Market Failures

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Be warned: Economies do not live on markets alone. The United States has a mixed economy, which combines private markets with elements of government intervention. Why do market-oriented countries still rely on government interventions?

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There are two reasons. First, efficiency may be hard to achieve in many real world situations when pollution or other externalities are present or when there is imperfect competition. Second, the outcomes of competitive markets, even when they are efficient, may not be socially desirable or acceptable.

A number of market failures spoil the idyllic picture assumed in our discussion of efficient markets: imperfect competition, externalities, and imperfect information.

Imperfect Competition. When a firm has market power in a particular market (say it has a monopoly because of a patented drug or a local electricity franchise), the firm can raise the price of its ...
... product above its marginal cost.

Consumers buy less of such goods than they would under competition, and consumer satisfaction is reduced. This kind of reduction of consumer satisfaction is typical of the inefficiencies created by imperfect competition.

Externalities. A second market failure is externalities. Recall that externalities arise when some of the side effects of production or consumption are not included in market prices. For example, a utility might pump sulfurous fumes into the air, causing damage to neighboring homes and to people's health.

If the utility does not pay for these impacts, pollution will be inefficiently high and consumer welfare will suffer.

Not all externalities are harmful. Some are beneficial, such as the externalities that come from knowledge-generating activities. For example, when Chester Carlson invented xerography, he became a millionaire; but he still received only a tiny fraction of the benefits when the world's secretaries and students were relieved of billions of hours of drudgery.

Another positive externality arises from public health programs, such as inoculation against smallpox, cholera, or typhoid; an inoculation protects not only the inoculated person but also others whom that person might infect.

Imperfect Information. A third important market failure is imperfect information. The invisible-hand theory assumes that buyers and sellers have full information about the goods and services they buy and sell. Firms are assumed to know about all the blueprints for operating in their industry. Consumers are presumed to know about the quality and prices of goods — such as which cars are lemons or the safety and efficacy of Pharmaceuticals and angioplasty.

Clearly, reality is far from this idealized world. The critical question is: How damaging are departures from perfect information? In some cases, the loss of efficiency is slight. I will hardly be greatly disadvantaged if I buy a chocolate ice cream that is slightly too sweet or if I don't know the exact temperature of the beer that flows from the tap.

In other cases, the loss is severe. Take the case of steel mogul Eben Byers, who early in this century took Radiator, sold as an aphrodisiac and cure-all, to relieve his ailments.

Later analysis showed that Radiator was actually distilled water laced with radium. Byers died a hideous death when his jaw and other bones disintegrated. This kind of invisible hand we don't need.

Luckily, few products are as poorly understood as Radiator. One of the important tasks of the government is to identify those areas where informational deficiencies are significant and then to find appropriate remedies.