Market failure

In neoclassical economics, market failure is a situation in which the allocation of goods and services by a free market is not Pareto efficient, often leading to a net loss of economic value. Market failures can be viewed as scenarios where individuals' pursuit of pure self-interest leads to results that are not efficient– that can be improved upon from the societal point of view.[1][2] The first known use of the term by economists was in 1958,[3] but the concept has been traced back to the Victorian philosopher Henry Sidgwick.[4] Market failures are often associated with public goods,[5] time-inconsistent preferences,[6] information asymmetries,[7] non-competitive markets, principal–agent problems, or externalities.[8]

The existence of a market failure is often the reason that self-regulatory organizations, governments or supra-national institutions intervene in a particular market.[9][10] Economists, especially microeconomists, are often concerned with the causes of market failure and possible means of correction.[11] Such analysis plays an important role in many types of public policy decisions and studies.

However, government policy interventions, such as taxes, subsidies, wage and price controls, and regulations, may also lead to an inefficient allocation of resources, sometimes called government failure.[12] Given the tension between the economic costs caused by market failure and costs caused by "government failure", policymakers attempting to maximize economic value are sometimes faced with a choice between two inefficient outcomes, i.e. inefficient market outcomes with or without government interventions.

Most mainstream economists believe that there are circumstances (like building codes or endangered species) in which it is possible for government or other organizations to improve the inefficient market outcome. Several heterodox schools of thought disagree with this as a matter of ideology.[13]

An ecological market failure exists when human activity in a market economy is exhausting critical non-renewable resources, disrupting fragile ecosystems services, or overloading biospheric waste absorption capacities. In none of these cases does the criterion of Pareto efficiency obtain.[14]


Different economists have different views about what events are the sources of market failure. Mainstream economic analysis widely accepts that a market failure (relative to Pareto efficiency) can occur for three main reasons: if the market is "monopolised" or a small group of businesses hold significant market power, if production of the good or service results in an externality, or if the good or service is a "public good".[15]

The nature of the market

Agents in a market can gain market power, allowing them to block other mutually beneficial gains from trade from occurring. This can lead to inefficiency due to imperfect competition, which can take many different forms, such as monopolies,[16] monopsonies, or monopolistic competition, if the agent does not implement perfect price discrimination.

It is then a further question about what circumstances allow a monopoly to arise. In some cases, monopolies can maintain themselves where there are "barriers to entry" that prevent other companies from effectively entering and competing in an industry or market. Or there could exist significant first-mover advantages in the market that make it difficult for other firms to compete. Moreover, monopoly can be a result of geographical conditions created by huge distances or isolated locations. This leads to a situation where there are only few communities scattered across a vast territory with only one supplier. Australia is an example that meets this description.[17] A natural monopoly is a firm whose per-unit cost decreases as it increases output; in this situation it is most efficient (from a cost perspective) to have only a single producer of a good. Natural monopolies display so-called increasing returns to scale. It means that at all possible outputs marginal cost needs to be below average cost if average cost is declining. One of the reasons is the existence of fixed costs, which must be paid without considering the amount of output, what results in a state where costs are evenly divided over more units leading to the reduction of cost per unit.[18]

The nature of the goods


Some markets can fail due to the nature of the goods being exchanged. For instance, goods can display the attributes of public goods[16] or common goods, wherein sellers are unable to exclude non-buyers from using a product, as in the development of inventions that may spread freely once revealed. This can cause underinvestment because developers cannot capture enough of the benefits from success to make the development effort worthwhile. This can also lead to resource depletion in the case of common-pool resources, where, because use of the resource is rival but non-excludable, there is no incentive for users to conserve the resource. An example of this is a lake with a natural supply of fish: if people catch the fish faster than they can reproduce, then the fish population will dwindle until there are no fish left for future generations.


A good or service could also have significant externalities,[8][16] where gains or losses associated with the product, production or consumption of a product, differ from the private cost. These externalities can be innate to the methods of production or other conditions important to the market.[2]

Traffic congestion is an example of market failure that incorporates both non-excludability and externality. Public roads are common resources that are available for the entire population's use (non-excludable), and act as a complement to cars (the more roads there are, the more useful cars become). Because there is very low cost but high benefit to individual drivers in using the roads, the roads become congested, decreasing their usefulness to society. Furthermore, driving can impose hidden costs on society through pollution (externality). Solutions for this include public transportation, congestion pricing, tolls, and other ways of making the driver include the social cost in the decision to drive.[2]

Perhaps the best example of the inefficiency associated with common/public goods and externalities is the environmental harm caused by pollution and overexploitation of natural resources.[2]

The nature of the exchange

Some markets can fail due to the nature of their exchange. Markets may have significant transaction costs, agency problems, or informational asymmetry.[2][16] Such incomplete markets may result in economic inefficiency but also a possibility of improving efficiency through market, legal, and regulatory remedies. From contract theory, decisions in transactions where one party has more or better information than the other is an asymmetry. This creates an imbalance of power in transactions which can sometimes cause the transactions to go awry. Examples of this problem are adverse selection and moral hazard. Most commonly, information asymmetries are studied in the context of principal–agent problems. George Akerlof, Michael Spence, and Joseph E. Stiglitz developed the idea and shared the 2001 Nobel Prize in Economics.[19]

Bounded rationality

In Models of Man, Herbert A. Simon points out that most people are only partly rational, and are emotional/irrational in the remaining part of their actions. In another work, he states "boundedly rational agents experience limits in formulating and solving complex problems and in processing (receiving, storing, retrieving, transmitting) information" (Williamson, p. 553, citing Simon). Simon describes a number of dimensions along which "classical" models of rationality can be made somewhat more realistic, while sticking within the vein of fairly rigorous formalization. These include:

  • limiting what sorts of utility functions there might be.
  • recognizing the costs of gathering and processing information.
  • the possibility of having a "vector" or "multi-valued" utility function.

Simon suggests that economic agents employ the use of heuristics to make decisions rather than a strict rigid rule of optimization. They do this because of the complexity of the situation, and their inability to process and compute the expected utility of every alternative action. Deliberation costs might be high and there are often other, concurrent economic activities also requiring decisions.

Coase theorem

The Coase theorem, developed by Ronald Coase and labeled as such by George Stigler, states that private transactions are efficient as long as property rights exist, only a small number of parties are involved, and transactions costs are low. Additionally, this efficiency will take place regardless of who owns the property rights. This theory comes from a section of Coase's Nobel prize-winning work The Problem of Social Cost. While the assumptions of low transactions costs and a small number of parties involved may not always be applicable in real-world markets, Coase's work changed the long-held belief that the owner of property rights was a major determining factor in whether or not a market would fail.[20] The Coase theorem points out when one would expect the market to function properly even when there are externalities.

A market is an institution in which individuals or firms exchange not just commodities, but the rights to use them in particular ways for particular amounts of time. [...] Markets are institutions which organize the exchange of control of commodities, where the nature of the control is defined by the property rights attached to the commodities.[10]

As a result, agents' control over the uses of their commodities can be imperfect, because the system of rights which defines that control is incomplete. Typically, this falls into two generalized rights – excludability and transferability. Excludability deals with the ability of agents to control who uses their commodity, and for how long – and the related costs associated with doing so. Transferability reflects the right of agents to transfer the rights of use from one agent to another, for instance by selling or leasing a commodity, and the costs associated with doing so. If a given system of rights does not fully guarantee these at minimal (or no) cost, then the resulting distribution can be inefficient.[10] Considerations such as these form an important part of the work of institutional economics.[21] Nonetheless, views still differ on whether something displaying these attributes is meaningful without the information provided by the market price system.[22]

Business cycles

Macroeconomic business cycles are a part of the market. They are characterized by constant downswings and upswings which influence economic activity. Therefore, this situation requires some kind of government intervention.[17]

Interpretations and policy examples

The above causes represent the mainstream view of what market failures mean and of their importance in the economy. This analysis follows the lead of the neoclassical school, and relies on the notion of Pareto efficiency,[23] which can be in the "public interest", as well as in interests of stakeholders with equity.[11] This form of analysis has also been adopted by the Keynesian or new Keynesian schools in modern macroeconomics, applying it to Walrasian models of general equilibrium in order to deal with failures to attain full employment, or the non-adjustment of prices and wages.

Policies to prevent market failure are already commonly implemented in the economy. For example, to prevent information asymmetry, members of the New York Stock Exchange agree to abide by its rules in order to promote a fair and orderly market in the trading of listed securities. The members of the NYSE presumably believe that each member is individually better off if every member adheres to its rules – even if they have to forego money-making opportunities that would violate those rules.

A simple example of policies to address market power is government antitrust policies. As an additional example of externalities, municipal governments enforce building codes and license tradesmen to mitigate the incentive to use cheaper (but more dangerous) construction practices, ensuring that the total cost of new construction includes the (otherwise external) cost of preventing future tragedies. The voters who elect municipal officials presumably feel that they are individually better off if everyone complies with the local codes, even if those codes may increase the cost of construction in their communities.

CITES is an international treaty to protect the world's common interest in preserving endangered species – a classic "public good" – against the private interests of poachers, developers and other market participants who might otherwise reap monetary benefits without bearing the known and unknown costs that extinction could create. Even without knowing the true cost of extinction, the signatory countries believe that the societal costs far outweigh the possible private gains that they have agreed to forego.

Some remedies for market failure can resemble other market failures. For example, the issue of systematic underinvestment in research is addressed by the patent system that creates artificial monopolies for successful inventions.


Public choice

Economists such as Milton Friedman from the Chicago school and others from the Public Choice school, argue that market failure does not necessarily imply that the government should attempt to solve market failures, because the costs of government failure might be worse than those of the market failure it attempts to fix. This failure of government is seen as the result of the inherent problems of democracy and other forms of government perceived by this school and also of the power of special-interest groups (rent seekers) both in the private sector and in the government bureaucracy. Conditions that many would regard as negative are often seen as an effect of subversion of the free market by coercive government intervention. Beyond philosophical objections, a further issue is the practical difficulty that any single decision maker may face in trying to understand (and perhaps predict) the numerous interactions that occur between producers and consumers in any market.


Some advocates of laissez-faire capitalism, including many economists of the Austrian School, argue that there is no such phenomenon as "market failure". Israel Kirzner states that, "Efficiency for a social system means the efficiency with which it permits its individual members to achieve their individual goals."[24] Inefficiency only arises when means are chosen by individuals that are inconsistent with their desired goals.[25] This definition of efficiency differs from that of Pareto efficiency, and forms the basis of the theoretical argument against the existence of market failures. However, providing that the conditions of the first welfare theorem are met, these two definitions agree, and give identical results. Austrians argue that the market tends to eliminate its inefficiencies through the process of entrepreneurship driven by the profit motive; something the government has great difficulty detecting, or correcting.[26]


Objections also exist on more fundamental bases, such as that of equity, or Marxian analysis. Colloquial uses of the term "market failure" reflect the notion of a market "failing" to provide some desired attribute different from efficiency – for instance, high levels of inequality can be considered a "market failure", yet are not Pareto inefficient, and so would not be considered a market failure by mainstream economics.[2] In addition, many Marxian economists would argue that the system of individual property rights is a fundamental problem in itself, and that resources should be allocated in another way entirely. This is different from concepts of "market failure" which focuses on specific situations – typically seen as "abnormal" – where markets have inefficient outcomes. Marxists, in contrast, would say that markets have inefficient and democratically unwanted outcomes – viewing market failure as an inherent feature of any capitalist economy – and typically omit it from discussion, preferring to ration finite goods not exclusively through a price mechanism, but based upon need as determined by society expressed through the community.


In ecological economics, the concept of externalities is considered a misnomer, since market agents are viewed as making their incomes and profits by systematically 'shifting' the social and ecological costs of their activities onto other agents, including future generations. Hence, externalities is a modus operandi of the market, not a failure: The market cannot exist without constantly 'failing'.

The fair and even allocation of non-renewable resources over time is a market failure issue of concern to ecological economics. This issue is also known as 'intergenerational fairness'. It is argued that the market mechanism fails when it comes to allocating the Earth's finite mineral stock fairly and evenly among present and future generations, as future generations are not, and cannot be, present on today's market.[27]:375 [28]:142f In effect, today's market prices do not, and cannot, reflect the preferences of the yet unborn.[29]:156–160 This is an instance of a market failure passed unrecognized by most mainstream economists, as the concept of Pareto efficiency is entirely static (timeless).[30]:181f Imposing government restrictions on the general level of activity in the economy may be the only way of bringing about a more fair and even intergenerational allocation of the mineral stock. Hence, Nicholas Georgescu-Roegen and Herman Daly, the two leading theorists in the field, have both called for the imposition of such restrictions: Georgescu-Roegen has proposed a minimal bioeconomic program, and Daly has proposed a comprehensive steady-state economy.[27]:374–79 [30] However, Georgescu-Roegen, Daly, and other economists in the field agree that on a finite Earth, geologic limits will inevitably strain most fairness in the longer run, regardless of any present government restrictions: Any rate of extraction and use of the finite stock of non-renewable mineral resources will diminish the remaining stock left over for future generations to use.[27]:366–69 [31]:369–71 [32]:165–67 [33]:270 [34]:37

Another ecological market failure is presented by the overutilisation of an otherwise renewable resource at a point in time, or within a short period of time. Such overutilisation usually occurs when the resource in question has poorly defined (or non-existing) property rights attached to it while too many market agents engage in activity simultaneously for the resource to be able to sustain it all. Examples range from over-fishing of fisheries and over-grazing of pastures to over-crowding of recreational areas in congested cities. This type of ecological market failure is generally known as the 'tragedy of the commons'. In this type of market failure, the principle of Pareto efficiency is violated the utmost, as all agents in the market are left worse off, while nobody are benefitting. It has been argued that the best way to remedy a 'tragedy of the commons'-type of ecological market failure is to establish enforceable property rights politically – only, this may be easier said than done.[14]:172f

The issue of anthropogenic global warming presents an overwhelming example of a 'tragedy of the commons'-type of ecological market failure: The Earth's atmosphere may be regarded as a 'global common' exhibiting poorly defined (non-existing) property rights, and the waste absorption capacity of the atmosphere with regard to carbon dioxide is presently being heavily overloaded by a too large volume of emissions from the world economy.[35]:347f Historically, the fossil fuel dependence of the Industrial Revolution has unintentionally thrown mankind out of ecological equilibrium with the rest of the Earth's biosphere (including the atmosphere), and the market has failed to correct the situation ever since. Quite the opposite: The unrestricted market has been exacerbating this global state of ecological dis-equilibrium, and is expected to continue doing so well into the foreseeable future.[36]:95–101 This particular market failure may be remedied to some extent at the political level by the establishment of an international (or regional) cap and trade property rights system, where carbon dioxide emission permits are bought and sold among market agents.[14]:433–35

The term 'uneconomic growth' describes a pervasive ecological market failure: The ecological costs of further economic growth in a so-called 'full-world economy' like the present world economy may exceed the immediate social benefits derived from this growth.[14]:16–21

Chang's criticism

Chang states that "it is (implicitly) assumed the state knows everything and can do everything.”[17] Thus, this implies several assumptions about government in relation to market failures. There are three main statements. First of all, government representatives are able to evaluate the scope of market failures and to what extent it differs from efficient outcome. Secondly, having acquired the aforementioned knowledge they have capacity to re-establish market efficiency. Lastly, there has arisen an idea according to which decisions of policy-makers are not influenced by self-interest, but they are driven by altruism.

Lipsey and Lancaster criticism

They came up with the theory of the so-called the “second best.” They refuse Chang's theory and state that is it not possible to restore Pareto optimality even if policy makers possess the sufficient knowledge, intervene efficiently and altruism serves as stimulus for their decisions. On the other hand, the “second best” theory holds that when market failure occurs in one branch of the economy, it should be feasible to increase social welfare in another branch of the economy by violating Pareto efficiency instead of restoring Pareto efficiency by government intervention.[37]

Zerbe and McCurdy

Zerbe and McCurdy connected criticism of market failure paradigm to transaction costs. Market failure paradigm is defined as follows:

"A fundamental problem with the concept of market failure, as economists occasionally recognize, is that it describes a situation that exists everywhere.”

Transaction costs are part of each market exchange, although the price of transaction costs is not usually determined. They occur everywhere and are unpriced. Consequently, market failures and externalities can arise in the economy every time transaction costs arise. There is no place for government intervention. Instead, government should focus on the elimination of both transaction costs and costs of provision.[38]

See also


  1. ^ John O. Ledyard (2008). "market failure," The New Palgrave Dictionary of Economics, 2nd Ed. Abstract.
  2. ^ a b c d e f Paul Krugman and Robin Wells (2006). Economics, New York, Worth Publishers.
  3. ^ Francis M. Bator (1958). "The Anatomy of Market Failure," Quarterly Journal of Economics, 72(3) pp. 351–79 (press +).
  4. ^ Steven G. Medema (2007). "The Hesitant Hand: Mill, Sidgwick, and the Evolution of the Theory of Market Failure," History of Political Economy, 39(3), p p. 331–58. 2004 Online Working Paper.
  5. ^ Joseph E. Stiglitz (1989). "Markets, Market Failures, and Development," American Economic Review, 79(2), pp. 197–203.
  6. ^ •Ignacio Palacios-Huerta (2003) "Time-inconsistent preferences in Adam Smith and David Hume," History of Political Economy, 35(2), pp. 241–68 [1]
  7. ^ • Charles Wilson (2008). "adverse selection," The New Palgrave Dictionary of Economics 2nd Edition. Abstract.
       • Joseph E. Stiglitz (1998). "The Private Uses of Public Interests: Incentives and Institutions," Journal of Economic Perspectives, 12(2), pp. 3–22.
  8. ^ a b J.J. Laffont (2008). "externalities," The New Palgrave Dictionary of Economics, 2nd Ed. Abstract.
  9. ^ Kenneth J. Arrow (1969). "The Organization of Economic Activity: Issues Pertinent to the Choice of Market versus Non-market Allocations," in Analysis and Evaluation of Public Expenditures: The PPP System, Washington, D.C., Joint Economic Committee of Congress. PDF reprint as pp. 1–16 (press +).
  10. ^ a b c Gravelle, Hugh; Ray Rees (2004). Microeconomics. Essex, England: Prentice Hall, Financial Times. pp. 314–46.
  11. ^ a b Mankiw, Gregory; Ronald Kneebone; Kenneth McKenzie; Nicholas Row (2002). Principles of Microeconomics: Second Canadian Edition. United States: Thomson-Nelson. pp. 157–58.
  12. ^ Weimer, David; Aidan R. Vining (2004). Policy Analysis: Concepts and Practice. Prentice Hall.
  13. ^ Mankiw, N. Gregory (2009). Brief Principles of Macroeconomics. South-Western Cengage Learning. pp. 10–12.
  14. ^ a b c d Daly, Herman E.; Farley, Joshua (2011). Ecological Economics. Principles and Applications (PDF contains full textbook) (2nd ed.). Washington: Island Press. ISBN 9781597266819.
  15. ^ Krugman, Paul; Robin Wells; Anthony Myatt (2006). Microeconomics: Canadian Edition. Worth Publishers. pp. 160–62.
  16. ^ a b c d DeMartino, George (2000). Global Economy, Global Justice. Routledge. p. 70. ISBN 0-415-22401-2.
  17. ^ a b c Brian., Dollery, (2001). The political economy of local government. Wallis, Joe (Joe L.). Northampton, MA: Edward Elgar Pub. ISBN 1840644516. OCLC 46462759.
  18. ^ "Natural monopolies exist when one firm dominates an industry". Retrieved 2018-04-24.
  19. ^ Huffman, Max (December 2010). "Neo-Behavioralism?": 9. SSRN 1730365.
  20. ^ Michael Parkin (2008). "Microeconomics," 9th Ed. p. 379. University of Western Ontario.
  21. ^ Bowles, Samuel (2004). Microeconomics: Behavior, Institutions, and Evolution. United States: Russel Sage Foundation.
  22. ^ Machan, R. Tibor, Some Skeptical Reflections on Research and Development, Hoover Press
  23. ^ MacKenzie, D.W. (2002-08-26). "The Market Failure Myth". Ludwig von Mises Institute. Retrieved 2008-11-25.
  24. ^ Israel Kirzner (1963). Market Theory and the Price System. Princeton. N.J.: D. Van Nostrand Company. p. 35.
  25. ^ Roy E. Cordato (1980). "The Austrian Theory of Efficiency and the Role of Government" (PDF). The Journal of Libertarian Studies. 4 (4): 393–403 [396].
  26. ^ Roy E. Cordato (1980). "The Austrian Theory of Efficiency and the Role of Government" (PDF). The Journal of Libertarian Studies. 4 (4): 393–403.
  27. ^ a b c Georgescu-Roegen, Nicholas (1975). "Energy and Economic Myths" (PDF). Southern Economic Journal. Tennessee: Southern Economic Association. 41 (3): 347–81. doi:10.2307/1056148.
  28. ^ Perez-Carmona, Alexander (2013). "Growth: A Discussion of the Margins of Economic and Ecological Thought". In Meuleman, Louis (ed.). Transgovernance. Advancing Sustainability Governance. Heidelberg: Springer. pp. 83–161. doi:10.1007/978-3-642-28009-2_3. ISBN 9783642280085 – via SlideShare.
  29. ^ Martínez-Alier, Juan (1987). Ecological Economics: Energy, Environment and Society. Oxford: Basil Blackwell. ISBN 0631171460.
  30. ^ a b Daly, Herman E. (1992). Steady-state economics (2nd ed.). London: Earthscan Publications.
  31. ^ Daly, Herman E., ed. (1980). Economics, Ecology, Ethics. Essays Towards a Steady-State Economy (PDF contains only the introductory chapter of the book) (2nd ed.). San Francisco: W.H. Freeman and Company. ISBN 0716711788.
  32. ^ Boulding, Kenneth E. (1981). Evolutionary Economics. Beverly Hills: Sage Publications. ISBN 0803916485.
  33. ^ Bonaiuti, Mauro (2008). "Searching for a Shared Imaginary – A Systemic Approach to Degrowth and Politics". In Flipo, Fabrice; Schneider, François (eds.). Proceedings of the First International Conference on Economic De-Growth for Ecological Sustainability and Social Equity (PDF contains all conference proceedings). Paris.
  34. ^ Valero Capilla, Antonio; Valero Delgado, Alicia (2014). Thanatia: The Destiny of the Earth's Mineral Resources. A Thermodynamic Cradle-to-Cradle Assessment (PDF contains only the introductory chapter of the book). Singapore: World Scientific Publishing. ISBN 9789814273930.
  35. ^ McConnell, Campbell R.; et al. (2009). Economics. Principles, Problems and Policies (PDF) (18th ed.). New York: McGraw-Hill. ISBN 9780073375694. Archived from the original (PDF contains full textbook) on 2016-10-06. Retrieved 2016-04-15.
  36. ^ Schmitz, John E.J. (2007). The Second Law of Life: Energy, Technology, and the Future of Earth As We Know It (Link to the author's science blog, based on his textbook). Norwich: William Andrew Publishing. ISBN 0815515375.
  37. ^ Lipsey, Richard (2007). "Reflections on the General Theory of Second Best at its Golden Jubilee". International Tax and Public Finance. 14: 349–364.
  38. ^ McCurdy, Howard E.; Zerbe Jr., Richard O. (1999). "The Failure of Market Failure". Journal of Policy Analysis and Management. 18: 558–578.

External links

Common-pool resource

In economics, a common-pool resource (CPR) is a type of good consisting of a natural or human-made resource system (e.g. an irrigation system or fishing grounds), whose size or characteristics makes it costly, but not impossible, to exclude potential beneficiaries from obtaining benefits from its use. Unlike pure public goods, common pool resources face problems of congestion or overuse, because they are subtractable. A common-pool resource typically consists of a core resource (e.g. water or fish), which defines the stock variable, while providing a limited quantity of extractable fringe units, which defines the flow variable. While the core resource is to be protected or nurtured in order to allow for its continuous exploitation, the fringe units can be harvested or consumed.

Economic interventionism

Economic interventionism (sometimes called state interventionism) is an economic policy perspective favoring government intervention in the market process to correct the market failures and promote the general welfare of the people. An economic intervention is an action taken by a government or international institution in a market economy in an effort to impact the economy beyond the basic regulation of fraud and enforcement of contracts and provision of public goods. Economic intervention can be aimed at a variety of political or economic objectives, such as promoting economic growth, increasing employment, raising wages, raising or reducing prices, promoting income equality, managing the money supply and interest rates, increasing profits, or addressing market failures.

The term intervention assumes on a philosophical level that the state and economy should be inherently separated from each other; therefore the terminology applies to capitalist market-based economies where government action interrupts the market forces at play through regulations, economic policies or subsidies (state-owned enterprises that operate in the market do not constitute an intervention). The term intervention is typically used by advocates of laissez-faire and free markets. Capitalist market economies that feature high degrees of state intervention are often referred to as mixed economies.

Environmental economics

Environmental economics is a sub-field of economics concerned with environmental issues. It has become a widely studied topic due to growing environmental concerns in the twenty-first century. Quoting from the National Bureau of Economic Research Environmental Economics program:

... Environmental Economics ... undertakes theoretical or empirical studies of the economic effects of national or local environmental policies around the world ... . Particular issues include the costs and benefits of alternative environmental policies to deal with air pollution, water quality, toxic substances, solid waste, and global warming.

Environmental economics is distinguished from ecological economics in that ecological economics emphasizes the economy as a subsystem of the ecosystem with its focus upon preserving natural capital. One survey of German economists found that ecological and environmental economics are different schools of economic thought, with ecological economists emphasizing "strong" sustainability and rejecting the proposition that natural capital can be substituted by human-made capital.


In economics, an externality is the cost or benefit that affects a party who did not choose to incur that cost or benefit. Externalities often occur when a product or service’s price equilibrium cannot reflect the true costs and benefits of that product or service. This causes the externality competitive equilibrium to not be a Pareto optimality.

Externalities can be both positive or negative. Governments and institutions often take actions to internalize externalities, thus market-priced transactions can incorporate all the benefits and costs associated with transactions between economic agents.. The most common way this is done is by imposing taxes on the producers of this externality, in this case pollution. This is usually done similar to a quote where there is no tax imposed and then once the externality reaches a certain point there is a very high tax imposed. However, since regulators do not always have all the information on the externality it can be difficult to impose the right tax. Once the externality is internalized through imposing a tax the competitive equilibrium is now Pareto optimal.

For example, manufacturing activities that cause air pollution impose health and clean-up costs on the whole society, whereas the neighbors of individuals who choose to fire-proof their homes may benefit from a reduced risk of a fire spreading to their own houses. If external costs exist, such as pollution, the producer may choose to produce more of the product than would be produced if the producer were required to pay all associated environmental costs. Because responsibility or consequence for self-directed action lies partly outside the self, an element of externalization is involved. If there are external benefits, such as in public safety, less of the good may be produced than would be the case if the producer were to receive payment for the external benefits to others. For the purpose of these statements, overall cost and benefit to society is defined as the sum of the imputed monetary value of benefits and costs to all parties involved.

Free-rider problem

In the social sciences, the free-rider problem is a type of market failure that occurs when those who benefit from resources, public goods, or services of a communal nature do not pay for them. Free riders are a problem because while not paying for the good, they may continue to access it. Thus, the good may be under-produced, overused or degraded. The free-rider problem in social science is the question of how to limit free riding and its negative effects in these situations. The free-rider problem may occur when property rights are not clearly defined and imposed.The free-rider problem is common with goods which are non-excludable, including public goods and situations of the Tragedy of the Commons. A free rider may enjoy a non-excludable good such as a government-provided road system without contributing to paying for it. For example, if a coastal town builds a lighthouse, ships from many regions and countries will benefit from it, even though they are not contributing to its costs, and are thus "free riding" on the navigation aid. If too many mariners are free riding on the services of this lighthouse, the town may not be able to afford its upkeep.

Although the term "free rider" was first used in economic theory of public goods, similar concepts have been applied to other contexts, including collective bargaining, antitrust law, psychology and political science. For example, some individuals in a team or community may reduce their contributions or performance if they believe that one or more other members of the group may free ride.


Freeloading and mooching are colloquial terms for when a person uses resources that do not belong to them, for their own gain or benefit. A person who freeloads is called a freeloader or a mooch. When unpaid overuse of public resources occurs in the public sphere, it raises a free-rider problem. An example of freeloading would be an uninvited guest abusing the hospitality of their family members, friends, or neighbors, by staying at their house, eating their food, and using their things, without offering to pay for such use.

Government failure

Government failure, in the context of public economics, is an economic inefficiency caused by a government intervention, if the inefficiency would not exist in a true free market. It can be viewed in contrast to a market failure, which is an economic inefficiency that results from the free market itself, and can potentially be corrected through government regulation. The idea of government failure is associated with the policy argument that, even if particular markets may not meet the standard conditions of perfect competition required to ensure social optimality, government intervention may make matters worse rather than better.

As with a market failure, a government failure is not a failure to bring a particular or favored solution into existence but is rather a problem which prevents an efficient outcome. The problem to be solved need not be a market failure; governments may act to create inefficiencies even when an efficient market solution is possible.

Government failure (by definition) does not occur when government action creates winners and losers, making some people better off and others worse off than they would be without governmental regulation. It occurs only when governmental action creates an inefficient outcome, where efficiency would otherwise exist. A defining feature of government failure is where it would be possible for everyone to be better off (a Pareto improvement) under a different regulatory environment.

Examples of government failure include regulatory capture and regulatory arbitrage. Government failure may arise because of unanticipated consequences of a government intervention, or because an inefficient outcome is more politically feasible than a Pareto improvement to it. Government failure can be on both the demand side and the supply side. Demand-side failures include preference-revelation problems and the illogics of voting and collective behaviour. Supply-side failures largely result from principal–agent problem.

Information asymmetry

In contract theory and economics, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other. This asymmetry creates an imbalance of power in transactions, which can sometimes cause the transactions to go awry, a kind of market failure in the worst case. Examples of this problem are adverse selection, moral hazard, and monopolies of knowledge.Information asymmetry extends to non-economic behavior. As private firms have better information than regulators about the actions that they would take in the absence of a regulation, the effectiveness of a regulation may be undermined. International relations theory has recognized that wars may be caused by asymmetric information and that "Most of the great wars of the modern era resulted from leaders miscalculating their prospects for victory". There is asymmetric information between national leaders, wrote Jackson and Morelli, when there are differences "in what they know [i.e. believe] about each other's armaments, quality of military personnel and tactics, determination, geography, political climate, or even just about the relative probability of different outcomes" or where they have "incomplete information about the motivations of other agents".Information asymmetries are studied in the context of principal–agent problems where they are a major cause of misinforming and is essential in every communication process. Information asymmetry is in contrast to perfect information, which is a key assumption in neo-classical economics. In 2001 the Nobel Memorial Prize in Economics was awarded to George Akerlof, Michael Spence, and Joseph E. Stiglitz for their "analyses of markets with asymmetric information".

Information good

Information good in economics and law is a type commodity whose market value is derived from information it contains. Examples include CDs containing pieces of music, DVDs containing movie content, and books containing short stories. Information goods are in contrast to material goods such as clothes, food, and cars. These can exist in either digitized form or analog format.In information goods, the valuable part is a pattern in which the material is arranged including the arrangement of ink on paper or a series of information on a compact disc. Those patterns might be either directly consumed through reading, viewing, or may be used to operate other devices such as a cassette player or a computer. The device, in turn, may produce some consumable pattern of information (such as visual, sound, or text).

Market risk

Market risk is the risk of losses in positions arising from movements in market prices.There is no unique classification as each classification may refer to different aspects of market risk. Nevertheless, the most commonly used types of market risk are:

Equity risk, the risk that stock or stock indices (e.g. Euro Stoxx 50, etc.) prices or their implied volatility will change.

Interest rate risk, the risk that interest rates (e.g. Libor, Euribor, etc.) or their implied volatility will change.

Currency risk, the risk that foreign exchange rates (e.g. EUR/USD, EUR/GBP, etc.) or their implied volatility will change.

Commodity risk, the risk that commodity prices (e.g. corn, crude oil) or their implied volatility will change.

Margining risk results from uncertain future cash outflows due to margin calls covering adverse value changes of a given position.

Shape risk

Holding period risk

Basis risk


In economics, a monopsony (from Ancient Greek μόνος (mónos) "single" + ὀψωνία (opsōnía) "purchase") is a market structure in which a single buyer substantially controls the market as the major purchaser of goods and services offered by many would-be sellers. In the microeconomic theory of monopsony, a single entity is assumed to have market power over sellers as the only purchaser of a good or service, much in the same manner that a monopolist can influence the price for its buyers in a monopoly, in which only one seller faces many buyers.

Natural monopoly

A natural monopoly is a monopoly in an industry in which low infrastructural costs and other barriers to entry relative to the size of the market give the largest supplier in an industry, often the first supplier in a market, an overwhelming advantage over potential competitors. This frequently occurs in industries where capital costs predominate, creating economies of scale that are large in relation to the size of the market; examples include public utilities such as water services and electricity. Natural monopolies were discussed as a potential source of market failure by John Stuart Mill, who advocated government regulation to make them serve the public good.

Paradox of competition

Paradox of competition in economics names a model of a situation where measures, which offer a competitive advantage to an individual economic entity, lead to nullification of advantage if all others behave in the same way. In some cases the finite state is even more disadvantageous for everybody than before (for the totality as well as for the individual). The term Paradox of competition (German: Konkurrenzparadoxon) was coined by German economist Wolfgang Stützel. It is about a case of a rationality trap.

Stützel distinguishes three categories of paradoxes of competition:

Circuit paradoxes

Classical paradoxes

Marx paradoxes

Public good

In economics, a public good is a good that is both non-excludable and non-rivalrous in that individuals cannot be excluded from use or could be enjoyed without paying for it, and where use by one individual does not reduce availability to others or the goods can be effectively consumed simultaneously by more than one person. This is in contrast to a common good which is non-excludable but is rivalrous to a certain degree.

Public goods include knowledge, official statistics, national security, common language(s), flood control systems, lighthouses, and street lighting. Public goods that are available everywhere are sometimes referred to as global public goods. Examples of public good knowledge is men's, women's and youth health awareness, environmental issues, maintaining biodiversity, sharing and interpreting contemporary history with a cultural lexicon, particularly about protected cultural heritage sites and monuments, popular and entertaining tourist attractions, libraries and universities.

Many public goods may at times be subject to excessive use resulting in negative externalities affecting all users; for example air pollution and traffic congestion. Public goods problems are often closely related to the "free-rider" problem, in which people not paying for the good may continue to access it. Thus, the good may be under-produced, overused or degraded. Public goods may also become subject to restrictions on access and may then be considered to be club goods; exclusion mechanisms include toll roads, congestion pricing, and pay television with an encoded signal that can be decrypted only by paid subscribers.

There is a good deal of debate and literature on how to measure the significance of public goods problems in an economy, and to identify the best remedies.

There is an important conceptual difference between the sense of "a" public good, or public "goods" in economics, and the more generalized idea of "the public good" (or common good, or public interest), "a shorthand signal for shared benefit at a societal level".In a non-economic sense, the term is often used to describe something that is useful for the public generally, such as education, although this is not a "public good" in the economic sense. However, services like education exhibit jointness of supply, i.e. the situation in which the cost of supplying a good to many users is the same, or nearly the same, as supplying it to one user. Public goods also exhibit jointness of supply, albeit with no diminishment of the benefits with increased consumption.

Socialism for the rich and capitalism for the poor

Socialism for the rich and capitalism for the poor is a classical political-economic argument, stating that in the advanced capitalist societies state policies assure that more resources flow to the rich than to the poor, for example in the form of transfer payments. The term corporate welfare is widely used to describe the bestowal of favorable treatment to particular corporations by the government. One of the most commonly raised forms of criticism are statements that the capitalist political economy toward large corporations allows them to "privatize profits and socialize losses." The argument has been raised and cited on many occasions.

State monopoly

In economics, a government monopoly (or public monopoly) is a form of coercive monopoly in which a government agency or government corporation is the sole provider of a particular good or service and competition is prohibited by law. It is a monopoly created by the government. It is usually distinguished from a government-granted monopoly, where the government grants a monopoly to a private individual or company.

A government monopoly may be run by any level of government - national, regional, local; for levels below the national, it is a local monopoly. The term state monopoly usually means a government monopoly run by the national government, although it may also refer to monopolies run by regional entities called "states" (notably the U.S. states).

Theory of the second best

In economics, the theory of the second best concerns the situation when one or more optimality conditions cannot be satisfied. The economists Richard Lipsey and Kelvin Lancaster showed in 1956, that if one optimality condition in an economic model cannot be satisfied, it is possible that the next-best solution involves changing other variables away from the values that would otherwise be optimal. Politically, the theory implies that if it is infeasible to remove a particular market distortion, introducing a second (or more) market distortion may partially counteract the first, and lead to a more efficient outcome.

Tragedy of the anticommons

The tragedy of the anticommons is a type of coordination breakdown, in which a single resource has numerous rightsholders who prevent others from using it, frustrating what would be a socially desirable outcome. It is a mirror-image of the older concept of tragedy of the commons, in which numerous rights holders' combined use exceeds the capacity of a resource and depletes or destroys it. The "tragedy of the anticommons" covers a range of coordination failures including patent thickets, and submarine patents. Overcoming these breakdowns can be difficult, but there are assorted means, including eminent domain, laches, patent pools, or other licensing organizations.The term originally appeared in Michael Heller's 1998 article of the same name and is the thesis of his 2008 book. The model was formalized by James M. Buchanan and Yong Yoon. In a 1998 Science article, Heller and Rebecca Eisenberg, while not disputing the role of patents in general in motivating invention and disclosure, argue that biomedical research was one of several key areas where competing patent rights could actually prevent useful and affordable products from reaching the marketplace.

Tyranny of small decisions

The tyranny of small decisions is a phenomenon explored in an essay of the same name, published in 1966 by the American economist Alfred E. Kahn. The article describes a situation in which a number of decisions, individually small and insignificant in size and time perspective, cumulatively result in a larger and significant outcome which is neither optimal nor desired. It is a situation where a series of small, individually rational decisions can negatively change the context of subsequent choices, even to the point where desired alternatives are irreversibly destroyed. Kahn described the problem as a common issue in market economics which can lead to market failure. The concept has since been extended to areas other than economic ones, such as environmental degradation, political elections and health outcomes.A classic example of the tyranny of small decisions is the tragedy of the commons, described by Garrett Hardin in 1968 as a situation where a number of herders graze cows on a commons. The herders each act independently in what they perceive to be their own rational self-interest, ultimately depleting their shared limited resource, even though it is clear that it is not in any herder's long-term interest for this to happen.

Major topics
Cultural aspects
Social aspects


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