Introduction
The collapse of the global financial system in 2008 and the subsequent recession through 2009 defied the reputation of the free market economy in the public imagination and discourse in a way that it had not been defied since the Great Depression.
The intellectual consensus after this particular recession was that free-market economies are not only unstable and exploitive (Boettke 2010), but contribute to market failure, thus the need for government’s intervention on a multiplicity of fronts to neutralize these objectionable characteristics (Devlin 2010).
Academics and economic commentators are still critically analyzing what could have gone wrong to occasion such an unprecedented financial crisis on the global front, but one of the possible reasons that continue to elicit increased attention is market failure (Dorn 2010). The present paper aims to shed more light into the concept of market failure, its causes, and the various interventions that government can adopt to correct this undesirable market outcome.
Understanding Market Failure
In precise terms, market failure is “…an economic term that encompasses a situation where, in any given market, the quantity of a product demanded by consumers does not equate to the quantity supplied by suppliers” (Investopedia 2012, para. 1).
This scenario is thought to arise due to the absence of certain economically ideal factors, which not only prevent the achievement of market equilibrium but also occasion negative ramifications on the economy due to fact that optimal allocation of resources is not realized (Investopedia 2012; Wetherly & Otter 2011).
In other words, market failure occurs when the allotment of commodities and services by a free market fails to meet the efficiency requirements, in large part due to the pursuit of pure self-interest and imperfections in the market mechanism (Palmer & Hartley 2006). Market failure is caused by a multiplicity of factors, discussed as follows:
Causes of Market Failure
Academics and economic experts are of the opinion that market failure may be caused either by non-disclosure of critical information among private sector players, or by inadequacy of information in the market (Devlin 2010). This view is reinforced by Basu (2009), who acknowledges that market failure is caused by incomplete information, as well as imperfect or asymmetric information.
According to this author, “…asymmetric information refers to the problem which principally arises from the non-disclosure of information; this means information is there but one agent does not disclose all the relevant parts of it, specially his/her true intention to his/her opposite agent” (p. 488).
On the other hand, incomplete information implies that all the relevant information that is essential for private sector actors to make informed investment decisions is not currently available, either due to the fact that it was not being collected and stored by relevant market agencies or because it has yet to emerge in a particular market (Wetherly & Otter 2011; Dorn 2010).
Borooah (2003) acknowledges that market failure may arise due to unfair competition practices perpetuated by monopolies. In the economic arena, agents perpetuate unfair competition practices with the view to serve their own best interests while relying on imperfect knowledge, leading to market failure (Booth 2008).
Still, extant research demonstrates that market failure can be triggered by externalities, which may come into play when the action of one agent inevitably influences the welfare of another agent in a market setting (Borooah 2003; Wetherly & Otter 2011; Palmer & Hartley 2006), or when skill formation may bear broader benefits or spillages that agents financing the formation may be unable to fully capture for themselves and which those making investments will not have any incentive to consider in making their decisions (Keep 2006).
Moving on, economic theory has proved that market failure can be triggered by risk and uncertainty, and by social welfare and inequality (Borooah 2003; Wetherly & Otter 2011). The challenge of risk and uncertainty, according to these authors, crops up when products and services are differentiated by ‘time of consumption’, and by position or level of contingency.
In terms of social welfare and inequality, it is felt that market failure may arise in any given market because disparity in the distribution of products and services between consumers may indicate that the social welfare linked to a stated level of production is actually sub-optimal (Borooah 2003).
Government’s Intervention Strategies
A strand of economic literature (e.g., Basu 2009; Wetherly & Otter 2011; Keep 2006) demonstrates that in many situations government intervention in a free-market economy materializes from the failure of the private sector to streamline the markets, and from government urge to protect investors and the public.
The 2008 financial recession certainly taught analysts and industry that assumptions of an efficient market are misplaced where systemic risk and uncertainty permeate various private sector actors, and where the collapse of one key player triggers the collapse of other players, not only in terms of domestic scope but also globally (Devlin 2010; Palmer & Hartley 2006).
This particular recession demonstrated to the world that government intervention in free market economy is indeed a necessity, and that incompetent support for the free market is, to say the least, dogmatic.
Market failure, along with its well known antecedents and systemic events, such as conflict of interests, insider trading, and fraud, continue to trigger a plethora of regulatory reform proposals, particularly from government and other stakeholders (Dorn 2010). As noted by this author, government- initiated reforms and proposals “…are directed at reducing systemic risks, within which context regulators are more actively targeting a range of so-called ‘market failures’, including non-compliance and crime” (p. 49).
To effectively correct market failures, therefore, government needs to develop and implement regulations that can guard against dubious and shady practices perpetrated by market insiders in the corporate world, and also lay down frameworks for addressing conflict of interest among free market actors (Dorn 2010; Devlin 2010).
Moving on, some analysts argue that government can correct market failure by changing the context within which markets operate, with a view to redistribute resources and alter the initial endowments in order to avoid grossly inequitable consequences (Borooah 2003; Wetherly & Otter 2011).
This view is supported by Basu (2010), who acknowledges that government has a role to intervene in free-market economies to ensure the benefits accruing from the market ‘trickle down’ to the population. However, government’s “…role would be limited by the injunction that, in the pursuit of redistributive objectives, [it] should not, by distorting incentives, prevent the free functioning of markets” (Borooah 2003, p. 2).
Another strand of literature demonstrates that government could attempt to correct market failure by privatizing public institutions, which continue to absorb much of the blame for entrenching monopolies and thus creating market imperfections (Dorn 2010; Wetherly & Otter 2011). This preposition, as noted by Borooah (2003), implies that government could attempt to correct the undesirable outcomes occasioned by market failure by abdicating its productive responsibilities in support of the public sector.
Such abdication, according to this author, would lead to the removal of imperfections, which are known to prevent markets from functioning properly as they are linked to a lack “…of competition (for example, through the existence of monopolies) or with the presence of barriers to price flexibility (for example, through price-support mechanisms like minimum wage legislation)” (p. 3).
Consequently, the task of government in such a scenario would be limited to taking obligatory steps to guarantee that all hurdles to the proper functioning of markets are eliminated.
To curtail externalities and inequities in the market, which leads to market failure, government could engage in the provision of public goods and restriction of public undesirables through increased taxes, public purchases and grants (Dolfsma 2011).
Critics, however, extrapolate that this kind of interference may actually lead to disturbance of market equilibrium, triggering more challenges particularly on the supply side (Booth 2008). For example, an electronic company accused of disturbing the market of a local economy by selling counterfeit products may relocate to another country instead of paying high taxes in penalties.
Such relocation, if done by half of the companies operating in a given market, will ultimately lead to low supplies and consequent market failure. This observation leads Boettke (2010) to argue that government must be extremely cautious when making decisions to intervene in a free market economy as such intervention, if not properly formulated and implemented, may imply doom to the market dynamics.
The above notwithstanding, it is well known that government must undertake the responsibility to formulate and maintain rules in the economy (Dolfsma 2011), and that rules set out by government not only profoundly influence the economic discourse but also affect the overall levels of income or income distribution (Palmer & Hartley 2006; Basu 2009).
This view is supported by Basu (2009), who suggests that it is the function of governments across the world to formulate rules for the better functioning of society. Consequently, it can be suggested that government may use this prerogative of being the ‘principal rule formulator and implementer’ to correct existing market failures.
Conclusion
From the above discussion, it is evident that there exists an obvious economic case for government’s intervention in markets where some form of market failure is unfolding due to the fact it must always act to safeguard the interests of the public.
Of course the role of the government in attempting to correct market failure is perceived by many economists as an issue of ideological discussion that transcends individuals and economies (Dolfsma 2011), but the issues discussed in this paper demonstrate that the state should be concerned with the appropriate functioning of the entire market system if desirable economic outcomes are to be achieved.
It cannot be rightly guessed that government will automatically succeed where free market forces have failed, and that all cases of market failure could be amenable to correction through government intervention; however, the government remains an indispensable player in streamlining market activities and processes.
Reference List
Basu, S. 2009, ‘Government success, failure of the market: A case study of rural India’, International Review of Applied Economics, vol. 23 no. 4, pp. 485-501.
Boettke, P. J. 2010, ‘What happened to efficient markets?’ Independent Review, vol. 14 no. 3, pp. 363-375.
Booth, P. 2008, ‘Market failure: A failed paradigm’, Economic Affairs, vol. 28 no. 4, pp. 72-74.
Borooah, V. K. 2003. Market failure: An economic analysis of its causes and consequences. Web.
Devlin, A. 2010, ‘Antitrust in an era of market failure’, Harvard Journal of Law & Public Policy, vol. 33 no. 2, pp. 557-606.
Dolfsma, W. 2011. ‘Government failure – four types’, Journal of Economic Issues, vol. 45 no. 3, pp. 593-604.
Dorn, N. 2010, ‘Regulatory conceptions of unacceptable market practices under three policy scenarios’, Journal of Banking Regulation, vol. 12 no. 1, pp. 48-68.
Investopedia 2012. Market failure. Web.
Keep, E. 2006, ‘Market failure and public policy on training: Some reasons for caution’, Development and Learning in Organizations, vol. 20 no. 6, pp. 7-9.
Palmer, A. & Hartley, B. 2006. The business environment, 5th ed, Berkshire, McGraw Hill.
Wetherly, P., & Otter, D. 2011, The business environment: Themes and issues, 2nd ed, Oxford, Oxford University Press.