Market Failure

What It Means

Market failure is a term used by economists to describe situations in which markets (the real or virtual places where buyers and sellers come together to do business with one another) fail to serve, or are incapable of serving, the best interests of society.

Most mainstream economists believe that markets offer the best way of organizing economic activity. The market forces that do most of the organizing are supply, demand, and prices. Supply is the quantity of goods that sellers are willing to sell over a range of prices, and demand is the quantity of goods that buyers are willing to buy over a range of prices. Prices rise or fall according to the competing interests of buyers (who want low prices) and sellers (who want high prices). In a free market, where there are many different buyers and many different sellers, prices end up at a level that accommodates both sides to an acceptable degree: buyers get what they want at prices that seem fair to them, and sellers are able to maintain profitable businesses. In addition, the market mechanisms described above encourage sellers to produce the amount and variety of goods and services that society wants and to do so in the most efficient ways possible.

Unfortunately the economy does not always function as smoothly in practice as it does in theory. There are cases in which markets either generate results that harm society or cannot provide the results that society wants. For instance, market activity often produces pollution (dirty air, water, or soil) at levels that are unacceptable to the public. Additionally markets cannot provide for national defense. Every resident of a country needs equal access to national defense, regardless of ability to pay. There is no effective way to generate capable armies and equipment based on supply, demand, and pricing. These are two instances of market failure.

Government intervention can sometimes correct or counteract market failure. Because the market system provides no incentive for companies to stop polluting, the government establishes laws and financial penalties for polluters. Similarly the government assumes exclusive control over matters related to national defense. There is no way to eliminate market failure entirely, however.

When Did It Begin

Until the twentieth century governments in capitalist countries largely stayed out of economic affairs. While there has never been any serious disagreement about governmental intervention in such areas as the defense industry, road-building, or public services (police and fire departments, for example), there was little precedent for governments to correct other forms of market failure prior to the Great Depression, which crippled the economies of North America and Europe in the 1930s.

British economist John Maynard Keynes (1883–1946), writing during the Depression, revolutionized economics by suggesting that the market mechanisms of supply, demand, and pricing could not always be trusted to regulate the economy effectively. Keynes persuaded world leaders that government had to take the lead in correcting the market failures that had caused the depression. Following Keynes’s advice, governments began spending money on public projects and aid programs. The influx of money into the economies of the affected countries helped them recover from the depression, establishing a precedent for government intervention in the economy.

But in the 1970s Keynes’s ideas fell out of favor, especially in the United States. Economic stagnation at that time was blamed on the very government intervention that had previously helped the country. As a result, subsequent U.S. government administrations only cautiously stepped in to correct market failures, and a distrust of the government’s ability to improve upon the performance of markets began to dominate economics and politics.

More Detailed Information

When a market failure occurs, there is inefficiency in the economy. The case of public goods represents one type of market failure. Public goods include parks, police and firefighting services, military protection, highways, streetlamps, and lighthouses, to name a few. Because of the nature of public goods, the market has little incentive to supply them, and governments must step in. Public goods are different from private goods in three key ways that make them unmarketable. First, when one person uses a public good, no one else is prevented from enjoying its use. Hundreds of ships can benefit equally from a lighthouse, just as hundreds of people can benefit equally from a park. By contrast, private goods, such as food or computers, cannot be enjoyed simultaneously by large numbers of people. The second key difference between public and private goods is that public goods cannot be easily denied to any person who wants to use them. There is no effective way to keep any particular ship from using the service provided by a lighthouse. It is relatively easy, however, to deny other people the right to eat food that you have bought for yourself. Third, public goods are beyond the purchasing reach of individuals. Lighthouses cost too much money to build and operate for any single person to bear the financial responsibility for one. Because of these three characteristics, no private business would be able provide a public good and still make a profit, so local and national governments raise money through taxes to supply these public services.

Another common form of market failure occurs when there is a lack of competition among companies in a certain industry. If, for instance, one sneaker company becomes so successful that it is able to buy out its rivals and form a monopoly (when a company gains exclusive control over the market for a particular product or service), or if two leading sneaker companies get together and conspire to raise prices, inefficiency results. Supply, demand, and pricing are then determined artificially rather than through the natural interaction that results from competition. Resources are wasted, with negative effects for the economy as a whole.

Yet another type of market failure is what economists call an externality. An externality is any byproduct of market activity that is not accounted for in the price of the goods produced. For instance, if a company’s factory pollutes a town’s air while making paper, the townspeople will bear the costs of that pollution (in the form of doctors’ bills, cleaning bills, lower real-estate values than in nearby towns, and so forth), whether or not they purchase the company’s paper. For the market to function efficiently, the factory and the purchasers of the paper, and not the townspeople, should be paying for the results of the pollution. Because these costs are not passed on to the paper buyers, they buy paper in larger quantities than they otherwise would, and the factory produces more paper to meet the demand, unhampered by any cut in its profits as a result of having to be responsible for the pollution itself. There are also positive externalities. For example, when a prestigious gourmet grocery store moves into a neighborhood, property values in the area around the store may rise. The homeowners near the grocery store get economic benefits without paying for them.

Market failures can also result from positive externalities. For example, leaving the development of immunizations and vaccines to the workings of a free market will result in too few people getting them. This is because private economic actors usually do not take into account the positive effects on others when they make consumption or production decisions. For instance, a single flu vaccination carries far greater social benefits than private benefits. Because each person who gets a vaccine not only avoids getting the virus himself but also helps to limit the spread of the disease, benefiting countless others. But when deciding whether to get a flu vaccination, individuals usually take their own private benefits into account: they get the shot to avoid contracting the flu, or they do not get it because they think they are not at risk of becoming seriously ill from the virus. Their demand does not accurately reflect the true demand for the product. In determining how much vaccine to supply, vaccine developers likewise fail to take the social benefits into account, because they have no financial motivation to do so. They consider their own private benefits, and therefore the supply of vaccines never meets the demand for them.

Finally, and more controversially, markets may be said to have failed when a certain good or service is more unequally distributed than society believes it should be. In the United States in the first few years of this century, the health care system represented a case of market failure in the eyes of many people, including some economists. Only people with wealth or certain types of jobs could get private health insurance that paid for medical care, even though most people were uncomfortable with the idea of denying health care to people with low-paying jobs and little wealth. Those who saw this situation as an instance of market failure called for government intervention, but many people denied that it was a case of market failure and believed that the government would not improve on the performance of the market system.

Recent Trends

There is no such thing as a perfectly functioning market system. Some amount of inefficiency will be present in the best of times. Mainstream American economists today usually declare, therefore, that market failure exists only when the inefficiency is dramatic and might call for government intervention. This level is reached, in the view of economists, when it seems likely that the government can do a better job of managing the situation than markets are doing. Thus, economists generally believe that whenever the government considers intervening in the economy, it must be shown that the damage the government might inflict on certain people will be less significant than the aid it will be giving to other people.