Market failure

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In welfare economics, market failure describes a situation in which the coordination via the market does not lead to a Pareto-efficient allocation of resources . This concept, based on neoclassical foundations , was elaborated explicitly by Francis Bator in 1958 .

The central causes of market failure are information asymmetries (example: adverse selection in the market for used cars), externalities (effects of production and consumption decisions that the market does not directly reflect, example: environmental damage ), natural monopolies and public goods .

Market failure is seen as a necessary but not a sufficient condition for government intervention to be considered to allocate resources more efficiently. In order to be justified from a regulatory point of view, state interventions would actually have to lead to an improvement in allocation in individual cases.


Origin of the equilibrium price

In the neoclassical theory of economics , the price mechanism leads to a market equilibrium in a perfect market assumed as a model , which brings about an efficient allocation of resources . A situation is said to be efficient if it is Pareto-optimal , i.e. no other distribution of goods is possible through which at least one actor would be better off without simultaneously making another worse off. The neoclassical theory defines a concrete market situation as a market failure when the allocation is not Pareto-optimal due to deviations from the perfect model market. Market failure goes hand in hand with the waste or the fallowing of socially scarce resources. In extreme cases, the market can collapse.

If, according to the first law of welfare economics, there were perfect markets for all scarce resources, then market failure would not be possible in equilibrium. However, since in reality the functioning of the price mechanism is always associated with costs, measured against this unrealistic standard there would always be a relative market failure (reproach of nirvana). According to Kenneth Arrow , market failure is therefore only given when the “transaction costs are so high that the existence of the market is no longer worthwhile.” Arrow also speaks of the failure of markets to exist. This is why the term “market failure” is “misleading” for Johannes Berger . It is by no means "that existing markets do not function properly and 'fail' in this sense, but that it is not possible to set up markets for certain tasks for a wide variety of mostly technical reasons."

Neoclassical theory makes a sharp distinction between allocation and distribution , defining market failure as a purely allocative defect, not as an assessment of the distribution of wealth and income . In addition to allocative market failure, reference to Richard Musgrave (1959) also speaks of distributive (as well as economic) market failure. According to this, distributive market failure occurs when the result of the market process does not match the ideas about what is fair and right in a normative sense. The criticism of this conceptual extension is that the market cannot reasonably be used for a fair distribution of income and therefore cannot fail in this regard.

Areas of application of the neoclassical model

Asymmetrical information

Asymmetrical information is present when the potential contracting parties in a market do not have the same information about the quality of a product or service offered or about a risk to be insured. The best-known example of a resulting suboptimal resource allocation is the Lemons problem on the used car market, pointed out by George A. Akerlof . The fear of the less well-informed market participants that they will be disadvantaged leads to a market price at which only the worst suppliers sell their used vehicles. There is no complete market clearance, but a negative selection or, in extreme cases, a complete market collapse. Asymmetrical information on financial markets is also cited as a reason for market failure, since most bank creditors are unable to assess the quality of bank management.

State intervention as solution mechanisms

Parts of commercial law also serve to prevent disinformation to other market participants (in Germany, for example, the provisions on general terms and conditions in the German Civil Code ); At the same time, statutory warranty rights are intended to protect the less informed.

Building brand reputation in the event of information deficits

The information problems can in part also be resolved without direct state intervention by means of trademarks or certificates from a trustworthy source, which are supposed to signal the quality.

public goods

Markets can fail in terms of a Pareto-efficient delivery of public goods . Public goods are characterized by (largely) non-rivalry in consumption and (as a rule ) non-excludability from consumption. For example, national security is a public good - it is consumed by everyone living in a country at the same time, without the consumer benefit of each individual being impaired by the consumption of other individuals. At the same time, no single individual can be excluded from it. In the literature, public goods are sometimes seen as a case of positive externalities (see the next section).

The private (i.e. via markets or similar voluntary) provision of such goods suffers from free rider behavior , which consists in letting the goods be provided by others in order to then enjoy the goods free of charge. Even if a total of u. If there were a sufficiently large willingness to pay, there would still be no effective market demand for this good due to the non-excludability.

Solution mechanisms

Due to the failure of decentralized allocation mechanisms for public goods, their socially organized (usually state) provision is often required. Although the state can secure the financing of public goods through recourse to taxes and similar mandatory charges, the definition of an efficient provision amount for the public good remains unsolved. In order to be able to determine this, information about the individual appreciation ( willingness to pay ) is essential. The reliable collection of such information is difficult or even impossible (so-called Gibbard-Satterthwaite theorem ), but in any case is associated with information acquisition costs, which hinder or prevent the achievement of an efficient allocation. Incidentally, the cost of each additional consumption of this good is almost zero, excluding additional users means Pareto inefficiency, since conversely, a higher level of benefit can be achieved due to non-rival consumption.

External effects

Pollution is a (technological) external effect

External effects can also be a reason for market failure. An external effect occurs when a trade between two market participants has (negative or positive) effects on uninvolved third parties. The exhaust gases from a truck not only damage the sender and recipient of the goods (negative) and the beautification of a building can enhance the surrounding buildings (positive). According to the neoclassical theory, the interests of these third parties in the market, i.e. by the parties involved in the market, are not taken into account, so that the allocation of resources is no longer efficient from an economic perspective. Since the effects on third parties are not included in the price calculation of the supplier and the customer, they have no influence on the price. In economics, an allocative market failure is therefore assumed in the case of environmental damage.

State intervention as solution mechanisms

Market failure due to external effects can theoretically be eliminated by internalization , i.e. by the fact that market participants have to include the external costs caused in their profitability calculation ( polluter pays principle ). With the Pigou tax , the state solves the market failure by taxing the polluter in the amount of external costs. However, the state must know the amount of the external costs as precisely as possible and there must also be no transaction costs. Coase negotiations and the Pigou tax are examples of this.

Another solution are bans on environmentally hazardous substances or requirements for the use of risk-reducing processes.

Market reactions to external effects

With the Coase theorem it can be shown that under the theoretically ideal conditions (clear allocation of property rights or rights of disposal, complete rationality , no transaction costs ), negotiations on the market that lead to an internalization of the external effects by the market participants. Against this background, many environmental economists have called for a - sovereign - justification of tradable environmental usage rights so that harmful effects can be internalized, for example, through trading in pollution certificates.

Market power (monopolies and cartels)

Market failures also include monopolies and cartels. By price fixing or monopoly pricing efficient (is Pareto optimal ) allocation of goods is prevented by the market mechanism. According to the theory of natural monopoly, there are certain markets in which a monopoly can establish itself on the market . In such cases the monopoly should be able to determine market prices. A profit-maximizing monopolist offers his products at prices that are above marginal costs ( Cournot's point ) and thus prevent a Pareto-optimal distribution.

In the case of a cartel, two or more providers agree and can thus achieve higher prices on the market.

State intervention as solution mechanisms

State interventions to prevent monopolies or cartels are mostly carried out through antitrust laws .

Market failure as a justification for government intervention

Line of reasoning

Neoclassical economists usually assume that the state should only intervene if the market fails. Further interventions would unnecessarily burden the market, since the markets would be disrupted in their self-regulating principles. However, states or governments can give priority to the pursuit of political goals to minimizing market inefficiency. Political interventions adversely affect market self-optimization, but the willingness to suffer temporary disadvantages through interfering with optimized systems is an important option that can be explained in terms of game theory and that very effectively expands the players' scope for action.

The first law of welfare economics formulates sufficient conditions under which the allocation in a competitive economy is Pareto efficient. If one or more of these conditions are violated, the market allocation is no longer necessarily efficient. This results in potential starting points for state intervention.

If, on the other hand, there is a Pareto-efficient market allocation, every deviation from this (for example due to state intervention) means that afterwards at least one individual in the economy will be worse off than before. This may be desirable, for example if the distribution situation is to be changed by redistributing from rich to poor. With the help of the Pareto criterion, which only allows an incomplete order of the socially achievable conditions, such measures cannot then be assessed.

In general, interventions in a Pareto-efficient market allocation go hand in hand with the loss of Pareto-efficiency; the only form of interventions that are not harmful to efficiency are (practically impracticable) redistribution of the initial equipment ( Second Law of Welfare Economics ). In reality, however, the conditions of Pareto-efficient allocation cannot be met or only approximately. After the theory of the second best then it is possible that the attempt of producing only some of the conditions leading to a further deterioration in market results. Instead, the best alternative course of action may be if state intervention through a sensible “counter-distortion” also replaces the previously realized conditions of the Pareto optimum with the optimization conditions of the modified model. For example, it could make sense as the second-best solution to reduce unemployment through protectionist measures that are not in line with the market, if the flexibilization of the labor market - as the first-best solution - cannot be politically implemented.


Supporters of public choice theory emphasize a lack of causal relation between the existence of market failures and government intervention. They justify this with the risk of government failure , that is caused by government intervention costs could u. Can be greater than the cost of market failure. Public choice economists attribute this to fundamental problems in democratic systems and the strong influence of lobbyists . Both they lead to a rent-seeking behavior in both the private sector and in government - the bureaucracy back. For this reason, the school of thought interprets cases that are colloquially referred to as "market failure" rather as the absence of the pure market due to a subversion of the free market due to the necessary effect of political intervention.

From an ordoliberal perspective, Manfred E. Streit argues that the theory of market failure leads to an economically weakly justified and politically-economically questionable preference for state tasks. Measured against the ideal of perfect competition, the market economy would always need to be corrected. In addition, “the state called for intervention is conceived as well-meaning and omniscient”, in stark contrast to the politically and economically explainable state action.

The Ecological Economics notes that it is not acting in externalities to market failure, but rather the result of normal market functioning, the market reward but market participants as possible externalized many costs. Basically speaking of market failure is a tautology : the theory postulates that the market leads to optimal resource allocation, which is obviously not the case. Instead of now stating that the postulate fails, a failure of the market is asserted and implies that the postulate would be correct if the market could only play unhindered - the failure is assumed to be reality instead of the theory, which should represent reality.

Market failure and the theory of the company

Following on from the theory of the company , which Coase first formulated in The Nature of the Firm (1937), Oliver Williamson assumes that hierarchically structured economic organizations can cope with forms of market failure. The reasons for the development of commercial enterprises are particularly information deficits and high transaction costs on markets. However, hierarchical organizations also have specific disadvantages. The optimal size of companies is determined by the balance between market failure and the failure of hierarchical organizations. Following Coase and Williamson, representatives of the new institutional economics call for the dichotomy of market and state failure to be overcome and for a general theory of organizational failure to be established. The aim would be to compare the suitability of different social institutions such as NGOs and families.


  • Michael Fritsch , Thomas Wein, Hans-Jürgen Ewers : Market Failure and Economic Policy. Microeconomic foundations of government action . 7th, updated and supplemented edition. Verlag Vahlen, Munich 2007, ISBN 978-3-8006-3462-0 ( Vahlen's handbooks of economics and social sciences ).
  • Bruno Molitor: Economic Policy . Chapter 4: Market Failure . 7th expanded edition. Oldenbourg Wissenschaftsverlag, Munich et al. 2006, ISBN 3-486-58134-1 .
  • Richard Abel Musgrave , Peggy B. Musgrave, Lore Kullmer: Public Finance in Theory and Practice . Volume 1. 6th, updated edition. Mohr, Tübingen 1994, ISBN 3-8252-0449-9 ( UZB 449), (Marktversagen p. 67 ff.).
  • Gareth D. Myles: Public Economics . Cambridge University Press, Cambridge et al. 1995, ISBN 0-521-49769-8 (on market failure: Chapter 2; on market failure: Chapters 9-11).
  • Peter Ulrich : Integrative Business Ethics. Basics of a life-serving economy . 2nd, revised edition. Paul Haupt, Bern et al. 1998, ISBN 3-258-05810-5 .

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