A High School Economics Guide

Supplementary resources for high school students

Definitions and Basics

Definition: Market failure, from Wikipedia.com

In economics, market failure is a situation in which the allocation of goods and services by a free market is not efficient, often leading to a net social welfare loss. 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. The first known use of the term by economists was in 1958….

Public goods are both non-rival and non-excludable (i.e., public goods are not only non-excludable) thus existence of a market failure is often the reason that self-regulatory organizations, governments or supra-national institutions intervene in a particular market. Economists, especially microeconomists, are often concerned with the causes of market failure and possible means of correction. Such analysis plays an important role in many types of public policy decisions and studies. However, government policy interventions, such as taxes, subsidies, bailouts, wage and price controls, and regulations, may also lead to an inefficient allocation of resources, sometimes called government failure.

Given the tension between, on the one hand, the undeniable costs to society caused by market failure, and on the other hand, the potential that attempts to mitigate these costs could lead to costs from “government failure”, there is sometimes a choice between imperfect outcomes, i.e. imperfect market outcomes with or without government interventions. But either way, if a market failure exists the outcome is not Pareto efficient.

Market Failures, Taxes, and Subsidies, at Crash Course Economics:

Public goods and externalities. What is an externality? Public Goods and Externalities, from the Concise Encyclopedia of Economics

Most economic arguments for government intervention are based on the idea that the marketplace cannot provide public goods or handle externalities. Public health and welfare programs, education, roads, research and development, national and domestic security, and a clean environment all have been labeled public goods….

Externalities occur when one person’s actions affect another person’s well-being and the relevant costs and benefits are not reflected in market prices. A positive externality arises when my neighbors benefit from my cleaning up my yard. If I cannot charge them for these benefits, I will not clean the yard as often as they would like. (Note that the free-rider problem and positive externalities are two sides of the same coin.) A negative externality arises when one person’s actions harm another. When polluting, factory owners may not consider the costs that pollution imposes on others….

Externalities: When is a Potato Chip Not Just a Potato Chip? at LearnLiberty

What is a public good? Defense, from the Concise Encyclopedia of Economics

National defense is a public good. That means two things. First, consumption of the good by one person does not reduce the amount available for others to consume. Thus, all people in a nation must “consume” the same amount of national defense (the defense policy established by the government). Second, the benefits a person derives from a public good do not depend on how much that person contributes toward providing it. Everyone benefits, perhaps in differing amounts, from national defense, including those who do not pay taxes. Once the government organizes the resources for national defense, it necessarily defends all residents against foreign aggressors….

Market-clearing vs. sticky prices: New Keynesian Economics, from the Concise Encyclopedia of Economics

The primary disagreement between new classical and new Keynesian economists is over how quickly wages and prices adjust. New classical economists build their macroeconomic theories on the assumption that wages and prices are flexible. They believe that prices “clear” markets—balance supply and demand—by adjusting quickly. New Keynesian economists, however, believe that market-clearing models cannot explain short-run economic fluctuations, and so they advocate models with “sticky” wages and prices. New Keynesian theories rely on this stickiness of wages and prices to explain why involuntary unemployment exists and why monetary policy has such a strong influence on economic activity….

Markets can fail if there are no property rights and negotiation is costly. The Coase Theorem: Ronald H. Coase, biography from the Concise Encyclopedia of Economics

“The Problem of Social Cost,” Coase’s other widely cited article (661 citations between 1966 and 1980), was even more path-breaking. Indeed, it gave rise to the field called law and economics. Economists b.c. (Before Coase) of virtually all political persuasions had accepted British economist Arthur Pigou’s idea that if, say, a cattle rancher’s cows destroy his neighboring farmer’s crops, the government should stop the rancher from letting his cattle roam free or should at least tax him for doing so. Otherwise, believed economists, the cattle would continue to destroy crops because the rancher would have no incentive to stop them.

But Coase challenged the accepted view. He pointed out that if the rancher had no legal liability for destroying the farmer’s crops, and if transaction costs were zero, the farmer could come to a mutually beneficial agreement with the rancher under which the farmer paid the rancher to cut back on his herd of cattle. This would happen, argued Coase, if the damage from additional cattle exceeded the rancher’s net returns on these cattle. If for example, the rancher’s net return on a steer was two dollars, then the rancher would accept some amount over two dollars to give up the additional steer. If the steer was doing three dollars’ worth of harm to the crops, then the farmer would be willing to pay the rancher up to three dollars to get rid of the steer. A mutually beneficial bargain would be struck….

An Education in Market Failure, by Morgan Rose. Teacher’s Corner at Econlib, March 11, 2002.

Markets are fantastic at allocating resources well by making sure that if there is a good or a service that a person values more highly than it would cost to produce it, then somebody (maybe the same person, but most likely not) will decide to produce it, a market exchange will take place, and both parties will be better off. If I think an order of chicken wings is worth more than six dollars….

Markets can be problematic where the net private benefit of a market transaction does not equal the net social benefit, which is the social benefit (the sum of private benefits of all individuals in a society) minus the social cost (the sum of private costs of all individuals in a society)….

In the News and Examples

There exists a tendency to automatically assume that the “solution” to a market failure is necessarily some form of government intervention. Not so fast… Is Market Failure a Sufficient Condition for Government Intervention? by Art Carden and Steven Horwitz at Econlib. April 1, 2013.

Externalities, public goods, asymmetric information, and market power provide necessary—but insufficient—conditions for intervention to be justified. They certainly are not talismans that provide interventionists with carte blanche to tinker with the members of a society as if they were pieces on a chessboard. Too often, critics of markets think that merely invoking these terms destroys the case for free markets.

An Introduction to Externalities, at Marginal Revolution University

Pollution Controls, from the Concise Encyclopedia of Economics

While there is general agreement that we must control pollution of our air, water, and land, various interest groups, public agencies, and experts have disputed just how we should control it. The pollution control mechanisms adopted in the United States have tended toward detailed regulation of technology….

A Little History: Primary Sources and References

John Maynard Keynes, biography from the Concise Encyclopedia of Economics

Advanced Resources

Coase on Externalities, the Firm, and the State of Economics on EconTalk, May 2012.

Nobel Laureate Ronald Coase of the University of Chicago talks with EconTalk host Russ Roberts about his career, the current state of economics, and the Chinese economy. Coase, born in 1910, reflects on his youth, his two great papers, “The Nature of the Firm” and “The Problem of Social Cost”. At the end of conversation he discusses his new book on China, How China Became Capitalist (co-authored with Ning Wang), and the future of the Chinese and world economies.

“The Failure of Market Failure,” Part I and Part II, by Anthony de Jasay at Econlib. October 2, 2006 and November 2, 2006, respectively.

Received wisdom advances two broad reasons why government is entitled to impose its will on its subjects, and why the subjects owe it obedience, provided its will is exercised according to certain (constitutional) rules. One reason is rooted in production, the other in distribution—the two aspects of social cooperation. Ordinary market mechanisms produce and distribute the national income, but this distribution is disliked by the majority of the subjects (notably because it is ‘too unequal’) and it is for government to redistribute it (making it more equal or bend it in other ways, a function that its partisans prefer to call ‘doing social justice’). However, the market is said to be deficient even at the task of producing the national income in the first place. Government is needed to overcome market failure. A society of rational individuals would grasp this and readily mandate the government to do what was needful (e.g. by taxation, regulation and policing) to put this right.

In this two-part essay, I claim that at least some, if not the whole, of the market failure argument fails to prove its case. In Part I, I look at the problem of contract enforcement and in Part II at the provision of public goods. There have been other writings using related arguments to the same effect, but one more such will not be too many.

Related Topics

Markets and Prices

Roles of Government

Property Rights

Government Failures and Public Choice Analysis