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In economics, a market failure is a case in which a market fails to efficiently provide or allocate goods and services. In more general terms, market failures are situations where market forces do not serve the perceived "public interest". Economists use model-like theorems to explain such cases. The two main reasons that markets fail are (1) sub-optimal market structures and (2) the lack of internalization of costs or benefits in prices and thus into microeconomic decision-making in markets.
External costs and benefits
Examples of latter include:
Strategies to reduce these imperfections require alternative, non-market, institutions, such as the centralized government or state, tradition, and/or community democracy. These are often studied in the field of collective action. See also Coase theorem.
Noncompetition
Examples of sub-optimal market structures include:
Interpretations
Note that all these types of failures refer to situations where markets create inefficiency. In modern neoclassical (orthodox) economics, if a certain result is Pareto efficient, then it is not considered a market failure, regardless of whether or not it serves the public interest, however defined. Therefore, in this view, it is possible for a result to go against the public interest even if market failure is not involved.
As could be expected, the issue of market failures (and how they should be addressed) is a source of dispute between different schools of economic thought. Many advocates of laissez-faire capitalism, such as libertarians and economists of the Austrian School, often deny the existence of market failures altogether, or see them as irrelevant or temporary. To them, a market failure is usually a failure in some way to have markets. Alternatively, they would say that results that some might call "market failures" cannot be such if those results are not intended to be avoided by the establishment of markets.
For example, while some would call a high degree of centralization of the wealth distribution in a small number of hands a "market failure", the laissez faire response would be that goal at distributing wealth evenly is not the purpose of establishing markets in the first place. The working of markets reflects the pre-existing inequality of distribution. Following the old saw that "he who pays the piper calls the tune", market failure involves the piper not playing the tune that that payer calls for -- or playing it in the wrong way. Moreover, conditions that some would regard as negative are commonly blamed on subversion of the free market by "coercive" government intervention.
On the other hand, if the operations of a market normally lead to increasing inequality of wealth ownership, many would see it as an example of market failure, e.g., the ability of those with the most wealth to use their economic power to increase their wealth. These critics would also ask who it was who determined the purpose of using markets in the first place. In many cases, "privatization", i.e., the replacement of government programs by free-maket ones, simply reflects the political influence of businesses and the ideology of powerful organizations such as the International Monetary Fund. Instead of a government program, which in theory reflects the democratically expressed will of the people, the result is a privately owned monopoly allied with the political insiders.
Others, such as social democrats and "New Deal liberals", view market failures as an ubiquitous problem of any unregulated market system, and therefore argue for extensive state intervention in the economy, in order to ensure both efficiency and social justice. A major argument against this view is that these liberals have too much faith in the benevolence of the government and in the ability of citizens to control their government democratically. Advocates of laissez faire point to a large number of examples of government failure, where the government interference with free markets made matters worse.
In the current era, we sometimes see professed New Deal liberal intentions merged with free-market ideas to form neoliberalism. In this vein, some propose "market-oriented solutions" to market failure: for example, they propose going beyond the common idea of having the government charge a fee for the right to pollute (internalizing the external cost, creating a disincentive to pollute) to allow polluters to sell the pollution permit. Often companies in other industries are willing to buy such permits, so that the government created an artificial market for pollution rights.
The Marxist school of economics also sees market failure as an inherent, though not necessarily widespread, feature of any capitalist economy. However, although Marxists argue for the abolition of capitalism, they often do not bring up the issue of market failure in their arguments (preferring to concentrate on other aspects instead). They do not see the "perfect market" (one without failures) as reasonable goal, while seeing capitalist exploitation, class conflict, and economic crises as existing even with "perfect" markets. Even when they do discuss this issue, they note that government leaders and those who benefit from market failures (polluters, monopolists, etc.) often form alliances, so that the government is not a neutral purveyor of technocratic solutions. Only popular pressure on both the government and the companies benefiting from market failure can lead to success in reducing its associated abuses.
Modern macroeconomics, especially that of the Keynesian or new Keynesian varieties, takes into account the existence of market failures which prevent the automatic attainment of full employment of resources and the working of Say's Law.
See also
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