Market Failure

A situation in which a free market fails to allocate goods or services efficiently, typically due to externalities, public goods, market power, or information asymmetry.

Source: Arrow 1963

Market failure is defined against a benchmark, the allocation a perfectly competitive market would reach, in which no one could be made better off without another being made worse off. A market fails when, left alone, it produces an outcome short of that benchmark, so that a different allocation could raise total welfare. The term describes a gap from an efficiency ideal, not a market that has stopped functioning. Naming the benchmark is what gives the concept its content. Bator (1958) set out this meaning.

Source: Bator 1958

The main sources are externalities, where costs or benefits fall on third parties and are omitted from prices; public goods, which are non-excludable and non-rival and so underprovided by markets; market power, where firms restrict output and raise prices above competitive levels; and information asymmetry, where unequal information degrades or unravels markets. Each causes the market quantity to diverge from the efficient one, so the market fails to allocate resources in the way competitive theory assumes.

Source: Arrow 1963

Health care exhibits market failure because several of its sources are present at once. Information is severely asymmetric between doctors and patients; externalities arise in communicable disease and public health; insurance markets face adverse selection and moral hazard; and providers can hold market power. Arrow's analysis showed that these features make medical care depart systematically from the competitive model. This concentration of market failures is a principal reason health care is so widely subject to regulation, insurance, and public provision.

Source: Arrow 1963

Market failure is addressed by interventions matched to its source: taxes and subsidies for externalities, public provision or funding for public goods, regulation or competition policy for market power, and disclosure, regulation, or insurance design for information problems. The aim is to move the outcome closer to the efficient one the market cannot reach alone. In health care, a combination of these, including public funding, insurance regulation, and professional oversight, responds to its several overlapping failures.

Source: Arrow 1963

Market failure identifies a departure from efficiency but does not by itself justify intervention, because intervention has its own costs and can fail too. Government action may be imperfectly informed, distorted by incentives, or costly to administer, so a remedy can leave matters no better or worse. Judging whether to intervene requires comparing the imperfect market with realistically imperfect intervention, not with an ideal. Market failure makes a case for considering action rather than establishing that action will improve the outcome.

Source: Arrow 1963