Market Failure

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Editors: Bertrand Badie , Dirk Berg-Schlosser , and Leonardo Morlino
Date: 2011
International Encyclopedia of Political Science
Publisher: Sage Publications, Inc.
Document Type: Topic overview
Pages: 6
Content Level: (Level 5)

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Market Failure

Market failure can be seen along a continuum. There is a wider and a narrower definition: the wider and imprecise one implying lack of output or even utter skepticism concerning the performance and functioning of markets and the narrower one limiting the term to deficiencies of the market. In this entry, the description of market failure and its basic model is followed by a discussion of market failures resulting from a wide variety of factors including asymmetrical information, monopolies, and external effects. Next, the entry examines public goods deficiencies as the narrower category of market failure. The last section discusses the distinction between market failure and economic crises.

With the worldwide financial and economic crisis that began in 2008, market failure has become a renewed focus of public discussion. Yet there is no need to let the state do what the market can do better—for example, organize free exchange relationships and produce consumer goods. Time-dependent public opinion creates shifts to and from more advocacy of state economic activities in creating an extended infrastructure for transport and goods such as public health and education and, nowadays, a heavy control and regulation of the financial sector. Irrespective of such tendencies, the “golden path”—apart from producing the “social goods proper” (see below)—is a combination of an effective judicial infrastructure respecting individual rights and property rights, market competition, the supervision of free access to markets, and avoidance of misuses by monopolies.

Market failure denotes situations where the result of market transactions is not equivalent to a Pareto optimal allocation. With such an allocation, no individual position could be improved while diminishing that of another person. Market failure thus implies a nonoptimal use of scarce resources. In neoclassical theorizing, which focuses on allocation issues rather than issues of distribution, market failure as a pure deficit in allocation stems from factors such as lack of information, external effects, market power, or the character of public goods, also called collective goods.

A basic causal model of market failure is presented in Figure 1. Market power is a background factor to informational asymmetry (as are other factors omitted here). Market power has a direct effect on market failure and an indirect one via external effects. As argued by Richard Musgrave (1959), the failure to produce public goods is the key component of market failure. The first three factors are instances of market deficiencies that can be healed to some extent by appropriate institutional devices. Public goods, by definition, cannot be created in a market since citizens cannot be excluded from consumption and are thus not willing to pay, therefore private production fails to emerge. One could also argue that the lack of public goods production is a cause for market failure just as much as a consequence. We leave this debate unresolved here, with just a line between the two variables to indicate the different nature of the variable “public goods” compared with the other three causal variables, which, in turn, could also be consequences of market failure.

Public goods, just as much as “public bads,” are characterized by nonrivalry in consumption and by the lack of excludability—that is, the ability to exclude others from consuming a good (e.g., security of a country). Partially, this is a case of positive externality. Free riding is tempting when potential consumers cannot be excluded from consuming the good without paying. A lack of effective demand is the result. Here the state can organize the provision of such public goods, yet often without sufficient information as to the adequate amount of such a good. Gathering such information is costly, however. Also the limitation of public goods would in itself be Pareto inefficient. Neoclassical economists argue that the state should interfere only in cases of market failure but not beyond and not for political goals.

Following the specifications of Musgrave and thus opting for a more limited definition of market failure, allocation problems in a market economy can be either market imperfections (market power

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Figure 1 A Basic Causal Model of Market Failure

Figure 1 A Basic Causal Model of Market Failure

and external costs/effects) or market failure (insufficient supply of public goods).

Usually, market failure is limited to a specific market. Market failure calls for state intervention. The counterposition is that state interventionism could lead to state failure. With the state increasingly being engaged in the economy, information scarcity increases due to the absence of fungible markets. Individuals might be treated as if they all had the same preferences. The greater the differences in their preferences are, the greater the welfare losses become. Citizens might be confronted with package solutions they would not agree to in their entirety, or coalitions may go for solutions other than those initially proclaimed by individual parties.

Consequently, the Austrian school of economics (e.g., Friedrich Hayek, 1944; Murray Rothbard, 1962) even denies such a thing as market failure, since markets are instruments of individual discovery with no preassigned collective goals. According to Hayek, the market is a context of discovery, whereas planned state economies never make discoveries stemming from the spontaneous coordination of individual actors in a market. Yet on many occasions, Hayek does not question the standard theory of public goods.

Instances of Market Failure

Among the factors that may bring about market failure are the ones related to asymmetrical information, monopolies, and external effects.

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Asymmetrical Information

Asymmetrical information occurs when the potential contract partners do not have equal information about the supplied goods, services, or risks to be insured. George Akerlof (1970) argues that uncertainty about the quality of goods on the part of consumers drives out good products (e.g., cars just as much as hard currencies in the case of Gresham's law) and leaves only the bad ones on the market. This “lemon” principle leaves only the poorest suppliers able to sell their cars. There is no market clearing, and a negative selection takes place.

Guarantees on the part of the suppliers or independent institutions monitoring the quality of goods as well as legal guarantees could help in mitigating this information asymmetry. The discipline of new institutional economics emphasizes the importance of appropriate incentives from and controls by institutions. The protection of patents is another instance of information asymmetry. Here the trade-off is between quickly disseminating new knowledge versus protecting research and the economic incentives that are derived from particular knowledge, at least for some time.

In addition to adverse selection, as in the “lemon” cases, asymmetrical information may also arise when a contract between partners provides that both should have symmetrical information, but, subsequently, one party is unable to observe the behavior of the other. When such a situation arises after contract formation, it creates

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a moral hazard in which one partner may be tempted to cheat.

Monopolies

Market power stems from three factors: unique technological inventions, the limitation of competition, and the indivisibility of the production apparatus. Under a monopoly, production is inefficient (a lower amount of goods is turned out at higher prices). A monopolist maximizing his or her market power is selling products at a price above the marginal costs (Cournot point) and not where the marginal returns equal those of the marginal production costs, as in a competitive market (a higher turnout of goods at lower prices).

Remedies against monopolistic markets are antitrust policies and, in cases of indivisibilities and natural monopolies, tax and subvention policies. The indivisibility of the production apparatus (e.g., networks for electric power and gas, the canal system railways) leads to scale effects and thus to lower average costs but also to larger sunk costs, that is, past costs that cannot be recovered when being confronted with new competitors. If only one supplier can do it efficiently, this is called a natural monopoly.

If there is a Pareto efficient situation, state intervention by necessity will violate that equilibrium, often for the sake of redistribution issues that are decided politically through majority voting. The median position of the voter in democracies with an interest in redistribution from the rich to the poor and the activities of lobby groups are key factors in such a view. The underlying factor is rent seeking—securing incomes above those in a free and competitive market—by private groups, government bureaucracies, and politicians. (The latter two entities point to the principal–agent problem.) Here, “market failure” is often defined in the reverse sense as an effect of state regulation and interference with otherwise free markets.

Adherents of public choice theorizing point to lack of causal evidence when bringing in the state to remedy situations of market failure. They argue that the costs of state failure could be even higher than those of market failure. Market failure can be closely linked to state failure, not just in case of the communist collapse but also in the market rule distortions created through the networks and influence of the financial sector on politicians to loosen rules on the financial markets. Oliver Blanchard (2009) succinctly lists these failures of the past decade:

The underestimation of risk contained in newly issued assets; the opacity of the derived securities on the balance sheets of financial institutions; the interconnection of financial institutions, both within and across countries; and the high degree of leverage of the financial system as a whole … all combined to create the perfect (financial) storm. (pp. 38–39)

External Effects

External effects occur in two variants. Negative external effects occur where the economic activities of two partners cause damage to a third one (e.g., toxic emissions into the air). Sometimes positive external effects—benefits (e.g., beautifying the environment)—are created by economic contractors. The internalization of external costs is theoretically possible, for example, via Coase negotiations. The Coase theorem states that, under clearly defined property rights, perfect rationality and no-transaction-costs bargaining may occur in such a way that external effects will be internalized by market participants. For future generations, such a condition is absent, however. By means of the Pigou tax, the state places a tax on the producer equal to the external costs. The latter must be known, however, and again transaction costs are not allowed.

Negative external effects (e.g., environmental degradation) are the most often quoted instances of market failure. Firms externalize their costs of production onto third parties (so that customers of respective firms do not have to pay directly) or, in the widest instance, onto the global environment, turning everyone into a victim.

Positive external effects occur in cases where a good is underproduced, because the supplier does not receive adequate compensation for the external rewards that would be provided if full production capacity were used. Other examples come from the health sector where a general vaccination could have external benefits for society at large, but costs for poor people might be too high, thus creating negative external effects of undersupply.

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The educational sector offers another instance, in which the provision of a good education nationwide provides many additional advantages for society at large. The provision of subventions for an increasing demand for these goods may, however, be inefficient and create issues of moral hazard (e.g., downgrading one's own private learning efforts since the education does not cost anything).

Public Goods Provision

Deficiencies in producing public goods are often listed as further instances of market failure. Public goods, such as clean air, are ones from which individuals cannot be excluded. Therefore, unlike private goods, public goods cannot be produced effectively through the private market. Following the logic of Musgrave and thus requiring more precise argumentation, they comprise the second and narrower category of market failure, in which the market fails entirely. In the cases dealt with thus far, gradual deficiencies of markets occurred. While the market is functioning in principle, there is, however, too much or too little of goods produced. But in the more basic case of complete market failure, some goods are not produced at all, even though the optimal allocation of goods requires them. Goods with only external returns, those with returns only to consumers and not to producers, are heavily undersupplied. The lighthouse is a classic example. Although the lighthouse provides strong external benefits for seafaring, there is no individual incentive to build it. The lighthouse is a public or collective good that is characterized by two features: There is no rivalry in consumption and no excludability (that is, one person's use of a good such as a lighthouse does not reduce the availability of the good to others). Free riding is a consequence of such a constellation. As long as individuals do not reveal how strong their preferences for public goods are, there will be no production of such goods unless the state steps in. The state monopoly of the legitimate use of force, external defense, levees, and the judicial institutional framework are also examples of public goods (what Musgrave describes as “social goods proper”). According to James Buchanan and Gordon Tullock (1962), the real task of the state is to protect property rights.

Crossing the two criteria of rivalry and exclusion in Figure 2, four types emerge.

The two pure types of goods—private goods (Case 1 in Figure 2) and public goods (Case 4 in Figure 2)—have already been discussed. With respect to the mixed goods in Case 2, consumers can be excluded by imposing fees on the consumption of these goods. Even though there is little or no rivalry in consumption (e.g., of streets, bridges, sports events, pipelines, or even cable TV—goods resembling the so-called toll goods), there is a tendency for underproduction of those goods (resulting in, e.g., traffic congestion). With decreasing average production costs, there is also an inherent tendency toward monopoly in such situations. Supervision of market tendencies by independent authorities and/or subsidies to consumers could counteract such tendencies toward underproduction.

With mixed goods in Case 3, where rivalry but no exclusion exists, the reverse instance of overusage emerges, as, for example, in the tragedy of the commons, described by Elinor Ostrom. By defining rights of usage for natural resources such free riding might be controlled. Other means of regulation could be mutual controls or by an agent, sanctions when violating rules, reciprocity, and mutual trust.

The mixed goods in Cases 2 and 3 show some resemblance to the cases of external effects


Figure 2 Exclusion and Rivalry With Public Goods, Mixed Goods, and Private Goods

Figure 2 Exclusion and Rivalry With Public Goods, Mixed Goods, and Private Goods

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discussed earlier. While external effects are market imperfections, (pure) public goods as such are not produced by the market at all.

With the state producing such goods on its own, at least two challenges arise. First, the state produces at costs that are too high (which can be counteracted by employing market means in the whole production process wherever possible). Second, consumers may waste resources because the state produces them at no cost to the consumers, creating an ethical issue. Also, consumer sovereignty can be limited through state production of the wrong goods or in wrong quantities (crowding out). The production of so-called merit goods, such as health, education, and high culture, is a fiat usually set by political/economic elites and rarely by majority opinion. In other markets, allocation of goods may suffer.

In the opposite cases of demerit goods, the state again could work with legal provisions and prohibitions, taxes, and subventions and with tradable certificates to introduce market elements—for example, in controlling environmental deterioration. Here economically inefficient and ecologically aberrant rules from the past create no incentives for technological progress. They can be substituted by technological progress the external costs of which are addressed better by auctions and by the selling of certificates. In the long run, overregulation of and by the state may be a crucial factor contributing to market failure, just as much as the lack of monopoly of violence and failure to guard property rights to begin with are.

Economic Crises

Analytically and empirically, one has to distinguish an economic crisis from situations of market failure. Situations of market failure (lack of public goods production) and market imperfection can be the causes as well as the correlates and consequences of economic crises. Yet economic crises in terms of supply shocks (e.g., the oil shocks of 1973 and 1980), or simply the overproduction of goods (as, e.g., in the automotive industry today), as well as demand shocks (e.g., in cases of natural catastrophes and poor harvests) must be distinguished from the cases and analyses of market failures. In a sloppy colloquial sense, the term market failure is often applied here but for incorrect and inconsistent theoretical reasons. An economic crisis basically means that producers have miscalculated the amount and type of goods consumers are willing to buy. The consequence is an uncleared market and, in case of a deepening crisis, a further extension of unsold products. This cumulative downward process (see Knut Wicksell, 1898) of overproduction and falling prices stops when consumers anticipate higher prices in the future and start buying again. Thus, a normal economic crisis has the character of a cleansing crisis, wiping out unproductive suppliers.

Such economic crises can be caused and intensified by financial crises (just as much as they can be alleviated through built-in stabilizers as in the European social market economies from 2008 onward; see Joseph Stiglitz, 2010). The Great Depression with the financial crises emerging in the early 1930s is a case in point. Institutional adjustments in the financial sector then included repealing the liberalization measures of the Glass-Steagall Act and separating commercial activities of banks from their investment activities, giving the Federal Bank a stronger leeway in raising liabilities for banks yet with very little Keynesian reflation of the economy. In the crisis after 2008, institutional adjustments included increased liability for banks and other financial agents, more transparency with hedge funds, better control of the stock exchanges and of rating agencies, elimination of speculative deals such as short sales, tax on financial transactions, higher taxing of banks, separation of investment banks from retail and commercial banks, breaking down banks that are “too big to fail,” and the socialization of private losses via a bailout through the taxpayer; these were intended to prevent financial bubbles (and the oversupply of goods such as housing) in the future. At the same time, from 2008 on there was a heavy reflation of the major economies to avoid the procyclical monetary and fiscal policies of the 1930s. Yet as noted by Carmen Reinhart and Kenneth Rogoff (2009), underlying factors such as human speculation and miscalculation as well as greed will always contribute to economic crises so that the very basic features of the next bubble will not be so different from those of previous ones. The economic fallout of both the Great Depression and the current crisis coming close to a breakdown of the financial engine of the free market system is

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grave enough. It is, however, even in its magnified effects, an instance of absent or failing institutional regulations. Given human creativity and greed, one will have to reckon with further such imbalances. They are instances of far-reaching contractions of markets due to a lack of institutional safeguards. Market failure in a more theoretically strict sense has, however, to be distinguished from these grave challenges.

Nevertheless, the failure of the institutional framework (creation of a public bad in not containing the financial speculation and letting it transgress into the goods and services markets) is a clear case of de facto market failure in the present financial and economic crisis. At the global level, there are no adequate rules to allow for the separation of real growth effects of financial transactions from cases of gross overspeculation. (Some economists argue that there could never be such a separation between sound and unsound financial transactions since every speculator is always met by a countertrader.) Legitimacy for a market society has been strongly undermined, fortunately in the absence of other more repressive system alternatives as present and tried in the 1930s.

Given the high debt burdens, the global market power, informational asymmetries, the externalization of costs, environmental damages, moral risks, and rent seeking in all its varieties, market failures may become more likely. The market does better than the state in providing incentives and competition, in allocating scarce resources, and in controlling economic and, thus often, political power. For these functions, state activities cannot be a substitute for the market. With historically unseen market extensions in a fully globalized economy, however, it may become more difficult to establish rules of consent shared worldwide. There are always some externalities involved, be they only in the form of misperceptions of one's own long-term advantages with respect to, for example, issues of global warming and other climate changes. The failed Copenhagen Climate Change Conference of 2009, just as much as the current financial crisis with dramatic public debt, not only figures in European, American, and the majority of Asian states but also speaks just as dramatically to new (potential) mixtures of market failures cum failures of political systems, whether they are organized around autocratic principles or around the preferences of the median voter, or occur in emergent systems such as the European Union and the eurozone. The temptations for free riding may have become higher under global economic markets, but so have external costs and burdens on future generations. There is a lag in ordered structures for global markets to function without creating excessive external costs.

Ekkart Zimmermann
Dresden University of Technology
Dresden, Germany

Further Readings

Akerlof, G. A. (1970). The market for lemons: Quality uncertainty and the market mechanism. Quarterly Journal of Economics, 84, 488–500.

Blanchard, O. (2009, June). The perfect storm. Finance & Development, pp. 37–39.

Buchanan, J., & Tullock, G. (1962). The calculus of consent: Logical foundations of constitutional democracy. Ann Arbor: University of Michigan Press.

Hayek, F. A. (1944). The road to serfdom. London: Routledge.

Musgrave, R. A. (1959). The theory of public finance. New York: McGraw-Hill.

Ostrom, E. (1990). Governing the commons: The evolution of institutions for collective action. Cambridge, UK: Cambridge University Press.

Reinhart, C. M., & Rogoff, K. (2009). This time is different: Eight centuries of financial folly. Princeton, NJ: Princeton University Press.

Rothbard, M. (1962). Man, economy, and state. New York: Van Nostrand Reinhold.

Stiglitz, J. E. (2010). Freefall: America, free markets, and the sinking of the world economy. New York: W. W. Norton.

Wicksell, K. (1898). Interest and prices. New York: Augustus M. Kelley.

Source Citation

Source Citation   

Gale Document Number: GALE|CX4190900338