Market failure

The neoclassical school attributes market failures to the interference of self-regulatory organizations, governments or supra-national institutions in a particular market, although this view is criticized by heterodox economists. Economists, especially microeconomists, are often concerned with the causes of market failure and possible means of correction. Such analysis plays an important role in many types of public policy decisions and studies.

However, government policy interventions, such as taxes, subsidies, wage and price controls, and regulations, may also lead to an inefficient allocation of resources, sometimes called government failure. Most mainstream economists believe that there are circumstances (like building codes, fire safety regulations or endangered species laws) in which it is possible for government or other organizations to improve the inefficient market outcome. Several heterodox schools of thought disagree with this as a matter of ideology.

An ecological market failure exists when human activity in a market economy is exhausting critical non-renewable resources, disrupting fragile ecosystems, or overloading biospheric waste absorption capacities. In none of these cases does the criterion of Pareto efficiency obtain.

Categories

Different economists have different views about what events are the sources of market failure. Mainstream economic analysis widely accepts that there are several causes of market failures. These include if the market is "monopolised" or a small group of businesses hold significant market power resulting in a "failure of competition"; if production of the good or service results in an externality (external costs or benefits); if the good or service is a "public good"; if there is a "failure of information" or information asymmetry; if there is unequal bargaining power; if there is bounded rationality or irrationality; and if there are macro-economic failures such as unemployment or inflation.

Failure of competition

Agents in a market can gain market power, allowing them to block other mutually beneficial gains from trade from occurring. This can lead to inefficiency due to imperfect competition, which can take many different forms, such as monopolies, monopsonies, or monopolistic competition, if the agent does not implement perfect price discrimination.

It is then a further question about what circumstances allow a monopoly to arise. In some cases, monopolies can maintain themselves where there are "barriers to entry" that prevent other companies from effectively entering and competing in an industry or market. Or there could exist significant first-mover advantages in the market that make it difficult for other firms to compete. Moreover, monopoly can be a result of geographical conditions created by huge distances or isolated locations. This leads to a situation where there are only few communities scattered across a vast territory with only one supplier. Australia is an example that meets this description. A natural monopoly is a firm whose per-unit cost decreases as it increases output; in this situation it is most efficient (from a cost perspective) to have only a single producer of a good. Natural monopolies display so-called increasing returns to scale. It means that at all possible outputs marginal cost needs to be below average cost if average cost is declining. One of the reasons is the existence of fixed costs, which must be paid without considering the amount of output, what results in a state where costs are evenly divided over more units leading to the reduction of cost per unit.

Public goods

Some markets can fail due to the nature of the goods being exchanged. For instance, some goods can display the attributes of public goods or common goods, wherein sellers are unable to exclude non-buyers from using a product, as in the development of inventions that may spread freely once revealed, such as developing a new method of harvesting. This can cause underinvestment because developers cannot capture enough of the benefits from success to make the development effort worthwhile. This can also lead to resource depletion in the case of common-pool resources, whereby the use of the resource is rival but non-excludable, there is no incentive for users to conserve the resource. An example of this is a lake with a natural supply of fish: if people catch the fish faster than the fish can reproduce, then the fish population will dwindle until there are no fish left for future generations.

Externalities

A good or service could also have significant externalities, where gains or losses associated with the product, production or consumption of a product, differ from the private cost. These gains or losses are imposed on a third-party that did not take part in the original market transaction. These externalities can be innate to the methods of production or other conditions important to the market.

"The Problem of Social Cost" illuminates a different path towards social optimum showing the Pigouvian tax is not the only way towards solving externalities. It is hard to say who discovered externalities first since many classical economists saw the importance of education or a lighthouse, but it was Alfred Marshall who wanted to explore this more. He wondered why long-run supply curve under perfect competition could be decreasing so he founded "external economies". Externalities can be positive or negative depending on how a good/service is produced or what the good/service provides to the public. Positive externalities tend to be goods like vaccines, schools, or advancement of technology. They usually provide the public with a positive gain. Negative externalities would be like noise or air pollution. Coase shows this with his example of the case Sturges v. Bridgman involving a confectioner and doctor. The confectioner had lived there many years and soon the doctor several years into residency decides to build a consulting room; it is right by the confectioner's kitchen which releases vibrations from his grinding of pestle and mortar. The doctor wins the case by a claim of nuisance so the confectioner would have to cease from using his machine. Coase argues there could have been bargains instead the confectioner could have paid the doctor to continue the source of income from using the machine hopefully it is more than what the Doctor is losing. Vice versa the doctor could have paid the confectioner to cease production since he is prohibiting a source of income from the confectioner. Coase used a few more examples similar in scope dealing with social cost of an externality and the possible resolutions.

Traffic congestion is an example of market failure that incorporates both non-excludability and externality. Public roads are common resources that are available for the entire population's use (non-excludable), and act as a complement to cars (the more roads there are, the more useful cars become). Because there is very low cost but high benefit to individual drivers in using the roads, the roads become congested, decreasing their usefulness to society. Furthermore, driving can impose hidden costs on society through pollution (externality). Solutions for this include public transportation, congestion pricing, tolls, and other ways of making the driver include the social cost in the decision to drive.

Perhaps the best example of the inefficiency associated with common/public goods and externalities is the environmental harm caused by pollution and overexploitation of natural resources.

Coase theorem

The Coase theorem, developed by Ronald Coase and labeled as such by George Stigler, states that private transactions are efficient as long as property rights exist, only a small number of parties are involved, and transactions costs are low. Additionally, this efficiency will take place regardless of who owns the property rights. This theory comes from a section of Coase's Nobel prize-winning work The Problem of Social Cost. While the assumptions of low transactions costs and a small number of parties involved may not always be applicable in real-world markets, Coase's work changed the long-held belief that the owner of property rights was a major determining factor in whether or not a market would fail. The Coase theorem points out when one would expect the market to function properly even when there are externalities.

A market is an institution in which individuals or firms exchange not just commodities, but the rights to use them in particular ways for particular amounts of time. [...] Markets are institutions which organize the exchange of control of commodities, where the nature of the control is defined by the property rights attached to the commodities.

As a result, agents' control over the uses of their goods and services can be imperfect, because the system of rights which defines that control is incomplete. Typically, this falls into two generalized rights – excludability and transferability. Excludability deals with the ability of agents to control who uses their commodity, and for how long – and the related costs associated with doing so. Transferability reflects the right of agents to transfer the rights of use from one agent to another, for instance by selling or leasing a commodity, and the costs associated with doing so. If a given system of rights does not fully guarantee these at minimal (or no) cost, then the resulting distribution can be inefficient. Considerations such as these form an important part of the work of institutional economics. Nonetheless, views still differ on whether something displaying these attributes is meaningful without the information provided by the market price system.

Information failures

Information asymmetry is considered a leading type of market failure. This is where there is an imbalance of information between two or more parties to a transaction. One example is incomplete markets, for example where second hand car buyers know there is a risk a car may break down, and systematically under-pay to discount this risk: this leads to fewer cars being sold overall; or where insurers know that some policyholders will withhold information, and systematically refuse to insure certain groups because of this risk. This may result in economic inefficiency, but also have a possibility of improving efficiency through market, legal, and regulatory remedies. From contract theory, decisions in transactions where one party has more or better information than the other is considered "asymmetry". This creates an imbalance of power in transactions which can sometimes cause the transactions to go awry. Examples of this problem are adverse selection and moral hazard. Most commonly, information asymmetries are studied in the context of principal–agent problems. George Akerlof, Michael Spence, and Joseph E. Stiglitz developed the idea and shared the 2001 Nobel Prize in Economics.

Unequal bargaining power

In The Wealth of Nations Adam Smith explored how an employer had the ability to "hold out" longer in a dispute over pay with workers because workers were more likely to go hungry more quickly, given that the employer has more property, and have fewer obstacles in organising. Unequal bargaining power has been used as a concept justifying economic regulation, particularly for employment, consumer, and tenancy rights since the early 20th century. Thomas Piketty in Capital in the Twenty-First Century explains how unequal bargaining power undermines "conditions of "pure and perfect" competition" and leads to a persistently lower share of income for labor, and leads to growing inequality. While it was argued by Ronald Coase that bargaining power merely affects distribution of income, but not productive efficiency, the modern behavioural evidence establishes that distribution or fairness of exchange does affect motivation to work, and therefore unequal bargaining power is a market failure. Notably, the price of labour was excluded from the scope of the original charts on supply and demand by their inventor, Fleeming Jenkin, who considered that the wages of labour could not be equated with ordinary markets for commodities such as corn, because of labour's unequal bargaining power.

Bounded rationality

In Models of Man, Herbert A. Simon points out that most people are only partly rational, and are emotional/irrational in the remaining part of their actions. In another work, he states "boundedly rational agents experience limits in formulating and solving complex problems and in processing (receiving, storing, retrieving, transmitting) information" (Williamson, p. 553, citing Simon). Simon describes a number of dimensions along which "classical" models of rationality can be made somewhat more realistic, while sticking within the vein of fairly rigorous formalization. These include:

• limiting what sorts of utility functions there might be.
• recognizing the costs of gathering and processing information.
• the possibility of having a "vector" or "multi-valued" utility function.

Simon suggests that economic agents employ the use of heuristics to make decisions rather than a strict rigid rule of optimization. They do this because of the complexity of the situation, and their inability to process and compute the expected utility of every alternative action. Deliberation costs might be high and there are often other, concurrent economic activities also requiring decisions.

The concept of bounded rationality was significantly expanded through behavioral economics research, suggesting that people are systematically irrational in day-to-day decisions. Daniel Kahneman in Thinking, Fast and Slow explored how human beings operate as if they have two systems of thinking: a fast "system 1" mode of thought for snap, everyday decisions which applies rules of thumb but is frequently mistaken; and a slow "system 2" mode of thought that is careful and deliberative, but not as often used in making ordinary decisions to buy and sell or do business.

Macro-economic failures

"Unemployment, inflation and "disequilibrium" are considered a category of market failure at a "macro economic" or "whole economy" level. These symptoms (of high job loss, or fast rising prices or both) can result from a financial crash, a recession or depression, and the market failure is evident in the sustained underproduction of an economy, or a tendency not to recover immediately. Macroeconomic business cycles are a part of the market. They are characterized by constant downswings and upswings which influence economic activity. Therefore, this situation requires some kind of government intervention.

Persistent labor shortages

Widespread and persistent domestic labour shortages in various countries are examples of market failure, whereby excessively low salaries (relative to the domestic cost of living) and adverse working conditions (excessive workload and working hours) in low-wage industries (hospitality and leisure, education, health care, rail transportation, warehousing, aviation, retail, manufacturing, food, construction, elderly care), collectively lead to occupational burnout and attrition of existing workers, insufficient incentives to attract the inflow supply of domestic workers, short-staffing and regular shift work at workplaces and further exacerbation (positive feedback) of staff shortages. Poor job quality and artificial shortages perpetuated by salary-paying employers, deter workers from entering or remaining in these roles.

Labour shortages occur broadly across multiple industries within a rapidly expanding economy, whilst labour shortages often occur within specific industries (which generally offer low salaries) even during economic periods of high unemployment. In response to domestic labour shortages, business associations such as chambers of commerce, trade associations or employers' organizations would generally lobby to governments for an increase of the inward immigration of foreign workers from countries which are less developed and have lower salaries. In addition, business associations have campaigned for greater state provision of child care, which would enable more women to re-enter the labour workforce at a lower wage rate to achieve economic equilibrium. However, as labour shortages in the relevant low-wage industries are often widespread globally throughout many countries in the world, immigration would only partially address the chronic labour shortages in the relevant low-wage industries in developed countries (whilst simultaneously discouraging local labour from entering the relevant industries) and in turn cause greater labour shortages in developing countries.