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Edit: Is it possible to broadly categorize the ways in which market failures occur into relatively few categories? If so, what are they?

B T
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Ian Robertson
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  • The different ways that market failure can occur form a countably infinite set. – Alecos Papadopoulos Feb 26 '16 at 18:07
  • @AlecosPapadopoulos: I would go so far as to say such a set is uncountably infinite :) – Herr K. Feb 26 '16 at 21:26
  • this answered question might be useful to you: http://economics.stackexchange.com/questions/9987/is-market-failure-constant-what-properly-defines-it/9991#9991 – BB King Feb 29 '16 at 20:02
  • Market failure can easily be boiled down to a number of categories you can count on one hand. Its absurd this question was closed. – B T Jul 05 '16 at 08:34
  • @BT I have edited the question in such a way so that it might seem less broad and have reopened it. I think it would be good to write the question so that we can discuss whether or not we can categorize market failures as you describe. I hope this keeps with the spirit of the original question. – jmbejara Aug 22 '16 at 20:20

2 Answers2

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Any situation where markets fail to clear leads to market failure. Some common reasons for this are:

  • Externalities, or agents not being responsible for costs or benefits of their actions

  • Information assymetry, or agents operating with different information

  • Irrationality, or agents doing random things for no reason
  • Principal agent problems, where someone entrusted with others funds uses them wastefully
  • Productive inefficiency, or firms failing to produce goods effectively given the allocated capital (think using Gatorade to water plants)
  • Allocative inefficiency, where firms are not provided the appropriate capital
  • Economies of scale, or the problem of capitalist firms failing to grow large enough to establish a service
  • Destructive competition- eg, private militaries blowing each other up
  • Shortsighted management of natural resources
  • Monopoly
  • Moral hazard, adverse selection, and other problems in contract theory
D J Sims
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    There are only 2 causes of market failure: externalities and the inability for a free market to move between Pareto Optima. NONE of the following are market failures: Information asymmetry, irrationality, principle-agent problems, productive or allocative inefficiency, economies of scale, short sightedness, or moral hazard. I wrote an article on what market failure is, and you just recited all the usual myths. https://governology.wordpress.com/2016/07/05/the-role-of-government-part-1/ – B T Jul 05 '16 at 08:37
  • Aren't those the same thing – D J Sims Jul 05 '16 at 08:48
  • Not at all. Externalities are when costs or benefits are imposed on someone else without their consent. The inability for a free market to move between Pareto Optima is a function rather of inaction - this is embodied in the second welfare theorem of economics. If your economy consists of 2 people, one with everything and one with nothing, utility could almost certainly be improved by a bit of wealth sharing. But the free market can't do that on its own. The likely outcome is that the person without resources would be employed by the other in some way. – B T Jul 05 '16 at 09:03
  • Externalities can be inaction – D J Sims Jul 05 '16 at 16:43
  • Sure.. but the point is that the market's inability to move to a state where one person is worse off means that it can't move to a more totally optimal state by making one person a little worse off but making a lot of people much better off. This isn't an externality, but is a market failure. – B T Jul 05 '16 at 23:35
  • That's the same as an externality – D J Sims Jul 06 '16 at 01:31
  • No its not at all. Look up the second fundamental welfare theorem of economics and Pareto efficiency. Or better yet, read the article I linked to. – B T Jul 06 '16 at 04:37
  • It's still the same thing – D J Sims Jul 06 '16 at 05:09
  • Where did you get the idea that "Economies of scale, or the problem of capitalist firms failing to grow large enough to establish a service" is a source of market failure? Are you talking about non-convexities of the production set? Because fixed costs on their own are not sources of the 2nd welfare theorem failing. – VCG Aug 27 '16 at 02:23
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I just wrote about this very thing. There are many misconceptions and incorrect information floating around about market failure.

The 3 types of market failures I identify are:

  1. Externalities
  2. Anti-competitive markets
  3. Suboptimal initial resource allocation

Almost all market failures come from externalities. This includes a very broad range of things including violence, fraud, and pollution.

Anti-competitive markets are basically natural monopolies. However, monopolies are very misunderstood beasts. There is reason to believe that monopolies don't generally cause significant deadweight losses, and its not clear whether monopolies have more or less ability and drive to innovate vs a competitive market. It seems likely that most monopolistic markets are economically worse than competitive markets, but it is far from clear that there is any realistic government alternative that can be expected to do better than the market in the long run.

Point 3 is basically the fact that everyone starts off with a different lot in life, and that some "lump-sum transfers" can improve society's total utility from a utilitarian point of view.

Market failure is a strong statement that requires more than simple inefficiency. A market failure is a systemic inefficiency that will prevent the system from ever reaching an optimal state.

Things that aren't market failures that you often see people claim:

  • Information asymmetries and imperfect information
  • "irrationality"
  • Simple inefficient behavior by a company or companies
  • "missing markets"
  • Merit and demerit goods
  • Time-inconsistent preference
  • Factor immobility and geographic immobility
  • Internalities

There are also several things usually talked about as market failures that are all just special cases of externalities:

  • Principle-agent problem (aka conflict of interest or moral hazard)
  • Public goods
  • Violence

And DJ Sim's answer above is particularly bad. He includes several things that are definitely not market failures that aren't even in the usual list of market failure myths:

  • Productive inefficiency, allocative inefficiency, and mismanagement of resources are all basically identical, and none of them are market failures, just the failure of a particular person or company to be efficient.
  • Economies of scale
Governology
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