Market Failure Theory

Market failure theory analyses the circumstances in which markets fail to allocate resources efficiently, providing a rationale for government intervention. The theory identifies several sources of market failure, including externalities, public goods, market power, and imperfect information.

Externalities

An externality arises when the production or consumption of a good affects the welfare of third parties without being reflected in the price. Negative externalities, such as pollution, impose costs on others, while positive externalities, such as education, confer benefits.

The presence of externalities means that the market outcome is not efficient, since the private cost or benefit differs from the social cost or benefit. The efficient outcome requires that the marginal social cost equals the marginal social benefit, which may require taxes, subsidies, or regulation.

Public Goods

A public good is a good that is non-rival and non-excludable. Non-rivalry means that the consumption of the good by one person does not reduce the amount available to others, and non-excludability means that it is not possible to prevent others from consuming it.

The characteristics of public goods mean that markets undersupply them, since individuals have an incentive to free ride on the contributions of others. The efficient provision of public goods requires collective action, typically through the government.

Market Power

Market power is the ability of a firm to influence the price of its product. A firm with market power sets price above marginal cost, which reduces output below the efficient level and creates a deadweight loss.

The presence of market power provides a rationale for competition policy and for the regulation of natural monopolies. The design of policy must balance the benefits of the efficiency that market power may reflect against the costs of the distortion that it creates.

Imperfect Information

Imperfect information arises when one party to a transaction knows more than the other. Asymmetric information can lead to adverse selection, in which the quality of the goods traded declines, and to moral hazard, in which one party takes actions that harm the other.

The presence of imperfect information provides a rationale for disclosure requirements, for the regulation of financial markets, and for the design of contracts and of institutions that mitigate the problems.

Policy

The theory of market failure provides a rationale for government intervention, but it does not imply that intervention is always beneficial. Governments may fail to correct market failures, for reasons including imperfect information, the influence of interest groups, and the administrative costs of intervention.

The analysis of policy must therefore compare the market outcome with the outcome of intervention, taking account of the failures of government as well as those of the market. The design of policy must address the specific failure and must be robust to the limitations of the public sector.

Externalities and Policy

The analysis of externalities provides the basis for several policies. A tax on a good that generates a negative externality, such as pollution, raises its price and reduces the quantity produced, aligning the private cost with the social cost. A subsidy on a good that generates a positive externality, such as education, raises its quantity.

The optimal tax or subsidy is equal to the marginal external cost or benefit at the efficient level of output. The determination of the optimal level requires estimates of the external cost or benefit, which are often difficult to obtain.

The policy can also take the form of regulation, which sets standards for the activities that generate the externality. The choice between taxes and regulation depends on the information available and on the nature of the externality. Taxes are more efficient when the costs of abatement differ across firms, since they allow firms to reduce emissions where it is cheapest.

Public Goods and Collective Action

The provision of public goods requires collective action, since individuals have an incentive to free ride. The analysis of collective action, developed by Mancur Olson, examines the conditions under which groups can organise to provide public goods.

The analysis holds that small groups are more likely to organise than large ones, since the costs and the benefits are more concentrated. The provision of public goods at the national level therefore requires institutions, including the government, that can compel contributions through taxation.

The analysis also applies to the international level, where the provision of global public goods, including the prevention of climate change, requires cooperation among countries. The absence of a global authority makes the provision more difficult, and it requires institutions and agreements that can overcome the incentive to free ride.

Government Failure

The theory of government failure analyses the circumstances in which government intervention fails to improve on the market outcome. The failures arise from imperfect information, from the influence of interest groups, and from the administrative costs of intervention.

The analysis holds that the comparison of the market outcome with the outcome of intervention must consider the failures of both. A policy that is intended to correct a market failure may create a worse outcome if the government fails.

The analysis informs the design of policy, which should address the specific failure and should be robust to the limitations of the public sector. The design should also include mechanisms for monitoring and for correction, so that policies that fail can be revised.

Summary

The theory of market failure identifies the circumstances in which markets fail to allocate resources efficiently and provides a rationale for government intervention. Its application requires attention to the failures of government and to the design of policies that are robust to the limitations of both the market and the public sector.

See also

• Economic Efficiency
• Public Economics
• Monopoly Power