Market failure refers to a situation where the rational and self-interested behavior of agents leads to an outcome that fails to satisfy a suitable optimality criterion, usually taken as the Pareto optimality criterion. In other words, a market failure describes a situation where it is possible to have an alternative situation where at least one person is made better off and nobody is made worse off.
Note that market failure is typically used in the following narrow contexts:
- The alternative scenarios are considered with the same current level of technology. In other words, if some new not-yet-invented technology can make everybody better off, that does not mean that the current situation is a market failure.
- The term is typically not used for isolated incidents where the market fails to lead to a Pareto optimal situation. Rather, it is used to describe situations where there are systemic obstructions to the achievement of Pareto optimal outcomes.
- The term market failure is typically not used for acts that are grossly irrational or unethical. However, the term market failure may be used for the failure of the emergence of Pareto optimal responses to such behavior by a few people.
- The term market failure does not include general complaints against markets and the quality of the society that markets lead to. It includes only those that can be characterized specifically in terms of the absence of Pareto optimality.
Types of market failures
See Category:Market failures for more details.
Here are some broad classes of market failures:
- Asymmetric information: This includes adverse selection and moral hazard.
- The absence of perfect competition, i.e., a situation of a monopoly or oligopoly.
- Principal-agent problems: Issues with delegation.
- External costs (over-produced) and external benefits (under-produced)
- Public goods (under-produced)
- Tragedy of the commons
- Bounded rationality
The political economy of market failure
Market failure is often seen as a reason for government control and regulation of the economy. However, even in case of a genuine market failure, there is also a possibility of government failure, i.e., that the government interventions and regulations intended (or purportedly intended) to solve the market failure exacerbate it, create more problems, or don't work at all.