Market Failure

When 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

For 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.

Competition 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.

In 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.

Is 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 Microsoft. 

What do you think? Is Microsoft a monopoly?

One 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 under competition.

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 intimidation.

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.

Public Goods

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 be provided.

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.

Incomplete Markets

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 markets.

Externalities

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.

When 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?

  1. The problems of establishing property rights and liability (Fifth Amendment)
  2. "Tragedy of the Commons"

b. At what level should the intervention take place?

  1. National standards
  2. Local regulation

c. How much intervention should there be?

  1. "Zero-Risk"
  2. "Safe-Levels"
  3. Balancing

d. Impact of the EPA

  1. Original budget of about $3 billion with 7,000  employees, up to about $5 billion in late 1980s
  2. 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.

Information Failures

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 information.

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.

Some observers 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 polluting area.

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 Policy Making."


NOTES
1. 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. 61-86.)
2. Congress drew its authority to pass the Sherman Antritrust Act from the "commerce clause" in the Constitution.