Market failure

In neoclassical economics, market failure is a situation in which the allocation of goods and services by a free market is not Pareto efficient, often leading to a net loss of economic value.[1] Market failures can be viewed as scenarios where individuals' pursuit of pure self-interest leads to results that are not efficient – that can be improved upon from the societal point of view.[2][3] The first known use of the term by economists was in 1958,[4] but the concept has been traced back to the Victorian philosopher Henry Sidgwick.[5] Market failures are often associated with public goods,[6] time-inconsistent preferences,[7] information asymmetries,[8] non-competitive markets, principal–agent problems, or externalities.[9]

While factories and refineries provide jobs and wages, they are also an example of a market failure, as they impose negative externalities on the surrounding region via their airborne pollutants.

The existence of a market failure is often the reason that self-regulatory organizations, governments or supra-national institutions intervene in a particular market.[10][11] Economists, especially microeconomists, are often concerned with the causes of market failure and possible means of correction.[12] 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.[13] Most mainstream economists believe that there are circumstances (like building codes or endangered species) 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.[14]

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.[15] It is critical to create checks on human activities that cause societal negative externalities.

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