NationMaster - Encyclopedia: Market failures

In economics, a market failure is a situation in which markets do not efficiently organize production or allocate goods and services to consumers. To economists, the term would normally be applied to situations where the inefficiency is particularly dramatic, so that non-market institutions provide a more desirable result. On the other hand, to many, market failures are situations where market forces do not serve the perceived "public interest". Here, the focus is on the economists' theories of market failure. Economics (deriving from the Greek words οίκω [oeko], house, and νέμω [nemo], distribute) is the social science that studies the allocation of scarce resources through measurable variables. ... Chichicastenango, Guatemala traditional market Market stall in internally displaced persons camp in Kitgum, northern Uganda Mercado dos Lavradores, Funchal (Madeira Islands) A market is a mechanism which allows people to trade, normally governed by the theory of supply and demand. ... Institutions are organizations, or mechanisms of social structure, governing the behavior of two or more individuals. ... Public interest is a term used to denote political movements and organizations that are in the public interest—supporting general public and civic causes, in opposition of private and corporate ones (particularistic goals). ...

Economists use model-like theorems to explain or understand such cases. The two main reasons that markets fail are:

External costs and benefits

Among the strategies to reduce these imperfections are improvements by market participants or 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. An externality occurs in economics when a decision (for example, to pollute the atmosphere) causes costs or benefits to individuals or groups other than the person making the decision. ... The network effect causes a good or service to have a value to a potential customer dependent on the number of customers already owning that good or using that service. ... In economics, a public good is one that cannot or will not be produced for individual profit, since it is difficult to get people to pay for its large beneficial externalities. ... A Common Property Resource or Common Pool Resource (CPR) is produced by a sufficiently large resource system that makes it costly but not impossible to exclude potential beneficiaries. ... The tragedy of the commons is a metaphor used to illustrate the conflict between individual interests and the common good. ... In the analyses of economics and political science, free riders are actors who take more than their fair share of the benefits or do not shoulder their fair share of the costs of their use of a resource, involvement in a project, etc. ... This page deals with property as ownership rights. ... In economics, information asymmetry occurs when one party to a transaction has more or better information than the other party. ... Adverse selection or anti-selection is a term used in economics and insurance. ... In law and economics, moral hazard is the name given to the risk that one party to a contract can change their behaviour to the detriment of the other party once the contract has been concluded. ... The principal-agent problem in economics refers to the difficulties that arise under conditions of incomplete and asymmetric information when a principal hires an agent. ... A state is an organized political community occupying a definite territory, having an organized government, and possessing internal and external sovereignty. ... For an article on the meaning of this term in the field of law, see custom_(law). ... A community is a set of people (or agents in a more abstract sense) with some shared element — in particular a group of people who live in the same area is a community. ... The economic theory of collective action is concerned with the provision of public goods (and other collective consumption) through the collaboration of two or more individuals, and the impact of externalities on group behavior. ... In law and economics, the Coase theorem, attributed to Ronald Coase, is a theorem relating to the economic efficiency of a governments allocation of property rights. ...

Noncompetition

In economic theory, imperfect competition, is the competitive situation in any market where the conditions necessary for perfect competition are not satisfied. ... In economics, market power (sometimes called monopoly power) is a market failure which occurs when one or more of the participants has the ability to influence the price or other outcomes in some general or specialized market. ... In economics, a monopoly (from the Greek monos, one + polein, to sell) is defined as a persistent market situation where there is only one provider of a kind of product or service. ... In economics, a monopsony is a market with only one buyer in the market, often an input market. ... An oligopoly is a market form in which a market is dominated by a small number of sellers (oligopolists). ... An oligopsony is a market characterised by a small number of consumers for a product or a service. ... The form of economic competition known as Monopolistic competition occurs when: There are many producers and many consumers in a given market. ... -1... Price discrimination exists when sales of identical goods or services are transacted at different prices from the same provider. ... Price Skimming Price skimming is a pricing strategy in which a marketer sets a relatively high price for a product or service at first, then lowers the price over time. ...

Interpretations

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.

Neo-classical School

Note that all the types of failures listed above refer to situations where markets create inefficiency. This follows the lead of the currently-dominant school of academic economics, i.e., the neoclassical (orthodox) school. In this perspective, 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 that may be defined. Therefore, in this view, it is possible for a result to go against the public interest even if market failure is not involved. For example, many would consider the existence of gross inequalities in the distribution of wealth and income to be against the public interest, but this situation can be Pareto efficient, in that no one person could be made better off without making some other person worse off. Redistribution aimed at reducing the degree of inequality would be inefficient under the Pareto definition. Neoclassical economics is the grouping of a number of schools of thought in economics. ... The term inefficiency has several meanings depending on the context in which its used: Economic inefficiency refers to a situation where we could be doing a better job, i. ... Pareto efficiency, or Pareto optimality, is a central concept in economics with broad applications in game theory, engineering and the social sciences. ... Public interest is a term used to denote political movements and organizations that are in the public interest—supporting general public and civic causes, in opposition of private and corporate ones (particularistic goals). ...

Put another way, consider 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 or poorly. This phrase also suggests, accurately, that markets serve those with the most wealth and income best, and those without such purchasing power worst; the working of markets reflects the pre-existing distribution of wealth. In the neoclassical view, the issue of the inequality of distribution of income and wealth left over from history is completely separate from that of market failure, at least in static analysis. Statics is the branch of physics that is concerned with physical systems that are in static equilibrium, that is, in a state where the relative positions of subsystems do not vary over time, or where components and structures are at rest under the action of external forces of equilibrium. ...

On the other hand, in dynamic analysis, if the operations of markets normally lead to increasing inequality of wealth ownership over time, many neoclassicals would see it as a result of market failure, e.g., the ability of those with the most wealth to use their economic power to increase their wealth. This phenomenon could reflect a lack of competition in markets or others from the list of market failures above. In physics, dynamics is the branch of mechanics that is concerned with the effects of forces on the motion of objects. ... There is no agreed-upon definition of power in economics. ...

Keynesian / Neo-Keynesian School

Modern macroeconomics, especially that of the Keynesian or new Keynesian varieties, applies the neoclassical view to interpret the failure to automatically attain full employment of resources (as with Say's Law) in terms of theories of market failure. Once modified to take market failure into account, the standard Walrasian model of general equilibrium usually produces Keynesian results. For new Keynesians, the main stress in on the non-adjustment of prices and (especially) wages. Keynesian economics, or Keynesianism, is an economic theory based on the ideas of John Maynard Keynes, as put forward in his book The General Theory of Employment, Interest and Money, published in 1936 in response to the Great Depression of the 1930s. ... New Keynesian economics developed partly in response to new classical economics. ... Macroeconomics is the study of the entire economy in terms of the total amount of goods and services produced, total income earned, the level of employment of productive resources, and the general behavior of prices. ... Keynesian economics, or Keynesianism, is an economic theory based on the ideas of John Maynard Keynes, as put forward in his book The General Theory of Employment, Interest and Money, published in 1936 in response to the Great Depression of the 1930s. ... New Keynesian economics developed partly in response to new classical economics. ... In economics, full employment has more than one meaning. ... Says law is an economic principle, formulated by Jean-Baptiste Say, that asserts that there can be no demand without supply. ... General Equilbrium (linear) supply and demand curves. ... New Keynesian economics developed partly in response to new classical economics. ...

Austrian and Public Choice Schools

Many advocates of laissez-faire capitalism, such as libertarians and economists of the Austrian School, often deny the existence of market failures altogether [1] (http://www.mises.org/story/1806), or see them as small, irrelevant, or temporary. For example, the problem of externalities is often played down by terming them mere "neighborhood effects". Public choice theory is a branch of economics that studies the decision-making behavior of voters, politicians and government officials from the perspective of economic theory. ... Laissez-faire is short for laissez faire, laissez passer, a French phrase meaning to let things alone, let them pass. First used by the eighteenth century Physiocrats as an injunction against government interference with trade, it is now used as a synonym for strict free market economics. ... Capitalism has been defined in various ways (see definitions of capitalism). ... The term libertarian is also claimed by libertarian socialism. ... The Austrian School is a school of economic thought which rejects opposing economists reliance on methods used in natural science for the study of human action, and instead bases its formalism of economics on relationships through logic or introspection called praxeology. ... An externality occurs in economics when a decision (for example, to pollute the atmosphere) causes costs or benefits to individuals or groups other than the person making the decision. ...

Economists of the Public Choice school often argue that market failure does not necessarily imply that government should attempt to solve market failures, because the costs of government failure might be worse than those of the market failure it attempts to fix. This failure of government is seen as the result of the inherent problems of democracy perceived by this school and also of the power of special-interest groups (rent seekers) both in the private sector and in the government bureaucracy. Public choice theory is a branch of economics that studies the decision-making behavior of voters, politicians and government officials from the perspective of economic theory. ... Government failure is a situation in which the government intervenes to correct for externalities and ends up making things worse. ... In economics, rent-seeking takes place when an entity seeks to extract uncompensated value from others by manipulation of the economic environment -- often including regulations or other government decisions. ... The private sector of a nations economy consists of those entities which are not controlled by the state - i. ... In sociological theories, bureaucracy is an organizational structure characterized by regularized procedure, division of responsibility, hierarchy, and impersonal relationships. ...

To these schools, a market failure is usually a failure 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. Moreover, conditions that many would regard as negative are often seen as an effect of subversion of the free market by coercive government intervention. Coercion is the practice of compelling a person to act by employing threat of force. ...

While some would dub 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 was never the purpose of establishing markets in the first place. But critics of laissez faire would ask who it was who determined the purpose of using markets. For example, in many cases, "privatization", i.e., the replacement of government programs by ones organized following market principles, simply reflects the political influence of businesses that see potential profit gains from marketization (i.e., rent-seeking) 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 sometimes a privately owned monopoly allied with the political insiders, the kind of crony capitalism that most economists, including the laissez faire schools oppose. Privatization (sometimes privatisation, denationalization, or, especially in India, disinvestment) is the process of transferring property, from public ownership to private ownership and/or transferring the management of a service or activity from the government to the private sector. ... In economics, rent-seeking takes place when an entity seeks to extract uncompensated value from others by manipulation of the economic environment -- often including regulations or other government decisions. ... An ideology is a collection of ideas. ... The flag of the International Monetary Fund (IMF) The International Monetary Fund (IMF) is the international organization entrusted with overseeing the global financial system by monitoring foreign exchange rates and balance of payments, as well as offering technical and financial assistance when asked. ... Crony capitalism or capitalist cronyism is a pejorative term that asserts that a particular capitalist economy may depend on an extremely close relationship between private business and the state institutions of politics and government, rather than by the espoused equitable concepts such as the free market, open competition, and economic...

New liberal schools

Others, such as social democrats and "New Deal liberals", view market failures as a very common 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 (usually interpreted in terms of limiting inequalities in wealth and income). Both the democratic accountability of these regulations and the technocratic expertise of the economists play an important role here in shaping the kind and degree of intervention. New liberalism (also called modern liberalism or social liberalism) is a stance in political economy that argues for extensive government regulation and partial intervention in the economy, though much less than what is advocated by social democrats. ... Social democracy is a political ideology emerging in the late 19th and early 20th centuries from supporters of Marxism who believed that the transition to a socialist society could be achieved through democratic evolutionary rather than revolutionary means. ... New liberalism (also called modern liberalism or social liberalism) is a stance in political economy that argues for extensive government regulation and partial intervention in the economy, though much less than what is advocated by social democrats. ... Justice is a concept involving the fair, moral, and impartial treatment of all persons, especially in law. ... Technocracy can refer to: A bureaucratic technocracy (this derogatory use is the most common). ...

A major argument against this view is that these liberals have too much faith in the benevolence of the government and/or in the ability of citizens to control their government democratically. As noted, advocates of laissez faire point to a large number of examples of government failure, where the government interference in markets made matters worse. The social democrats and New Deal liberals would riposte that we should seek the best combination of markets and government, in light of the failures of both. Of course, to most economists, markets could not exist without government enforcement of individual property rights and contracts, so that the idea of a totally free market system is ridiculous. A free market is an idealized market, where all economic decisions and actions by individuals regarding transfer of money, goods, and services are voluntary, and are therefore devoid of coercion and theft (some definitions of coercion are inclusive of theft). Colloquially and loosely, a free market economy is an economy...

In the current era, we sometimes see professed New Deal liberal intentions merged with laissez-faire 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 term neoliberalism is used to describe a political-economic philosophy that had major implications for government policies beginning in the 1970s – and increasingly prominent since 1980 – that de-emphasizes or rejects positive government intervention in the economy (that complements private initiative), focusing instead on achieving progress and even social...

Marxist School

In general, Marxists would argue that the system of individual property rights is a fundamental problem in itself, and that resources should be allocated in another way (usually democratically or assigned by a central planner or planning board held democratically responsible to the people). This is different from concepts of "market failure" which focuses on specific situations – typically seen as "abnormal" – where markets have inefficient outcomes. Marxists, in contrast, would say that all markets have inefficient and democratically-unwanted outcomes. Marxism is the political practice and social theory based on the works of Karl Marx, a 19th century German philosopher, economist, journalist, and revolutionary, along with Friedrich Engels. ...

That is, the Marxist school of economics sees market failure as an inherent feature of any capitalist economy. However, although Marxists argue for the abolition of capitalism, they often do not raise 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. Further, they see capitalist exploitation, class conflict, and economic crises as existing even with "perfect" markets. The issues of wealth inequality and increases in its degree (discussed above) moves to center stage, along with the associated inequalities of social power. Marxism is the political practice and social theory based on the works of Karl Marx, a 19th century philosopher, economist, journalist, and revolutionary, along with Friedrich Engels. ... In political economy, economics, and sociology, exploitation usually does not include simple theft, since the latter is not a persistent economic or social relationship, as when a pimp exploits his prostitute. ... Class conflict is both the friction that accompanies social relationships between members or groups of different social classes and the underlying tensions or antagonisms which exist in society. ... In economics, crisis is an old term in business cycle theory, referring to the sharp transition to a recession. ...

Even when they do discuss the issue of market failure, Marxists 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 in the name of the people. In this view, market failure and government failure normally go together. Only popular pressure on both the government and the companies benefiting from market failure can lead to success in reducing market failures.

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