fumes on Sunday mornings. The market fails
to count these costs because no one-buyer, seller, or disturbed neighbor-is willing to go to the
trouble of collecting payments for the damages.

A more complicated case occurs in a model economy consisting of a factory, a household that
supplies labor to the factory, and a second household that has no direct connection to the factory.
A hypothetical map of this little economy, showing the locations of the actors and some of the
effects they must endure, is shown in Figure 26-1. The factory produces an industrial product
(steel or autos or railway spikes) and must purchase labor from a nearby household. A sure
market relationship exists between the two. The household receives wages in return for its labor.
There exists, however, a third party-a household downwind that has no economic relationship to
the factory but must absorb the polluting discharges from its chimneys. The factory is taking
away clean air from this household, but the household cannot make the factory compensate for
the effect. The market fails because there is no way for the injured parties to make the factory
pay for damages it incurs.

The effects on the third-party household are external to any transactions engaged in by the
factory. Hence, such market failures have come to be called externalities.