Market failure is a situation where the forces of SUPPLY and DEMAND in a market result in an outcome that is not efficient, not equitable, or not acceptable. The most common type of market failure occurs when a market does not include all the COSTS or benefits associated with the PRODUCTION or CONSUMPTION of a good. EXTERNALITIES exist in this situation, meaning there is a difference between the private costs and benefits and society’s costs and benefits. In theory, competitive markets allocate production and consumption so that marginal social benefits equal marginal social costs, resulting in an efficient allocation of RESOURCES, but market power and lack of clearly defined property rights often results in inefficient resource allocation, creating market failures. In the United States, governments use ANTITRUST LAWs, public utility regulation, subsidies, taxes, and environmental regulations to correct for market failure due to inefficient allocation of resources. Antitrust laws and utility regulation reduce or control the market power of monopolists, lowering prices and increasing market output. Taxes and environmental regulations motivate or force businesses to include environmental costs in their market decisions, increasing prices and reducing the allocation of resources in those market; pollution credits are also being used to correct for market failure due to inefficient resource allocation. Those businesses that can reduce their pollution most do so efficiently and then sell pollution credits to firms that cannot reduce their pollution as easily. The second type of market failure occurs when the market outcome is not socially acceptable, although this depends on people’s political/economic philosophy and has shifted over time in the United States. Market failure associated with socially unacceptable distribution of INCOME and consumption is corrected through progressive taxation and income-transfer programs. Markets can also fail to create and maintain stability. Rapidly increasing prices (INFLATION) or increasing levels of UNEMPLOYMENT are generally unacceptable market outcomes. Government fiscal and/or monetary policies are utilized to even out fluctuations in BUSINESS CYCLES correcting for this form of market failure.
See also FISCAL POLICY; MONETARY POLICY; PUBLIC UTILITIES.