What is market failure

Market failure

The necessity of state economic policy is justified with the market failure. One speaks of market failure when pricing does not work in a competitive economy or does so only inadequately.

Market failure can be caused by:

• The prices do not include all the costs incurred in production because they (do not have to) be taken into account in pricing, which leads to external effects. Individual and collective costs and benefits diverge. Since the economic agents only calculate the costs and benefits actually incurred, technical externalities arise that lead to a misallocation due to an "organizational error" of the market. The state is called upon to attribute the consequences of their economic actions to those responsible in order to restore self-regulation of the market in this way. One possibility for such internalization is to create a clear system of ownership.

• A second case of market failure occurs when it comes to public goods. Nobody can be excluded from their use (non-rivalry), there is no pricing. Since the private production of goods is unprofitable or would not take place to the socially desirable extent, the state is forced to offer public goods.

• Since the market mechanism is only fully functional when there is competition, the state must prevent restrictions on competition by designing the economic system: a general prohibition of cartels is anchored in the law against restraints of competition, mergers are subject to state control, companies with a dominant market are monitored to see whether they abuse their market power. Natural monopolies are also a case of market failure.

• A market failure can also be seen in the fact that the price mechanism only reflects short-term scarcity. While longer-term shortages (e.g. due to natural resources that will at some point be depleted) are not included in the pricing, as the information about them is not taken into account.

indicates cases in which the market does not lead to an optimal allocation, i.e. the price mechanism fails. If market failure is recognized, it is up to the state. He will intervene with instruments of competition policy when competition is hindered, eliminated by monopolies or access to the market is blocked (regulation). External effects of production and consumption also call for corrective economic policy activity. External costs are not charged to the buyer via the price. Only when the external costs are charged to the producers through government intervention (in accordance with the polluter pays principle) do they enter the pricing process. In the case of external use, the state can subsidize the corresponding private activity. No market exchange will take place if non-paying third parties ("free riders") cannot be excluded from using the offer. These public goods cannot go on the market; they have to be offered by the state. A market supply based on scarcity does not take place here.

Functional deficits of the market economy with regard to allocation, distribution and stability requirements. The notion that the market economy fails to achieve important goals is as old as the market economy itself. Even today it is argued against the market economy again and again that it favors materialistic values ​​and thus prevents people from a good, fulfilled life. In addition, short-sighted particular interests are given too much weight in a market economy, so that overarching goals affecting the entire community (such as social justice or the preservation of nature) are systematically neglected. Today, a little less significant is the view held by various quarters (especially by Karl MARX, but also to some extent by Joseph A. SCHUMPETER) that market-economy systems also have considerable functional deficits in their very own field, namely the provision of private goods. Because the planning horizon of the economic agents acting in isolation is too limited, economic development is cyclical and crisis-ridden and does not lead to the technically possible increase in prosperity. The doctrine of the reasons for market failure, which is a cornerstone of modern neoclassical finance, must be sharply distinguished from such objections to the market economy, some of which are strongly ideological. It is not based on a critical basic attitude towards the market economy, but accepts it in principle and therefore wants to see state interventions precisely justified by considerations within the framework of theoretical models. The competitive market equilibrium serves as a reference standard, in which, under certain ideal conditions, without any central planning, a PARETO-optimal allocation is obtained solely through decentralized coordination of the isolated decisions of the economic entities involved. This is exactly what the first law of welfare says. The various reasons for market failure can now be subdivided according to which of the assumptions on the ideal-typical model of an economy with competition are violated. The classic cases of an allocative market failure justified in this way concern extremalities - public goods and - increasing returns to scale. Both external effects and public goods ultimately lead to an allocation distortion because property rights are not fully developed and the price mechanism therefore fails. An economic subject supplies another without being able to demand the payment of a price for it (by threatening to be excluded from consuming the good in question). There is a gap in the price system, which means that there is too much demand for the corresponding good and / or too little is offered. Specifically, this means that in the event of a negative externality (e.g. in the case of environmental damage), the respective activity is extended beyond the macroeconomically optimal level, or that in the case of isolated trading of the participants, the level of supply with a (pure) public good remains below the macroeconomically optimal level. In addition to the standard examples of public goods (such as national defense or a good accessible to all), the problem of enforcing norms has recently been seen as an important area of ​​application of the theory of public goods: even if an individual wants a more just society, it is still for actually irrational, because of this altruistic motivation to make personal sacrifices on his own initiative. With regard to the envisaged ethical goal, in a large group one's own contribution has a negligibly small effect, so that a single individual may strive for the position of a moral free rider. In this way, distribution problems can be understood as problems with the provision of a public good and can thus be interpreted as a consequence of a market failure. Finally, if the production technology for a certain good has the property of increasing economies of scale, then production at the macroeconomically optimal level causes losses for the production company and can therefore not be brought about by the market. It is even to be expected that a company will survive in the market, which then behaves as a supply monopoly and causes corresponding welfare losses. In addition to these classic reasons for market failure, there have recently been those that can be traced back to - asymmetrical information between the supplier and the customer of a good. Asymmetric information with regard to product quality can lead to mutually beneficial transactions not taking place, i.e. too little production and / or demand. In extreme cases, certain markets do not even emerge or collapse. Important problems can be illustrated using the example of an insurance market. For example, the insurer may not be able to determine exactly ex ante which risk class an individual insured person belongs to. However, if he were to charge a premium based on the medium risk, the good risks have no incentive to take out insurance. The effect that the quality of the contract object is negatively correlated with the price is referred to as - adverse selection. On the other hand, the insurer cannot rule out negligent behavior on the part of the insured by means of controls when granting insurance cover. The possibility that a contracting party influences the value of the contract object through behavior that is not generally observable is referred to as moral hazard. Adverse selection and moral risk can prevent the emergence of functioning insurance markets, so that individuals are not (fully) insured to the optimum extent for the economy as a whole. Other important areas of application for problems of asymmetric information are in addition to credit markets as well as labor markets. For some time now, attempts have been made to explain unemployment through information asymmetries, without, however, until now there has been a closed and universally accepted interpretation of unemployment as a result of a market failure. The diagnosis of a market failure initially seemed to result in an unambiguous therapy. Exactly when one of the reasons for a market failure is present, the state has to intervene with corrective measures. This idea, which at first seemed almost self-evident, is now subject to considerable doubts. The demand for state measures only really makes sense if the state is actually able to bring about an improvement in the allocation. However, this can be prevented by imperfections in the political process (state failure). However, the distance between the result of the market process and the best possible state that can realistically be achieved (the second-best solution in the case of government intervention) is reduced even further by taking the following criticism into account: The common market failure theories exaggerate the extent of the allocation disruption by neglect the possibility of at least partial self-correction of the market. For example, Ronald H. COASE has drawn attention to the fact that in the case of externalities, state intervention is not necessary, primarily because the cause of an externality and the person affected by it can possibly ensure internalization themselves through negotiation. In the case of public goods, for example, the use of retaliation strategies (fit-for-tat) can enable a cooperative solution and thus an efficient private provision. In addition, the preferences of individuals can be such that the voluntary payment of a contribution to a public good as such has a beneficial effect for them, even if only because they hope for social recognition through altruistic action. With increasing economies of scale, an individual supplier may forego charging the monopoly price in order to deprive potential other suppliers of the incentive to enter the market. From this point of view, the conclusion of increasing economies of scale to a natural monopoly is at least premature. It is even possible to produce at a macroeconomically optimal level if the provider manages to cover costs through flat-rate payments (basic fees) to be paid by the consumer. In the case of information asymmetries, the solution that is at best achievable by the state can possibly also be implemented on the market if the insurers manage to restrict some policyholders to partial insurance by exchanging information. These possibilities for the market to correct themselves are of course again limited. Negotiations in the sense of COASE reach their limits when the number of participants is large or information asymmetries exist between the negotiating partners. However, a negotiated solution is also ruled out if those affected by an externality are not even born today. Corresponding restrictions can also be found with regard to the other categories of market failure. Literature: Richter, W., Wiegard, W. (1993). Inman, R.P. (1987)

Previous technical term: market linkage merger | Next technical term: market shift

Report this article to the editors as incorrect & mark it for editing