A market failure, defined here as a market that does not reach an equilibrium state where quantity supplied equals quantity demanded, exists everywhere.
Every time we walk into a store, we see a market failure happening. Products are stacked on shelves, waiting for buyers. This is oversupply (surplus) and a market failure. If the market is in equilibrium and completely liquidated, when you (the marginal consumer) enter a store, you should only see the exact quantity of goods you want to buy at a price exactly equal to what you are willing to pay for a marginal unit. Nothing else should be left behind. When you purchase a product, the store will close after selling everything it wants to sell at the price determined by the interaction between the buyer and seller. Obviously, no such result exists. Some of the goods we want exist in surplus. Some items may be out of stock. And as a result, the market failed.
But this failure is crucial to the way markets work, broadly referred to as “market processes.” As Hayek reminds us in his famous essay “The Use of Knowledge in Society,” the elements necessary for a fully cleared market (perfect knowledge of preferences, perfect knowledge of available resources, perfect knowledge of relevant information) are not known in advance. Once you know that, you can easily allocate products. The market becomes a trivial optimization problem. Rather, they are manifested through the mechanisms of the market itself.
There are two ways to conceptualize how market processes shape prices and transmit this related knowledge. The first, developed by Leon Walras, is to treat the economy as a giant auction (what I called “taonument” or “trial and error”). People make bids, and their bids are accepted or rejected by sellers. If there is excess demand, the price will be bid up. If there is excess surplus, prices will fall until the market reaches equilibrium.
There is some truth to the Walras family auction story, but it is not enough to explain reality. Some markets have an auction process that causes prices to rise or fall until the market clears. Even if we treat Walras’s auction as a metaphor, rather than expecting a literal auction, it falls short. Metaphorically speaking, it’s like a silent auction. The buyer enters the store and checks the price. That’s more than they’re willing to pay for something good, so they walk away. That is, the seller’s “offer” is rejected by the buyer. The seller then adjusts the offer until it matches the bid amount. The item is then sold at that price. However, as mentioned above, in the majority of markets this is not the case. We always have shortages/surpluses.
A second way of thinking about how prices arise and adjust comes from John Hicks. Hicks argues that prices are fixed (at least in the short term), rather than being set by people coming together to bid on goods. Prices are set when the shopkeeper opens the door each day. People come. Some people will buy it at that price, and some people won’t. And at the end of the day, you close your store with unsold or missing inventory. But price changes can be expensive, especially in large stores. You may need to change shelf labels or update your electronic price checker. Additionally, buyers face real-world constraints as well. Fixed wages are the biggest constraint. Given the costly adjustment process and the persistence of consumer behavior, it is easier for store owners to adjust supply rather than price. When making changes, you should consider things like inventory and current spending trends. As a result, the market can be constantly in a state of surplus and shortage.
Of course, there are other reasons why markets can become permanently imbalanced. Given how difficult forecasting is, it makes sense that companies would want to keep excess inventory on hand. This helps smooth consumption cycles and avoids the bullwhip effect, where small changes in consumer behavior lead to larger, more widespread changes in inventory management. Additionally, consumers are more likely to punish companies for shortages than for surpluses, so holding excess inventory may be a way to avoid consumer anger.
In any case, the important point here is that market failures are ubiquitous. But it is also necessary for the functioning of the market. If a store owner ends the day with excess inventory, far more than he wants to carry, it sends him an important signal. That means your price is too high. If you can’t adjust the price, find something else to adjust. When a customer goes to a store and sees the price they are willing to pay, it sends an important signal to the customer. That means your expectations are off. Find a replacement or reevaluate your aspirations. These signals only occur if the market fails.
But now let’s look at a more precise definition of market failure. A stricter definition of market failure is not simply when a market is out of balance, but where there are barriers that prevent it from reaching an equilibrium where goods are allocated to their highest and best uses. Factors such as externalities, high barriers to entry, collective coordination problems, and high transaction costs can prevent markets from reaching optimal levels of price and quantity. Under these circumstances, interventionists often advocate government intervention to resolve market failures. However, even under these circumstances, market failure itself is essential to the success of the market process.
Market failures can also be seen as opportunities for profit. There are unfinished trades, and those who can spend those trades stand to profit. Those who can break down barriers or offer better alternatives will benefit. In other words, market failures create the very incentives needed to correct them. Smart entrepreneurs find ways to overcome these barriers, solve market failures, and turn a profit. Government intervention is probably not necessary.
Does this mean there is no role for government in market failures? I don’t think so, no. But it points to the limits of government. Governments can play the role of referee rather than being an active player. If there are artificial barriers that cause market failure, the most helpful thing to do is to remove those barriers. Alternatively, create solutions that allow private markets to occur (e.g., change the rules to allow class action lawsuits in case of externalities). Governments are just like any other economic entity. They are limited by constraints and have limited knowledge. There is no reason to think that the government will be able to intervene in the market better than the current participants. The best thing governments can do to prevent market failure is to remove artificial barriers and get out of the way.
All of this goes on to say that market failure is some kind of misnomer (yes, it’s a different name). The market has not failed in the sense that it is not functioning. Rather, it’s about having exactly what you need to generate the knowledge you need. It is better to conceptualize market failure as a “failure condition” in which some goal is not achieved. In this case, it is similar to failing a class exam. Yes, the exam had a “fail state” in the sense that the goal (pass) was not achieved. But inevitably, the information came. This is my strength, this is my weakness, and this is how I can improve. And that information (for conscious students) is how one improves. Similarly, market failures generate information about how the market can improve.
The market has failed. Long live the market!
