Market Failure the OECD Defines

Market Failure

The OECD defines market failure as a situation in which "market outcomes are not Pareto efficient." There are a number of causes of market failure, and some of these can be addressed by government intervention. Technically, a market is going to be inefficient unless a state of perfection competition exists. Thus, when one of the conditions of perfect competition is violated, market failure can be said to exist. Externalities, public goods and information problems can all be sources of market failure. These sources of failure are often addressed through government intervention.

One example of market failure not addressed in the readings is that derived from strategic needs. For example, the markets for some foods and some military goods are distorted. The demand for such goods is not rational, because the demand is not directly related to consumption. Governments are essentially creating this market failure in order to ensure that strategic resources are available should they be needed. The actual demand is not necessarily tied to this expected demand in any way -- for example of the tens of thousands of nuclear weapons ever built, only two were actually used. The demand is perceived rather than actual. This could be classed as a form of information deficiency, but this form exists even in markets with perfect competition.

Market power is another cause of market failure, as the power that a firm exerts distorts demand in the market, especially with respect to pricing. Pricing is an important element of market power, because all other things being equal lower prices create a positive feedback loop whereby the firm with lower prices increases its market share allowing it to lower prices further. Eventually, the firm could end up with a monopoly is competitors do not find a way to differentiate themselves.

Government can have some influence on market failures, but cannot eliminate them. Conditions of perfect competition are usually created outside the influence of government. Often, government policy contributes to market failure rather than prevents it. Government can, however, reduce the impact of market failure. The programs by which government would do this must be well-conceived and well-executed, however, or they can worsen market failure. An example of this would be the bank bailouts. The government averted the direct market failure of the U.S. banking industry in the short-term, but in the long-term the government probably created a perverse incentive in the banking industry to increase risk-taking, knowing that the bank was not going to suffer the downside risk. Bailouts of the savings and loan industry contributed to this attitude among bankers, the concept of "too big to fail" creating a climate of risk-taking in the industry.