M-Clark(Encyc)-45210.qxd 6/5/2007 6:47 PM Page 983
Market Failure———983
Young, Michael W. (2004). Malinowski: Odyssey of an in endowments rather than through interventions in the
Anthropologist, 1884–1920. New Haven, CT: Yale workings of the price system. For example, if certain
University Press.
individuals were unable to afford decent housing, the
second welfare theorem would suggest that the appro-
priate corrective measure, if someone desired it, is to
MARKET FAILURE increase those individuals’ incomes (funded via a
nondistortionary tax) rather than to provide targeted
Market failure theories underlie most economic argu- housing subsidies or impose price controls. Such policy
ments for government intervention in the economy. would not work to correct any market failure; rather, it
When markets operate in accordance with standard would work to select among efficient outcomes for
economic assumptions, no person can be made better reasons of equity.
off except by making someone else worse off. The When the conditions underlying the first welfare
range of government activity in such a world conse- theorem fail to hold, we can expect market failure.
quently is constrained. However, when markets fail to Market failure consequently has a very precise mean-
operate in accordance with the standard model, gov- ing for economists, despite its often loose usage
ernment policy may improve economic outcomes by elsewhere: it requires a failure of the first welfare the-
ameliorating the market failure. orem rather than simple dissatisfaction with market
outcomes.
When markets fail, government intervention may
Efficient Markets: The First and improve outcomes; however, one cannot guarantee
Second Welfare Theorems such improvement. Economists define market failure
Economists define market failure against a theoretical, relative to a norm of Pareto efficiency rather than in
ideally operating economy. When individuals are free comparison with a potential policy intervention. For
to trade in a competitive marketplace where no exter- purposes of policy analysis, identification of market
nalities in production or consumption exist, the result- failure is not sufficient to require government inter-
ing distribution of resources in the economy is Pareto vention; rather, one should base policy intervention on
efficient: no person can be made better off without sound comparative institutional analysis that balances
making some other person worse off. At this equilib- the imperfections of markets and politics.
rium, the price system has coordinated the activities
of all market participants such that all resources have
Ways Markets Fail: Competition,
moved to their most highly valued uses. Work by
Externalities, and Public Goods
Kenneth Arrow, Gerald Debreu, and Francis Bator in
the 1950s provided formal proof of the conditions When markets are not competitive, market failure
under which market equilibrium is Pareto efficient: may result. A monopolist has an incentive to restrict
the first fundamental theorem of welfare economics. output and raise price, creating deadweight losses.
The first welfare theorem refers only to the efficiency Where monopolists can engage in price discrimina-
of the equilibrium; it says nothing about whether the tion, they reduce such losses. Antitrust policy works to
resulting allocations are fair or just. However, many mitigate losses due to lack of competition; however,
potential allocations satisfy Pareto efficiency. The sec- the costs of such policy need careful weighing against
ond welfare theorem shows that any efficient equilib- potential benefits.
rium is achievable through the operation of competitive Externalities can also generate market failure.
markets with redistribution of individual endowments When an activity generates external costs, we expect
or wealth. Consequently, if one deems the results of a that the market outcome will involve too much of the
market process inequitable, economists would argue externality-generating activity when compared with
that any correction should be implemented via changes a Pareto optimum; conversely, activities generating
Market Failure———983
Young, Michael W. (2004). Malinowski: Odyssey of an in endowments rather than through interventions in the
Anthropologist, 1884–1920. New Haven, CT: Yale workings of the price system. For example, if certain
University Press.
individuals were unable to afford decent housing, the
second welfare theorem would suggest that the appro-
priate corrective measure, if someone desired it, is to
MARKET FAILURE increase those individuals’ incomes (funded via a
nondistortionary tax) rather than to provide targeted
Market failure theories underlie most economic argu- housing subsidies or impose price controls. Such policy
ments for government intervention in the economy. would not work to correct any market failure; rather, it
When markets operate in accordance with standard would work to select among efficient outcomes for
economic assumptions, no person can be made better reasons of equity.
off except by making someone else worse off. The When the conditions underlying the first welfare
range of government activity in such a world conse- theorem fail to hold, we can expect market failure.
quently is constrained. However, when markets fail to Market failure consequently has a very precise mean-
operate in accordance with the standard model, gov- ing for economists, despite its often loose usage
ernment policy may improve economic outcomes by elsewhere: it requires a failure of the first welfare the-
ameliorating the market failure. orem rather than simple dissatisfaction with market
outcomes.
When markets fail, government intervention may
Efficient Markets: The First and improve outcomes; however, one cannot guarantee
Second Welfare Theorems such improvement. Economists define market failure
Economists define market failure against a theoretical, relative to a norm of Pareto efficiency rather than in
ideally operating economy. When individuals are free comparison with a potential policy intervention. For
to trade in a competitive marketplace where no exter- purposes of policy analysis, identification of market
nalities in production or consumption exist, the result- failure is not sufficient to require government inter-
ing distribution of resources in the economy is Pareto vention; rather, one should base policy intervention on
efficient: no person can be made better off without sound comparative institutional analysis that balances
making some other person worse off. At this equilib- the imperfections of markets and politics.
rium, the price system has coordinated the activities
of all market participants such that all resources have
Ways Markets Fail: Competition,
moved to their most highly valued uses. Work by
Externalities, and Public Goods
Kenneth Arrow, Gerald Debreu, and Francis Bator in
the 1950s provided formal proof of the conditions When markets are not competitive, market failure
under which market equilibrium is Pareto efficient: may result. A monopolist has an incentive to restrict
the first fundamental theorem of welfare economics. output and raise price, creating deadweight losses.
The first welfare theorem refers only to the efficiency Where monopolists can engage in price discrimina-
of the equilibrium; it says nothing about whether the tion, they reduce such losses. Antitrust policy works to
resulting allocations are fair or just. However, many mitigate losses due to lack of competition; however,
potential allocations satisfy Pareto efficiency. The sec- the costs of such policy need careful weighing against
ond welfare theorem shows that any efficient equilib- potential benefits.
rium is achievable through the operation of competitive Externalities can also generate market failure.
markets with redistribution of individual endowments When an activity generates external costs, we expect
or wealth. Consequently, if one deems the results of a that the market outcome will involve too much of the
market process inequitable, economists would argue externality-generating activity when compared with
that any correction should be implemented via changes a Pareto optimum; conversely, activities generating
