Market Failure

Published by Mario Oettler on

Market failure is a situation in which the allocation of goods through a free market is not Pareto efficient.

Definition Pareto efficiency:

Pareto efficiency is a situation in which no participant can improve its position (e. g., income) without making at least one other participant worse off.

Market failure is often associated with:

  • Public/common goods
  • Externalities
  • Principal-agent problems
  • Time-inconsistent preferences

Example of Pareto Efficiency

Imagine a company with 20 employees has a budget of 1 million EUR to spend on salaries. If we assume that each employee receives 48,000 EUR of salary, we would spend 960,000 EUR in total. This situation is not Pareto optimal since it would be possible to increase a single employee’s salary by 40,000 EUR (to 88,000 EUR) without taking something away from the other 19 employees. Of course, it would also be possible to increase the salary of all 20 employees to 50,000 EUR.

The last two situations are Pareto optimal since it is now not possible to increase one employee’s salary without reducing the salary of another employee. This can be observed in the NFL, where teams have a salary cap that determines how much a team can spend on salaries in a season.