Market Failure

Market failure arguments lie at the root of a number of arguments supporting government intervention in the economy. A claim of market failure, by its nature, suggests some reason that voluntary, private institutions cannot produce valuable goods and services to the appropriate extent. These arguments fall into several categories, but most commonly center on the issues of public goods and externalities. Sometimes the phrase “collective action problems” serves as a more general rubric for what are perceived as failures of the market to deal with specific issues.

There are two aspects to the problem of public goods. The first, “nonrivalry,” suggests that an additional person can consume a good without infringing on the consumption of others. For instance, if a movie theater is not full, another viewer can be admitted at little or no social cost. “Nonexcludability” suggests that it is hard to charge individuals for a particular good or service. For instance, imagine that nuclear defense against foreign attack were privatized. An individual who did not contribute to its provisioning could still enjoy the benefits of living under a nuclear umbrella. For this reason, it is likely that too few individuals would purchase the service, with the result that markets would fail to provide an adequate national defense.

In today’s world, nonexcludability is regarded as the more important and more fundamental problem that economics and political science must address. Nonrivalry is less formidable because private suppliers of public goods have a strong incentive to gather as many paying customers as possible. If inefficient exclusion is indeed a problem, monopoly is the likely culprit. At one point or another, virtually every good or service has been labeled a public good. National defense, the rule of law, and police protection are the most universally accepted examples, but the list often includes, among many examples, roads, fire protection, social welfare insurance, health care, a clean environment, and subsidies to science and the arts.

The issue surrounding externalities is closely related to that of public goods and nonexcludability. A positive externality occurs when the action of one person confers a benefit on another when the second person does not pay for the benefit in some form or another. The externality is potentially significant when the people involved cannot conduct the appropriate trades. For instance, it may benefit my neighbors if I clean up my yard. If I do not take these benefits into account, my yard might remain excessively sloppy. Furthermore, my neighbors may be reluctant to pay me to clean my yard knowing that otherwise I might be sloppy simply in order to charge them for having a neighbor with a clean yard. Positive externalities therefore tend to be underprovided.

Negative externalities occur when the actions of a person harm another and the two cannot contract so that the one harmed is compensated for the damage suffered. Pollution is a classic case of a negative externality, but crime and traffic congestion are equally common examples. Externalities, whether positive or negative, constitute another, more general way of talking about nonexcludable public goods. In both cases, individual actions create benefits and costs for others, which cannot be traded in ordinary markets.

It is often the case that the problem of externalities can be solved by a better definition of property rights. If, for example, a lake or river is privately owned, the owner may have a personal incentive to keep the resource clean and flowing as it should. A publicly owned resource, in contrast, often is one where no one has a strong incentive to maintain its value. This situation has been dubbed “the tragedy of the commons.” Many pollution problems, rather than illustrating the failures of markets, are more accurately seen as failures of government to adequately define property rights.

Well-​defined property rights also can solve many local public goods problems. Proprietary communities, for instance, are able and often do provide water and electricity services, crime prevention, and numerous other public goods. Private contractors are willing to build new roads and freeway extensions provided they have the right to charge for their investments. Other public goods are produced by “tying” arrangements, such as when a private shopping mall provides security services, roads, and street lamps, all to encourage consumers to visit the mall.

Many solutions to public goods and externality problems are technological in nature. New technologies can help us identify and penalize polluters, thus improving property rights protection. We also can better define property rights, such as using electronic tags by which private owners can own or harvest wild herds of animals. The owners then have an incentive to maintain the value of those animals, rather than overhunting them. New technologies also might help us decentralize the supply of electricity and water, making those services less of a natural monopoly. Cable and satellite technologies have made TV less of a public good. In other instances, technologies lower transaction costs and allow people to trade in new ways. The Internet has proved enormously successful in finding and mobilizing relevant customers, and new securities markets can lower the cost of making transactions.

Market innovations have eased the production of health care and social welfare insurance. The Internet, for instance, now gives customers better access to health care information. HMOs simplify the purchase of health care, especially for cost-​conscious individuals, and new and better insurance contracts make it easier for individuals to spread risk. The notion of catastrophic health care insurance, for instance, did not have wide currency until the 20th century.

Sometimes nonmonetary incentives also contribute to solving public goods problems. Altruism and the desire to feel good about oneself encourage individuals to give to charities and to behave well toward their neighbors. Social norms for reciprocity often develop, thereby allowing smaller initial amounts of altruism to develop into more systematic chains of assistance. The quest for fame encourages many artists, scientists, and donors. Einstein did not become rich, but his name will live in history, and many individuals help fund museums and artistic institutions, in part, to receive reflected glory. Public goods theories often take an excessively simple view of human motivations. Complex motivations imply that private entrepreneurs have access to many different ways of putting together “a deal” to produce public goods. Pecuniary incentives are just one part of a broader package of available instruments.

Indeed, there are occasions when it is arguable whether a public good or externality constitutes a significant dilemma at all. For instance, education is commonly described as a public good, but this notion is questionable. It does not suffice to cite stale clichés about the benefits of an educated population. Education yields significant enjoyment and pecuniary returns to those who seek it. The private incentive to become educated may well suffice to generate high levels of educational investment. Not surprisingly, some theories of market failure (signaling theories) say we have “too much” education, whereas other theories say we have “too little” education.

Perhaps most important, any given market failure must be compared to what is likely to occur if the government were to attempt to rectify the problem. It is not enough to establish that markets fail to provide a perfect outcome. All policy analysis is comparative, and we must consider whether markets or politics, in a given instance, will lead to greater imperfections. Politics brings in its wake bureaucracies, poorly informed voters, high discount rates, and special interest groups, among other imperfections. Once government starts intervening to support the production of public goods, it is likely to overstep its bounds and create new problems that were not initially present. It is absurd to point to market failures and to totally ignore political failures.

Market failure theories should be evaluated within the broader context of problems centering on the lack of or the difficulty of acquiring the relevant knowledge. In many cases, it is difficult to determine just how much of a good or service should be produced. For this reason, it is almost impossible to second-​guess market provision. This uncertainty does not prove that market provision is always the correct one, but it does make us more skeptical about fine-​tuning the economy. Often the best the economist can do is analyze the general properties of differing regimes and ask which does best at serving consumer welfare, keeping the peace, and encouraging innovation. Here the record of a market economy and the rule of law is a relatively strong one. We may wish to strengthen markets, rather than intervening each and every time we think we can improve on them. Such discretionary interventions may erode the long-​run economic, political, and cultural foundations of a market order.

In summary, market failure is a broad and complex area. It potentially encompasses the entirety of our economy and involves many disparate policy issues. Few economists would argue that public goods and externalities can never justify government intervention. Nonetheless, the public goods and externalities arguments are often overrated in their force. Public goods and externalities do exist, but they provide incentives for new ways to generate and capture gains from trade.

Further Readings

Cowen, Tyler, ed. Public Goods and Market Failures: A Critical Examination. New Brunswick, NJ: Transaction, 1992.

Cowen, Tyler, and Eric Crampton, eds. Market Failure or Success: The New Debate. Cheltenham, UK: Edward Elgar, 2003.

Klein, Daniel, and Fred Foldvary, eds. The Half-​Life of Policy Rationales: How New Technology Affects Old Policy Issues. New York: New York University Press, 2003.