the market does not provide efficient outcomes for
society, economists say that the market has "failed." Economists
have identified six different types of market failures.1
Monopolies: The Failure of Competition
the market to produce efficient outcomes, there must be
competition. Let's imagine that you want a hamburger for
lunch and that eating a hamburger is worth $3.00 to you.
The best outcome for you in this situation would be for
you to get your burger for nothing. Barring that, an acceptable
outcome would be for you to get a burger for any amount
between $.01 and $3.00. If you live in a typical American
town, you have more than one choice of places to buy your
burger so you can compare prices. You can also consider
a wide variety of other factors as well. The distance you
have to travel, the quality of the burger, even how clean
the burger place is may influence your choice. Once you
have decided on the burger you want, purchased it and eaten
it, an economist would say you have "maximized your utility"--you
obtained the satisfaction you wanted (eating a burger)
for the least amount of money possible, taking into consideration
a variety of other factors.
is the magic ingredient that makes all of this possible.
For example, if Bubba's Burger Barn sells burgers for
$3.00 and Betty Lou's Hamburger Haven sells them for
$2.00, you would buy a burger from Betty Lou if price
were the only consideration. If Bubba's place was closer
to your home, the burgers were better tasting and the
lobby was cleaner than Betty Lou's, you might decide
that Bubba's burgers were worth an additional dollar
to you. Because you have more than one choice, you
can spend your money on the burger that brings you
the greatest satisfaction.
the example above, there is bound to be a happy ending
(and a full stomach). If there were no competition
in the burger market, however, the ideal outcome might
not be possible. Imagine for a moment that there is
only one burger store in your town and that it sells
burgers for $4.00. That is a dollar more than a burger
is worth to you. Without an alternative, you would
forego a burger and eat something else for lunch. This
is an inefficient outcome for both you and the burger
store (assuming it costs the burger store less than
$3.00 to make a burger). Although you are willing to
buy a burger for $3.00, you are unable to purchase
one for that price. And although you are willing to
pay $3.00 for a burger that costs the burger store
less than that to make, it earns no money by selling
you a burger because the price is too high.
the single burger store in your town what economists
call a monopoly? In part, the answer depends on how
you define a monopoly. If you have played the game
Monopoly, you know that once you own all of the properties
of a given color you own a "monopoly." Similarly, when
a firm or individual is the sole owner, producer or
seller of a particular good or service, that firm or
individual is a monopolist. However, determining whether
or not the burger place in your town is a monopoly
is not as simple as asking whether or not there are
competing burger stores in town.
Is Microsoft A Monopoly?
Chances are you are viewing this page on a computer
running a Microsoft operating system such as Windows 98 or Windows NT.
In fact, Microsoft operating systems are installed on nearly 90% of all
personal computers in the United States. In November of 1999, a federal
judge declared that Microsoft's market dominance gives it monopoly power
which it has used unfairly to drive out competition.
It remains to be seen, however, what if any actions will be taken against
What do you think? Is Microsoft a monopoly?
must first decide whether or not there is the potential for
competition. Is there any reason another burger store could not be
opened in your town? Probably not. If there are no significant barriers
to a competitor's entry into the market, the firm will probably not
behave as a monopoly because it will be kept in check by the possibility of
competition. It is also important to decide what we mean by a "market" when
we are deciding whether or not a firm is a monopolist. If we are
concerned with the burger market in your town, the burger store,
as the sole provider of made-to-order hamburgers in your town, might
be considered a "burger monopoly." However, the burger store does
not have a monopoly on the food market in your town. The scale
of a monopoly--perceived or real--is critical in deciding whether
or not government intervention is justified. While a monopoly in
the food market in a town would be a cause for serious public concern,
a monopoly in the burger market may not be as troubling.
When monopolies exist, competition does not. Monopolies cause the market
to fail because monopolists tend to restrict production of goods or provision
of services and increase prices for them above the natural market level
While Americans generally admire big business and respect those who have
become rich through hard work and ingenuity, concerns that large corporations
were becoming too powerful began to arise in the middle to late 1800s as
large conglomerates or trusts gained control over such markets as the oil,
sugar, whiskey and steel industries. Popular opinion rapidly turned against
these trusts as the people began to believe that they were being short-changed
by their business practices. In response to these concerns, the Congress
passed the Sherman Antitrust Act in 1890. It declared illegal every contract,
combination (be it a trust, monopoly or otherwise), or conspiracy that
restrained interstate and foreign trade.2 The Act had little immediate
impact, however, largely because the Supreme Court refused to uphold its
constitutionality. Antitrust efforts were given new life, however with
Theodore Roosevelt's "trust-busting" campaigns and a change in
the opinion of the Court. In 1914, Congress passed the Clayton Act and
established the Federal Trade Commission, expanding and tightening antitrust
laws by explicitly forbidding actions taken to force competitors out of
business by slashing prices, buying up and hoarding supplies, bribery or
Enforcement of federal antitrust laws has been inconsistent and has varied
from president to president. Perhaps the most significant antitrust action
taken by the United States government came in 1983 when American Telephone
and Telegraph (AT&T) was broken up as the result of a suit filed under
the Sherman Antitrust Act in 1974. While the 1980s and early 1990s were
characterized by a more corporation-friendly interpretation of federal
antitrust laws, the Justice Department after the election of Bill Clinton
has been more wary of large corporations and their trust-like tendencies.
Currently, the Justice Department is moving forward on antitrust and unfair
business practice charges against Microsoft (see the "Is Microsoft
a Monopoly" insert on this page).
These monopolies, or trusts, were
broken up because political leaders concluded that it was in the public
interest to do so. The market, in these instances, had failed to promote
the public good, so the government took action to correct the market's
failure to do so.
The Break-Up of AT&T
The Sherman and Clayton Acts were largely focused on protecting consumers
from monopolistic practices on the part of large corporations. In
the case of AT&T, however, it was other businesses that led the
charge, claiming that they were being unfairly prevented from competing
with AT&T. The Courts agreed and in 1983 AT&T's 22 local
phone companies were reorganized into seven independent companies--the "Baby
Bells" which still offer regional local phone service in the
United States. AT&T was allowed to continue offering its long-distance
services, but it currently faces stiff competition in that market
from MCI, Sprint and numerous others. Was
the public interest served?
While monopolies are generally perceived as producing economic outcomes
that are contrary to the public good, there are some monopolies that
are permitted to exist. Some are even facilitated by government. In the
case of new inventions, patents are rewarded giving their creators an
effective monopoly over their invention for a period of time. Creativity
and ingenuity is rewarded by granting the creators of things such as
new medicines, machines and processes the exclusive right to use and
sell what they have created. The public good is promoted because the
financial incentives associated with inventing a revolutionary product
encourage inventors to create things that benefit society. In the case
of public utilities, such as water, sewage disposal and electricity,
there are what economists call "natural" monopolies. Once a
sewage system or water and power lines are in place, it would be very
inefficient and disruptive to create another system to provide the same
services. In these cases, the government either owns and operates these
systems or carefully regulates the semi-private companies that run them.
These kinds of monopolies are generally called publicly regulated utilities.
The second market failure economists have identified is the underprovision
of public goods. Examples of public goods include national defense
and navigational devices such as lighthouses and buoys. Public goods
will either be underprovided or not provided at all by the market.
Public goods have two defining characteristics. First, once a public
good is provided for a group of people, there is no additional cost associated
with it being enjoyed by an additional individual or group of individuals.
For example, once a national defense system is in place to protect a
nation of 270 million people, there is no additional cost to protect
an additional person born into that nation. Similarly, once a lighthouse
is built to guide in all existing ships, it costs nothing for a newly
built ship to benefit from its existence.
The second defining characteristic of public goods is that once they
are provided for one person, it is difficult--if not impossible--to prevent
their enjoyment by other people. A buoy in a harbor may have been put
there to alert boats that they are approaching shallow waters. It is
impossible, though, to prevent swimmers in the same harbor from using
the buoy as an indicator that they are approaching deep waters. It is
usually impossible to prevent one individual or group from enjoying a
public good that is available to others.
Because the benefits from a public good enjoyed by any individual are
almost always less than the cost of producing the public good, the market
does not provide them. For example, each individual in the United States
benefits from the security provided by the American national defense
system. However, at the individual level, that benefit is not worth the
trillions of dollars it costs to build and maintain that system. (Even
if it was, no single individual could pay for such a system.) At the
same time, the overall benefits of national security to the entire nation
are greater than the costs of providing them. It is in the interest of
the public, then, for the government to pool the resources of individuals
and pay for a robust national defense system that would otherwise not
Other commonly cited examples of public goods include roads, public
parks and public education. While these are not "pure" public
goods because they do not perfectly adhere to the above definition, they
nonetheless share some of the same characteristics as pure public goods.
These are things which are generally underprovided by the market. In
these cases there is an economic basis for governmental intervention
in the economy. Such interventions generally enjoy strong public support.
As noted above, there are some goods and services which may not be "pure" public
goods which are nonetheless under supplied by the market. There are numerous
goods and services that have the potential to improve the economic fortunes
of individuals and of society that are not widely available. In such
circumstances, the need or demand for a particular good or service is
higher than the available supply of that good or service, hence there
is an incomplete market.
Traditionally, the market has tended to under supply insurance for particular
kinds of activities or risk (especially health insurance). The market,
on its own, also under supplies loans for education and small business
ventures. In each of these cases, there are government programs to complete
or supplement the naturally incomplete markets that exist. Medicaid and
Medicare are government financed "insurance" programs for the
poor and the elderly. The Department of Education and state and local
student loan agencies underwrite or guarantee loans to students attending
accredited colleges and universities. And the Small Business Administration
helps individuals secure the funding they need to start their own businesses.
In addition to insurance and loans, some markets are incomplete because
there are weak or nonexistent "complimentary" markets for particular
goods or services. For example, if there was strong public demand for
professional baseball, but there were no way of broadcasting games to
the public, there would be an incomplete market. Television and radio
broadcasts complete the market by allowing the public to enjoy baseball
games. In most cases, the market naturally provides the complimentary
goods and services needed to make the provision of other profitable goods
and services possible. However, in some circumstances the amount of coordination
required to complete a market is so extensive that government intervention
may be required. In some cases the financial risks associated with research
and development of competing markets are so high that no firm or individual
will undertake them. In such cases, government intervention may be warranted.
In the case of the Internet, governmental support is largely responsible
for the creation of a massive multi-billion dollar complementary market.
The governments of many other nations take a very aggressive role in
coordinating businesses and the markets they operate in. For years, Japan's
Ministry International Trade and Industry (MITI) has been held up as
a shining example of successful governmental coordination of a nation's
economy. Recent economic setbacks and trends in Japan, however, have
cast doubt on the ability of MITI to out-guess and out-perform the natural
forces of the market. This experience suggests that governments must
exercise caution when they attempt to coordinate the market or address
problems caused by incomplete markets because there may be good reasons
that markets are incomplete or poorly coordinated. It may be that the
costs of providing certain goods and services, coordinating different
markets or of establishing complimentary markets are not justified by
the benefits (profits) they offer. Just because an activity is not likely
to be profitable, however, does not mean that the government should not
engage in it. Such considerations, however, ought to be taken into account
as politicians and government officials consider government efforts to "complete" incomplete
The market generally assures that when benefits are enjoyed, they are
enjoyed by the individual who incurs the expenses to provide them.
However, there are circumstances when individuals or firms do not bear
all of the costs for the benefits they enjoy. When someone other than
the recipient of a benefit bears the costs for its production, the
costs of the benefit are external to its enjoyment. Economists call
these external costs negative "externalities." Externalities
amount to a market failure to distribute costs and benefits efficiently.
An example of an externality is a poultry farm that raises and sells
chickens, thereby earning a profit (benefit). While raising the chickens,
however, the farm releases a significant amount of pollution into the
river that runs by the farm. The people who live downstream from the
farm bear an external cost (polluted water) of the farm's operations.
Similarly, when a motorist enters the freeway, he or she adds to the
congestion, danger and pollution already there. Some of the costs of
the motorist's activities are born by other drivers on the road. These
costs can become significant when numerous drivers enter the freeway
at the same time (rush hour). Because individuals and firms are not bearing
the full costs of their actions while enjoying the full benefits thereof,
the incentive is to persist in the externality-producing behavior.
negative externalities arise, the government often seeks to remedy
the resulting imbalance in costs and benefits by regulating or penalizing
the behavior that produces the externality. (Such actions are frequently
responses to complaints by those who bear the costs of the externalities.)
These efforts by government minimize the occurrence of negative externalities
and facilitate a more efficient distribution of benefits and costs.
A Case Study: The EPA
Established in 1970 as a consolidation of functions performed
by several other agencies. Response to market failure to control over-production
of pollution (negative externality). The decisions that had to be made
(these hold true for all regulatory or public good provision decisions):
a. Should the government intervene?
- The problems of establishing property rights
and liability (Fifth Amendment)
- "Tragedy of the Commons"
b. At what level should the intervention take place?
- National standards
- Local regulation
c. How much intervention should there be?
d. Impact of the EPA
- Original budget of about $3 billion with 7,000
employees, up to about $5 billion in late 1980s
- Biggest impact: Costs of compliance with
regulation--more than $50 billion in 1981 6
Not all externalities are negative, however. In some
cases, all of the benefits of an activity are not captured by the individual
or firm who pays for them. For example, if a family remodels their home
and cleans up their yard, the value of their home increases, but so do
the homes of their neighbors. The family that remodeled is the sole bearer
of the costs of remodeling and cleaning up, but other home owners in the
area receive some of the benefits in the form of a positive externality.
In general, positive externality-producing activities will be under-provided
by individuals in an unregulated market. In such cases where the positive
externalities produce a collective public good, the government may be
justified in promoting such behavior through financial or other incentives.
An example of a positive externality-producing behavior the government
currently encourages with tax benefits is adoption. Parents who adopt
enjoy the benefits of bringing a child into their home, but the rest of
society enjoys the external benefits of having that child in an environment
where he or she is likely to become a positive contributor to society.
Another market failure stems from the market's inadequate provision
of information. Recall the burger example from above. In the scenario
as it was described, you had information about two hamburger places--Bubba's
and Betty Lou's. Suppose, however, that there was a third burger
place which had a better burger for only $1.00. If you did not know
about the third store, your information would be incomplete and you would
be making a less than optimal decision because of your lack of
In general, the burden is on the consumer to do enough research to make
the best decision they can when they are buying a product or service.
In any given buying situation, there will naturally be a point at which
consumers will quit shopping and make a purchase. There is always the
possibility that they did not search long enough to find the best deal,
but the added costs of searching for more information (which takes time
and sometimes money) are not worth it. Economists say that in such situations,
additional time spent searching brings rapidly diminishing returns. Once
a reasonable number of options have been considered, a reasonable decision
can be made without expending more time and energy discovering other options.
It also follows that the greater the amount of the purchase, say for a
car or a home, the more time an individual will spend researching and
shopping before making a decision. In contrast, buying toothpaste may
require no more "research" than scanning the shelf at the supermarket.
In most cases, most people find enough information to make good buying
decisions. However, there are some circumstances under which the market
will not provide the information consumers need to make good choices.
For example, some sellers of goods and services, such as used car dealers
or banks, may not voluntarily disclose important information about what
they are selling. In such cases, the government often requires individuals
or firms to provide detailed information about their products or services.
The nutritional content labels on food packages, the disclosure notices
on your credit card statements and the "fine print" on loan
applications are all sources of information that are required by the government.
It is unlikely that this information would be routinely and voluntarily
offered to consumers if the government did not require it.
have argued that onerous information disclosure requirements are
too burdensome and costly and that they hurt both businesses and consumers.
Others counter that information is essential to an efficient and prosperous
society and that the government should do all it can to encourage the
availability and dissemination of the kinds of information consumers and
citizens need to make good decisions.
"Tragedy of the Commons"
One of the most problematic kinds of information failures stems from
what economists call a "tragedy of the commons." A "commons" is
a publicly shared resource or area. The problem that often arises
with the use of such resources or areas is that any one individual's
activities probably won't severely deplete or damage the resource
or area. However, when too many people use the resource or area too
much, it can be devastated. That is the "tragedy." In almost
every case where a tragedy of the commons occurs, the people who
depleted or damaged the "commons" would have altered their
behavior if they had known what they were doing. Public information
campaigns against littering are an example of government sponsored
efforts to alert people to a potential tragedy of the commons. In
some cases, however, information is not enough and limitations must
be put on the use of certain places and resources. Examples of such
regulations include limits on the number of fish you can catch in
a particular river or lake or penalties and fines for littering or
The "Business Cycle," Unemployment and Inflation
In the free enterprise system, there are numerous ups and downs at
the individual level as people change jobs, lose jobs, get new
jobs, get raises, or earn money from investments. Any one individual's
economic fortunes have only a minimal impact on the overall economy.
When a single individual loses his or her job and maybe even declares
bankruptcy, the national economy is unhurt. Moreover, it is comparatively
much easier for the individual to recover from a personal economic
collapse than it is for the entire nation to do so.
When the entire economy falters and unemployment and inflation rise high
above normal levels, however, the state of the economy can have a dramatic
impact on individuals who might otherwise be doing well. Just as a growing
economy benefits most of the individuals who participate in it, a shrinking
economy hurts individuals. While such times can be painful, they have
long been recognized as part of a natural "business cycle" in
which there are upturns and downturns at fairly regular intervals.
While virtually all economists agree that high unemployment and inflation
rates are clear indications that the market has failed in some way, there
is a great deal of controversy about the proper role of government in
addressing such problems. In response to the Great Depression in the 1930s
when unemployment rose to 24%, Franklin Delano Roosevelt undertook an
aggressive economic recovery program he called the "New Deal." Among
other things, unemployment insurance and the Social Security programs
trace their roots to the New Deal era. While many have credited New Deal
programs for pulling the nation out of its worst economic depression ever,
others have speculated that the entry of the United States into World
War II and the retooling of the economy to support the war effort is what
really changed the nation's fortunes.
Today the debate rages on. In 1980, Ronald Reagan came into office in
the midst of the worst economic downturn since World War II. Instead of
pursuing New Deal style policies with federally subsidized jobs programs
and massive social spending, Reagan and his economic advisors argued that
the best remedy for America's economic woes was to cut taxes. Riding the
wave of popularity that had swept him into office, Reagan convinced the
Congress to cut taxes and the economy improved. However, because Reagan
was not able to secure the reductions in federal spending that he sought
and because he and the Congress cooperated in engaging the Soviet Union
in a costly arms race, the federal debt exploded. To complicate matters
further, the evidence was less than conclusive that Reagan's tax cuts
had been the cause of America's rebound from economic recession. When
Bill Clinton came into office in 1992 in the midst of another economic
downturn, his solution was much more like Roosevelt's than Reagan's. This
time, however, the Congress did not fully cooperate with the newly elected
president and many of his proposed programs did not become law. His much
ballyhooed "economic stimulus" package, however, passed both
houses of the Congress--by one just one vote in both cases. Seven years
later, America is in the midst of the longest peace-time economic expansion
in American history. Does the economic stimulus package get the credit?
Reagan's tax cuts? Or is the American economy simply riding the wave of
a booming, technology-driven world economy?
The debate is unlikely to be settled anytime soon, but the United States
government and its leaders are sure to continue their efforts to prevent
the economy from falling into the lowest lows of the business cycle and
to help kickstart the economy when it does falter. The various tools the
government has at its disposal as it does so are discussed later in "Economic
Stiglitz, Joseph. 1988. Economics of the Public Sector, 2d ed.
New York: W.W. Norton & Co. (See Chapter 3, "The Economic Rationale for Government," p.
Congress drew its authority to pass the Sherman Antritrust Act from the "commerce
clause" in the Constitution.