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Economics Terms A-Z

Market Failure

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“Market failure” is a term that economists use to describe a market that is not functioning optimally. This is typically measured in terms of social welfare. Market failure in economics means that there’s a better outcome the market could achieve, one that would lead to an increase in social welfare.

Sometimes, but not always, this involves making a Pareto improvement. For example, consider a market that under-produces a good or service that does not exhibit any externalities. If production was increased, overall social welfare would increase with no negative consequences.

Market failure signifies that the sum of individuals’ self-interested actions have caused the market to reach an outcome that is not in the best interest of everyone involved. This is called market “failure” because typically, Adam Smith’s “invisible hand” does lead individuals’ self-interested actions to reach the socially optimal outcome in a market, as Smith famously observed.

Paul Krugman and Robin Wells put it this way in their seminal text Macroeconomics:

“ failure […] happens when the individual pursuit of oneʼs own interest, instead of promoting the interests of society as a whole, actually makes society worse off.”

It’s important to note that in the cases of both market failure and market efficiency, individuals are assumed to be rational. In other words, market failure does not result from individuals acting “incorrectly”, but rather from the best privately optimal decision(s) becoming misaligned with the best choice(s) for overall societal well-being.

There are many potential causes of market failure. These include the presence of externalities, asymmetric information, market power (like monopoly or oligopoly), government overreach, recessionary pressures, and more. Most of these causes have something in common (with the exception of macroeconomic phenomena like recessions and bad government): they cause individual’s incentives to become misaligned with the socially optimal outcome.

Market failure in economic theory

Although it is widely agreed in the modern era that markets do fail, the reasons they fail and the strategies to correct them are important sources of ideological differentiation between economic schools of thought.

In classical economic theory, market failure is seen as either not realistic, or is viewed as a situation that cannot be improved by any intervention strategy. Many classical economists promoted a “laissez faire” approach to the economy as a result. However, these views were challenged by historical events, like the Great Depression, that pure classical theory could not adequately explain (but that’s not to say classical ideas have disappeared: some contemporary economists still hold to updated and modernized theories that a laissez faire approach is best in most cases).

In fact, this is one of the key criticisms of classical economic theory and eventually gave rise to John Maynard Keynes’ new economic school of thought, which was introduced towards the end of the Great Depression and dominated economic policy until the 1970s. Named Keynesianism after him, this school leans heavily into prescribing government intervention as one possible solution to many different forms of market failure.

Of course, classical economic theories have been adapted and updated to better explain our world, resulting in the Neoclassical school. In much the same way, the Keynesian ideas have been criticized and reformulated, giving rise to New Keynesian economics.

Regardless of which school of thought an economist belongs to, most modern economists agree that market interventions can be utilized in market failure situations. The goal of these interventions is to induce the socially optimal equilibrium that maximizes overall social benefit (as measured by utility).

Private market solutions and occasionally charitable activity can sometimes be proposed as alternatives to government intervention. For instance, litter can be viewed as a failure in the “market” for waste disposal services. A community might introduce a volunteer cleanup program or a community watch program to reduce litter.

Put another way, littering creates a negative externality for others who use common spaces like public parks; littering thus reveals the under-provision of cleanup services, a common problem with public goods.

Mitigating market failure with government intervention

However, government intervention is the most common means of mitigating the effects of externalities. It can take the form of taxes, subsidies, regulations such as price ceilings or floors, or even tariffs or trade restrictions. However, even if the optimal equilibrium is known and the intervention works flawlessly, the process is not without drawbacks. Deadweight loss is created whenever governments intervene in markets.

For example, the market for cigarettes produces a negative externality, as it forces non-smokers to deal with secondhand smoke. Further, the health problems caused by smoking increase healthcare costs. In a country with a healthcare system funded by taxpayers, this increases every taxpayers’ expenses to support individuals who wish to smoke.

The market failure from the negative externalities of smoking cause this market to over-produce cigarettes (as compared to quantity that would produce the optimal social benefit), since the private costs to market participants fail to include the full social costs. By taxing the market, the government can (theoretically) induce the socially optimal amount of cigarette sales, which will be lower than the amount of sales from the unregulated market.

This improves overall social welfare by reducing the negative externality by more than the amount of the deadweight loss in the market for cigarettes. However, deadweight loss is still created; buyers and sellers of cigarettes must contend with the new tax, which reduces their welfare from the cigarette market (and possibly lowers the welfare of suppliers of intermediary goods used in the production, distribution, and selling of cigarettes). However, all of these stakeholders still benefit from lower healthcare costs and cleaner air caused by reducing the negative externalities.

Market failure with positive externalities

Market failure also often occurs when there are positive externalities. In this case, private producer and consumer surplus is typically already maximized by the market. But, in this case the market produces some benefit for people who aren’t participating in the market. Because the benefits to these non-participants aren’t factored into private decisions, consumers and producers don’t supply and demand the socially-optimal quantity in the market. This is often the case with public goods and common resources.

An example of this is the market for education. Education is greatly beneficial for society overall; when more people are better educated, the economy benefits from more innovation and research and higher levels of human capital.

But, education is expensive; even without considering possible tuition costs, education greatly reduces the student’s income during their years of study by preventing them from working full time (which is a major opportunity cost of schooling). This can be a difficult or financially painful period for the individual, before they’re able to make use of their education to command a higher salary. Therefore, some individuals choose not to pursue higher education even when they’re capable of doing so.

Thus, subsidizing education can help a society to realize the benefits of improved human capital. This would increase the amount of degrees being granted (or professional skills training courses  completed) compared to the privately optimal market equilibrium. However, this too introduces deadweight loss: in order to subsidize education, the government must charge higher taxes in some other area of society.

Market failure as a macroeconomic concept

Many of the examples shared in this article come from a microeconomic perspective. But market failure can be viewed on a macroeconomic level as well.

Consider one of the most important topics in macroeconomics: (un)employment. Employment is a result of laborers selling (and employers demanding) work hours from qualified workers. There is a natural rate of unemployment that is (usually) deemed unavoidable as the force of creative destruction operates in the economy.

However, times of recession or depression are usually accompanied by excessive unemployment that causes economic hardship for many people. This is a very undesirable outcome, as it reduces social welfare and indirectly reduces consumer demand, which can create a negative feedback loop.

In this way, excessive unemployment can be viewed as a market failure in the market for labor. Government policies during times of recession often include attempts to correct this failure by increasing employment. For example, the US granted so-called “Paycheck Protection Program (PPP)” loans to businesses during the COVID-19 pandemic, intending to help businesses retain workers rather than cut staff.

Good to Know

Market failure isn’t limited to private markets for goods and services. This term describes any market that is operating inefficiently, producing sub-optimal outcomes for society. Government actions are typically mentioned as examples of how to correct market failure, but in some cases, they can become a source of market failure.

Corruption is a good example of how a government’s operations can create market failure. Corrupt governments fail to operate in society’s best interests, instead serving the private interests of corrupt officials.

This may take the form of bribes or kickbacks, the granting of monopolies when they shouldn’t be formed, and excessive printing of money that can lead to inflation or hyperinflation. These scenarios cause excessive expenses for taxpayers. These taxpayers lose money to activities that don’t benefit them and can even lower their utility, as they face higher prices due to additional monopolies, or an erosion of the value of their wealth from hyperinflation.

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