Market failures occur when the allocation of goods and services by markets are not efficient and lead to net social welfare loss. In his book Public Economics – Principles and Practice, Economist Peter Abelson describes common causes of market failure and solutions governments might take in response.
Common Causes of Market Failure
Public goods describe goods and services which are non-excludable or non-rival in consumption. Markets are less likely to produce an efficient amount of goods when the private benefit is low and the public benefit relatively high.
Externalities describe costs or benefits that arise from an activity but are not accrued to the firm or persons involved directly, due often to the lack of enforceable property rights. Common property resources describe resources that are free for all to use. Here, resource over-utilisation is more likely because it is free and does not incorporate the value of use to others.
Imperfect competition in the form of natural monopolies, oligopolies and monopolistically competitive markets have potential to control markets, misallocate resources and create deadweight loss. Imperfect competition may occur due to economies of scale or scope, product differentiation and competitive advantages due to innovation. Market power in factor markets may also result in an inefficient under- or over-supply of goods and services as well. Common examples include firm control on resource supply and union control over labour supply.
Information failures and asymmetric information can lead to misallocations or inefficient levels of goods and services when buyers and sellers are not well informed. Important concepts include:
- Incomplete markets that do not possess information that should be readily available or are constrained by uncertainty may lead to market failure;
- Moral hazards occur when the behaviour of an economic agent changes, to the detriment of another, after a transaction has taken place;
- Principal-agent problems occur when one economic agent makes a decision or action on behalf of another, but in the best interest of itself;
- Adverse selection occurs when an economic agent makes a transaction to its benefit and detriment to another due to private information or lack of disclosure; and
- Consumer sovereignty refer to individuals who are in control and the best judge of their own welfare. However, traits such as incomplete self-control or bounded rationality in consumers lead to poor decision making and socially optimal outcomes.
Other concepts and potential sources of market failures:
- High factor mobility, transaction and enforcement costs might contribute to inefficiencies in markets and less than optimal resource allocation.
- Disequilibrium describes instances of excess demand or supply in markets. In competitive markets, prices may not clear the market because of lagged responses from economic agents, due to imperfect foresight and exogenous shocks.
Government Functions and Instruments
Abelson notes that governments have four primary economic functions to establish legal infrastructure to enable market activity; allocate resources where there are market failures; provide social welfare and equitable redistribution, and deliver sound macroeconomic management.
Market failures can lead to an inefficient allocation or production of goods and services, and create net social welfare loss. Conversely, efficient markets can often produce highly unequal outcomes as well. Governments may intervene to achieve more socially preferred levels and allocation of resources and output; and when the expected net benefits from intervention exceed the current or expected net benefits without intervention. Valuation of net benefits can often be subjective because alternative decisions present complex trade-offs that are difficult to compare directly (e.g. trade-offs in economic, social and environmental benefits; or trade-offs between efficiency and equity).
There are many instruments for intervention that governments could pursue:
- Lower intervention: Information provision and moral exhortation, market creation (e.g. auctions), facilitation and assistance, or simply do nothing;
- Medium intervention methods: Public funding and payments, government incentives and fiscal instruments (e.g. taxes, subsidies, price floors and price ceilings); and
- Higher intervention methods: Regulation and legislation, public provision through state-owned enterprises, redistribution and reallocation activities;
References
Abelson, P. (2018). Public Economics – Principles and Practice. Available
at <http://www.appliedeconomics.com.au/publications/>