Market Failure

Market failure is a situation in which a market left to itself does not produce an efficient outcome: too much of something gets made, too little of something else, or a trade that would benefit everyone never happens. Economists use the term in a precise sense. A market fails when the allocation it delivers falls short of Pareto efficiency, meaning resources could be rearranged so that at least one person gains and nobody loses.

The idea sits at the centre of microeconomics and public finance. It is the standard economic argument for taxes, subsidies, regulation and public provision, and it is paired with its mirror image, government failure, which describes the ways those interventions can themselves go wrong. Market failure is not the same as an unfair outcome: a market can be efficient and still leave large inequalities, which economists treat as a separate question.

Think of a busy shared kitchen in an office. Everyone is happy to cook, but nobody feels responsible for washing the communal pans, so the sink fills up. Each person acts sensibly for themselves, yet the kitchen as a whole ends up in a worse state than anyone wants. Nothing is broken about the people; the arrangement simply gives them the wrong signals.

Markets usually work well because prices carry information and reward people for meeting each other's needs. Market failure is the name for the cases where prices send the wrong signal or no signal at all, such as when a cost lands on someone outside the deal, when nobody can be charged for a benefit, or when one side knows far more than the other.

Textbooks group the causes into a handful of families. They often overlap in real cases.

• Externalities. An externality is a cost or benefit that falls on people outside a transaction, such as pollution from a factory or the wider gains from vaccination. Because the buyer and seller ignore it, the market produces too much of harmful activities and too little of helpful ones.
• Public goods. Public goods such as national defence or street lighting are non-rival and non-excludable, so private firms struggle to charge for them and the free-rider problem leads to underprovision.
• Common resources. Shared resources like fisheries or groundwater are open to overuse, the pattern known as the tragedy of the commons.
• Market power. A monopoly or tight cartel can restrict output and raise prices above marginal cost, leaving trades unmade that both sides would have valued.
• Information problems. Asymmetric information can unravel markets through adverse selection and distort behaviour through moral hazard.
• Incomplete markets and coordination failures. Some risks cannot be insured or traded at all, and economies can get stuck in bad equilibria, such as a bank run in which each depositor withdraws because they expect others to.

Classical economists already accepted that some services, such as defence and justice, needed the state; Adam Smith listed public works among the sovereign's duties in 1776. The modern framework took shape in the twentieth century. Arthur Pigou's The Economics of Welfare (1920) analysed gaps between private and social costs, Paul Samuelson formalised public goods in 1954, and Francis Bator popularised the phrase "anatomy of market failure" in a 1958 paper. From the 1960s onwards, Ronald Coase argued that clearly defined property rights and low bargaining costs could let private parties solve some of these problems themselves, a claim now known as the Coase theorem, while George Akerlof, Michael Spence and Joseph Stiglitz showed how information gaps distort markets, work recognised by the Nobel Prize in 2001.

Governments respond in several ways, and the right tool depends on the cause.

• Pricing the side effect. A Pigouvian tax, such as a carbon tax, makes polluters pay for the harm they cause; tradable permit schemes like the EU Emissions Trading System, launched in 2005, cap the total instead.
• Direct provision or funding. Defence, basic research and much infrastructure are paid for from taxes because private markets would supply too little.
• Regulation. Disclosure rules, product standards, antitrust enforcement and deposit insurance target information problems and market power.
• Assigning rights. Creating fishing quotas, pollution permits or intellectual property gives someone an ownership stake in a resource that was previously unpriced.

Economists commonly weigh these options with cost-benefit analysis, comparing the welfare loss from the failure with the costs and side effects of the fix.

Economists from the public choice and Chicago traditions argue that the existence of a market failure does not prove that government action will improve matters. Officials face their own incentives, regulators can be influenced by the industries they oversee (known as regulatory capture), and interventions invite rent-seeking. Coase's work on lighthouses, which suggested that some British lighthouses were historically financed by private fees collected at ports, is often cited to show that "textbook" public goods can sometimes be supplied privately.

From the other side, many economists argue that market failures are more pervasive than early models assumed. Climate change, described by the 2006 Stern Review as the greatest market failure the world has seen, and the 2008 financial crisis, with its mispriced risks and systemic spillovers, are often given as examples. Most mainstream economists now treat the question case by case: the existence of a market failure is a reason to look for a remedy, and the risk of government failure is a reason to design that remedy carefully.

• IMF Finance & Development: Externalities
• The Nobel Prize: Economic Sciences 2001