Market failure, Public Goods and Externalities, New Keynesian Economics

Definition: Market failure,

An economic term that encompasses a situation where, in any given market, the quantity of a product demanded by consumers does not equate to the quantity supplied by suppliers. This is a direct result of a lack of certain economically ideal factors, which prevents equilibrium....

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....

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....

In the News and Examples

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

An Education in Market Failure, by Morgan Rose. Teacher's Corner at Econlib

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)....