Market Failure

This essay presents three kinds of market failure. Information asymmetries, positive and negative externalities, and public goods are among its main features. The appropriate allocation of resources is a common theme throughout this essay. Acknowledging some key differences between public goods and private goods, determinations of what goods are most desirable and what allocation best satisfies societal goals and wants ultimately requires some value judgments. The reader receives information with which to distinguish public goods from private goods and to gain a better understanding of the role of governmental interventions. As a role primarily devoted to the reallocation of resources, the explicit purpose those interventions is to ensure the production and availability of the goods and services that society deems desirable and able to satisfy a wide array of diverse wants. Government often steps into the marketplace when there is an absence of incentives for private enterprise to provide and offer them. It also enters the market when there is a need to adjust resource allocations in order to diminish the effects of a two-party transaction on a third or external party. The reader of this essay also learns that government enters the market for other reasons as well.

Keywords Externalities; Governmental Interventions; Information Asymmetries; Private Goods; Public Goods; Resource Allocations; Societal Goals; Value Judgments

Economics > Market Failure

Overview

A commonality exists among the diverse efforts of high school students who search for colleges, motorists who travel on freeways, and those who purchase gasoline. Aside from their deliberate intent to move from one point in time and space to a different point, these individuals unknowingly experience a market failure in one form or another. Market failures are of three varieties: Information asymmetries, public goods, and externalities. Let us begin this essay with a brief introduction to each type of market failure.

• Information asymmetry appears relevant to the search processes of college-bound high school seniors who probably hold lots of data and receive a great deal of advice, but lack complete or accurate information to arrive at a sound decision.
• A public good, for example, is in the concrete and asphalt pavements that motorists use in our daily travels.
• An externality appears relevant as the price of gasoline tends to omit the costs of removing carbon monoxide from the air all of us breathe whether we own or use a motor vehicle.

All three kinds of market failure arise from a misallocation of resources. The allocation of resources is a critical component in studies of economics and in advancing the frontiers of production and of knowledge. Knowledge accumulates in a variety of ways and economics is a social science informing us that the strength of a market system resides primarily with its efficient allocation of resources. Efficiency in allocation requires a market in which prices reflect the true cost of producing the combination of goods most valued by consumers. More importantly, efficiency is an elusive concept in that it attempts to account for the preferences of parties directly or indirectly involved in a marketplace transaction.

It is safe to assume that consumers want to pay the lowest price for gasoline, producers want to receive the highest price, and parties outside the transaction want to be free from inhaling pollutants. However, the market price they pay at the gas pump typically omits the cost of removing carbon monoxide from the air we breathe. Obviously, this is a major weakness of a price-oriented market system and in the overarching conceptual and analytic frameworks. Like most scientific fields, advancements to the frontiers of economic knowledge can occur by comparing theoretical propositions to hard data. Those comparisons take time requiring systematic analysis and the testing of a set of underlying assumptions.

Applications

In the sections ahead, this essay applies and discusses real issues as they relate to the topic of market failures. As readers progress through this text, they will find coverage of issues in resource allocation, three types of market failure, and the roles of government in dealing with marketplace situations. A significant portion of this essay draws from, refers readers to, textbooks (Arnold, 2005; Guell, 2008; McConnell & Brue, 2007) commonly employed in introductory economics courses. As is the typical case for coursework in economics, we will begin this essay with an introduction of a set of applicable and useful assumptions.

A Set of Economic Assumptions

Studies in economics usually begin by learning and acknowledging a specific set of assumptions.

• First and foremost among the assumptions relevant to this essay is the ceteris paribus assumption, which by translation into English means all else held constant.
• A second assumption is that consumers and producers behave as rational agents who have access to full, perfect information relevant to their decisions.
• Third is the assumption that transactions engage individuals or a group who are limited in terms of the resources and influences they bring to an exchange decision.
• The last assumption relevant to this essay is that an exchange between two parties produces benefits and costs for them only thereby omitting or ignoring the relevance of their exchange to a third party or larger society.

When any number of the latter assumptions become unrealistic or fail to hold true economists typically characterize the situation as a market failure.

Some Perspectives on Market Failure

This section summarizes some circumstances in which the government increases the amount of information available to marketplace participants, implements measures to correct the allocation of resources, and induces the shifting of resource allocations between private and public sectors. It also provides the reader with some comparable perspectives on market failure. McConnell & Brue (2007) define market failure as the following:

Determinations of what goods are most desirable and what allocation best satisfies social wants requires some value judgments. In general, economists consider themselves free to accept or to reject those value judgments. The origin of their indifference stems, in part, from the discipline's orientation to testing assumptions that are cast in the form of objective "what is" as opposed to those in the form of subjective "what should be" statements. In addition, normative statements often take the form of policy recommendations that reflect social goals. As something worthy of brief mention here, welfare economics is a topic that specifically focuses attention on what actions, if any, government should take in redistributing income.

Some of those actions are presumably more effective than others by whatever measure one wants to choose, but coverage of such an approach is largely beyond the scope here. Furthermore, this essay tends to ignore government failures though many scholars focus their attention to the connections between government failures and market failures. Moreover, for those readers who hold an interest in exploring the divergence between market failure policy and social goal policy, they will find a concise summary published in a recent article by Winston (2006) wherein he writes:

Bearing the name of Italian sociologist and economist Vilfredo Pareto (1848-1923), readers should keep in mind that Pareto optimality is a measure of efficiency. It refers to a situation in which any additional changes in an outcome or an existing allocation of economic resources will make one party better off but only at the expense of making another party worse off. In other words, Winston is referring to a market failure as a situation in which governmental actions will help some and hinder others. In addition, he includes a set of causes broader in content than we will cover in this essay. Specifically, we will focus our attention on imperfect information, externalities, and public goods and omit market power and natural monopoly.

In his article, Winston points out the breadth and depth of gaps in theoretical approaches to and empirical research on market failures and on effectiveness of market failure policies. Most scholars would readily agree that hard data leads to relevant findings, but the normative nature of policy orientations seemingly inhibit the testing of assumptions. Let us consider some additional complexities from Winston's article before we narrow the focus of this essay even more.

Government attempts to correct market failures may generate additional problems and/or make matters worse for a number of reasons. Winston may be accurate in the following assessments: The costs from government failures are greater than those from market failures; a general disconnect exists between market failure policy and social goal policy; and, a need exists for evidence and research on the extent of that divergence. Furthermore, one might agree with Winston that microeconomic theory tends to project itself with a fixation on identifying and characterizing potential sources of market failure. Perhaps it is true that economists and other social science scholars would accomplish more by recognizing and analyzing the causes of government failure, by focusing attention on the extent to which market failure policy improves social welfare, by refining microeconomic efficiency to exhibit greater concern for income distribution, and by closing the distance between social goal policy and Pareto optimality.

Overall, Winston does offer some good points with which to frame a future research agenda, but it is very likely that many will find some difficulty with his assertion that the self-correcting perspective on the economy would lead to better outcomes. For the sake of balance and offering food for future thought, it is important that we turn our attention away from that perspective by offering a countervailing point of departure. One could assert that the self-correcting feature may be a factor contributing to market failure. As we move forward with the sections that lay ahead, this essay elaborates on the three kinds of market failure in the following order: Public goods, externalities, and information asymmetries.

Public Goods

This section describes the first type of market failure covered in this essay. Public goods differ from private goods in some specific ways. The provision of private goods entails an efficient allocation of resources, firms are the major providers, an individual's consumption displaces another's consumption, and only those who are willing and able to pay will receive benefits. The key difference resides with patterns in individual consumption and benefit accrual, which are in summary form in this section. Ultimately, the question will center on whether resources shifts from the private sector to the public sector should occur and what criterion informs the answer.

Rivalry & Excludability

Rivalry in consumption and excludability from benefit are the two characteristics that distinguish private goods from public goods. Let us begin with the rivalry characteristic. A private good is rival because its consumption by one person displaces consumption by another person. It is reasonable to think of pizza as a private good. For example, the slice of pizza from the larger pie just consumed by one person is no longer available for consumption by another person. In contrast, a public good such as national defense or homeland security is not rival in consumption. All persons receive protection simultaneously and there is no displacement in consumption.

Excludability refers to whether a mechanism exists that prevents a person from gaining the benefits associated with a good. In a free-enterprise market-based system, the price for a private good or service typically excludes those who are unwilling and/or unable to pay for it. Public goods are nonexclusive because anyone can benefit regardless of payment. For this reason, government will provide the public good and impose taxes to cover its provision. For example, all residents of the United States benefit from national defense although some do not pay the price for it, which takes the form of a federal tax.

The Free-Rider Problem

Non-rival consumption and non-excludable benefits are two characteristics that define the free-rider problem. Those two characteristics also carry forward into the method for deriving market demand for public goods. Consider the simple example in which there are only two individuals demanding a public good. The vertical summation method adds the price each individual is willing and able to pay for some given amount of the public good. Assume each consumer desires two units of the public good. One consumer is willing and able to pay $10.00 for them and the other consumer is willing and able to pay $20.00 for them; the price that corresponds to two units of public goods is $30.00.

The Marginal Benefit Curve

The collective demand curve for a public good is the same as the marginal benefit curve. To determine the optimum quantity of the public good, we need to overlay the market demand curve with the market supply curve. The optimum quantity occurs where those two curves intersect and, by extension, where marginal benefit equals marginal cost. The market supply curve is the marginal cost curve whether the good is public or private. By definition, marginal cost is the additional total cost that one additional unit of output generates.

Students usually find course and textbook coverage of private good market-level demand derivation straightforward. In contrast to public goods, it employs a horizontal summation procedure that takes into account all the individual-level demand curves for any given price. For each price, one can record the amount each individual in the larger market is willing and able to purchase adding them together to determine the market-level demand. The equilibrium market price and quantity are determined at the intersection of the market demand and the market supply curve.

Government Resource Allocation

Government is the supplier of public goods. It does so to correct market failures and to remedy the over- or under-allocation of resources. The best allocation occurs where equality exists between marginal benefit and marginal cost and/or where maximization of net benefit occurs. Drawing from the ideals of marginal equality or maximization, the next section on externalities provides details about the methods by which government alters resource allocations.

Externalities

This section describes the second type of market failure covered in this essay. Third parties may experience the costs or benefits of a market exchange between two parties. Their resultant experiences are from spillover effects or externalities. On the one hand, market systems fail when a third party incurs costs from an exchange between two parties, which by definition is a negative externality. On the other hand, a market failure occurs when a third party receives benefits from an exchange between two parties, which by definition is a positive externality.

Intervention

Externalities provide a basic rationale for governmental intervention in a market-based economy. Interventions may take the form of legislation, taxes, or subsidies depending on the nature of the externality. Common examples of negative externalities include air pollution and the resultant cost of breathing incurred by third parties. A positive externality, for instance, is a case in which most other individuals received an inoculation to eradicate a contagious disease. The few individuals who did not pay for it and/or refused to participate in inoculation face a negligible risk of contracting the disease.

There is an association between the nature of an externality and resource allocation status. As a correction for externalities, the approach entails adjusting the demand side or the supply side in order to adjust the allocation. On the one hand, because negative externalities typically correspond with an over-allocation of resources, the total cost approach corrects the situation adding the value of costs to the existing the supply curve. This corrective action remedies the over-allocation. On the other hand, because positive externalities typically correspond with an under-allocation of resources, the total benefit approach corrects the situation by adding the value of benefits to the existing demand curve. This corrective action remedies the under-allocation of resources.

Those actions require interventions specific to the adjustment in resource allocations. On the one hand, corrections for negative externalities and its over-allocation situation require legislation such as the Clean Air Act of 1990. Legislation effectively increases marginal costs and thereby results in a decrease in supply. On the other hand, corrections for positive externalities and under-allocation entail government subsidies involving buyers or sellers. A subsidy effectively decreases marginal costs thereby increasing supply whereas an increase in demand results when buyers receive the subsidy.

Global Environmental Issues

Highly applicable to the externality concept is the issue of global pollution and climate change. Governments and concerned parties are promoting standards that limit the amount of pollutants and prevent any further increase in pollution within a geographic area. This recent development has created a market for externality rights given there is an agreement on what constitutes an optimal amount of pollution. An exchange of pollution rights occur between organizations in that vicinity. Organizations that keep their emissions lower than the standard level can then sell their pollution rights to another organization that is currently unable and/or or willing to reduce its emission levels. However, this model may or may not help reduce pollution around the globe because of wind currents and other climate related variables.

Climate change is a challenge for developed, developing, and emerging nations around the globe. As economies heat up, so inevitably do their carbon emissions. Balancing the rights and needs of the people of growing economies with responsible and effective measures to curb global warming is a political conundrum. Whether nations will be able to provide solutions, with supporting data, documentation, and information, is yet to be seen. With the notion of sharing relevant data, we turn to the next section and it presentation on asymmetries in information.

Information Asymmetries

This section describes the third, and last, type of market failure covered in this essay. Information asymmetries are a subtle form of market failure that constrain rational decision making processes thereby increasing the likelihood of an unfavorable outcome. At the core of the problem is incomplete and/or inaccurate information along with significant costs for acquiring better information. As a possible remedy, government will intervene to increase the amount of information that is available to buyers and sellers.

Interventions

A few examples of those interventions include: Weights and measures that provide buyers of gasoline with validations of its octane content and unit volume; licensing of professions to protect patient safety and to certify educator competencies; regulations promoting safe occupational and workplace environments and those governing truthful disclosures in contractual arrangements. The issue of trustworthiness surfaces frequently whether it is implicit or explicit and whether it focuses on buyer or seller. A popular phrase "buyer beware" comes to mind and seems highly relevant here.

Moral Hazard & Adverse Selection

Contractual relations present two forms of information asymmetries. Sometimes a buyer's behavior changes after the execution of a contractual document. At the extreme, some individuals will affix their signatures to anything and then ignore or deliberately violate the provisions contained in a contract in a whimsical manner. Those actions and behavioral changes serve as examples of one form, which is a moral hazard. Sometimes information withheld at the time of contract execution results in a transfer of real costs from the buyer to the seller. At the extreme, someone with a terminal health condition will seek to obtain the lowest premiums for health insurance by concealing critical information. This action serves as an example of the second form, which is adverse selection. The key difference between these two forms of information asymmetry is the first occurs around the contract execution point whereas the second occurs at that point. The fine print of most contractual agreements between a buyer and a seller address these two forms and specify sanctions for their engagement.

Asymmetries also arise when there are significant differences in the information held or available between buyers and sellers. Those differences may be known or unknown at the time of a transaction. Sometimes the lack of information regarding the safety, the price, or the quality of a good or service becomes an issue for contention. At other times, there may be an abundance of raw data available to one or both parties of a transaction, but it is not quite in the form one would consider meaningful information.

There is a difference between data and information especially in this era of knowledge management. As we head for closure, readers of this essay who are undergraduate college students may recall all the data they sifted through in arriving at the decision of which institution to attend. Certainly, a condensation or synthesis would have been beneficial to them and their sponsors and possibly to admissions officers as well. At the time of this writing, a few individuals along with governmental and nonprofit organizations are at work devising a user-friendly system through which college-bound individuals will be able to gain immediate, low-cost access to electronic information on the performance and quality of colleges and universities in the United States.

In conclusion, this essay presented the reader with three kinds of market failure. Information asymmetries, positive and negative externalities, and public goods were its main features. Along those lines, it presented some information with which to distinguish public goods from private goods and to gain a better understanding of the role of government interventions. That role is primarily about the reallocation of resources for the explicit purpose of ensuring the availability of those goods and services most desired by society in satisfying a wide array of diverse wants. Sometimes there is little or no incentive for private enterprise to provide and offer them. In addition, this essay provides a brief overview of some perspectives on the appropriate role of government in a market-based economy. The author hopes readers are better equipped, in part due to this essay, to focus their attentions and energies on their economics and business studies and on their scholarly or professional aspirations.

Terms & Concepts

Adverse Selection: Information known to one party at the time of transaction that is withheld from second party generating additional costs for the latter.

Allocation of Resources: A combination of land, labor, and capital for use in producing goods and services; efficiency requires combinations most valued by society and equality between marginal costs and marginal benefits.

Ceteris Paribus: Latin meaning "all else is held constant."

Demand: The amount of a good or service an individual consumer or a group of consumers wants at a given price.

Excludability: The principle that benefits accrue only to those with the willingness and the ability to pay for a good or service.

Externalities: Spillovers from a transaction between two parties that affect third parties in a positive or a negative manner.

Free-rider Problem: Occurs with public goods because of the difficulties of excluding non-payers from receiving benefits and the absence of rivalry in consumption.

Information Asymmetries: Instances in which information is inaccurate, incomplete, and/or unavailable to one or both parties of a transaction.

Knowledge Management: The actions and processes involved in transforming complex, raw data into meaningful information and relevant knowledge to facilitate decisions.

Market: A virtual space where consumers and producers interact while exchanging a specific item in accordance with their demand and supply schedules.

Marginal Benefit: The additional benefit as the result of obtaining an extra unit of a good or service.

Marginal Cost: The additional cost as the result of obtaining an extra unit of a good or service.

Market Failure: The results stemming from imperfect or unavailable information for consumer and producer decisions; from an individual or group hold and bring a disproportionate amount of influence into a market transaction; and/or from an imposition of costs on or harm to third parties and those outside the exchange or transaction.

Moral Hazard: A situation in which the behavior of one party changes around the point of execution in an agreement; at the extreme, one party agrees to contractual provisions, but subsequent behaviors and actions are whimsical and/or in conflict with agreement.

Pareto Optimality: The situation in which any change that produces a gain for one party is at the expense of another party.

Public Goods: Goods and services usually provided through governmental intervention for which the consumption of a good by one individual does not affect that by another and the benefits accrue whether another is a payer or nonpayer.

Rivalry: Occurs when the consumption of a private good or service by one individual displaces that by another; an item is available only to one consumer at a specific point in time.

Supply: The amount of a good or service an individual producer or a group of producers will provide at a given price.

Bibliography

Andersen, B., Rosli, A., Rossi, F., & Yangsap, W. (2013). Are there "institutional failures" in intellectual property marketplaces? evidence from information and communication technology firms. International Journal of Management, 30(2 Part 2), 723-739. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=87836949&site=ehost-live

Arnold, R. A. (2005). Economics(7^th ed.). Mason, OH: Thomson South-Western.

Guell, R. C. (2007). Issues in economics today(3^rd ed.). Boston, MA: McGraw-Hill Irwin.

Lee, D.R., & Clark, J.R. (2013). Market failures, government solutions, and moral perceptions. CATO Journal, 33(2), 287-297. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=87693005&site=ehost-live

McConnell, C. R. & Brue, S. L. (2008). Economics(17^th ed.). Boston, MA: McGraw-Hill Irwin.

Winston, C. (2006, September) Government failure vs. market failure: Microeconomics policy research and government performance. Books and Monographs 06-05. Retrieved December 23, 2007, from http://www.aei-brookings.org/publications/abstract.php?pid=1117

Yue, L., Luo, J., & Ingram, P. (2013). The failure of private regulation: elite control and market crises in the manhattan banking industry. Administrative Science Quarterly, 58(1), 37-68. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=87803878&site=ehost-live

Suggested Reading

Bator, F. (1958). The anatomy of market failure. Quarterly Journal of Economics, 72(3), 351-379. Retrieved December 24, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=7696084&site=ehost-live

Fridson, M. (2003). Famous fables of economics: Myths of market failures (Book). Financial Analysts Journal, 59(5), 97-98. Retrieved December 1, 2007, from EBSCO Online Databse Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=11003435&site=ehost-live

Glaeser, E., & Shleifer, A. (2003). The rise of the regulatory state. Journal of Economic Literature, 41(2), 401. Retrieved December 1, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=10116642&site=ehost-live