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Market failure

A situation in which the market system produces an allocation of resources which is not Pareto-efficient: it is possible to find ways of changing the resource allocation in such a way as to make some consumer(s) hetter off and none worse off. The prevalence of market failure would then refute Adam Smith’s famous doctrine of the invisible hand: individualistic self-seeking behaviour by consumers and firms will be guided by the invisible hand (of market forces) to achieve the highest level of welfare for society as a whole. Market failure is predicted as likely to occur in the presence of monopoly and oligopoly, externalities, public goods and common property resources. In each case individualistic behaviour leads to a sub-optimal result. A conclusion often drawn is that there is then a case for government intervention to ‘correct’ the market failure, e.g. by regulating monopoly, taxing external diseconomies and supplying public goods. It has been pointed out, however, that this is to commit the fallacy of supposing that the alternative to imperfect markets is ‘perfect government’. In fact government may have neither the means nor the inclination to correct adeq uately for market failure. The question becomes one of deciding which of two imperfect forms of organization is likely to lead to the hetter outcome, and this is a far more complex issue than the simple demonstration of market failure.

Reference: The Penguin Dictionary of Economics, 3rd edt.