Market Failure

The best way to understand market failure is first to understand market success, the ability of a collection of idealized competitive markets to achieve an equilibrium allocation of resources which is Pareto optimal. This characteristic of markets, which was loosely conjectured by Adam Smith, has received its clearest expression in the theorems of modern welfare economics. For our purposes, the first of these, named the First Fundamental Theorem of welfare economics, is of most interest. Simply stated it reads: (1) if there are enough markets, (2) if all consumers and producers behave competitively, and (3) if an equilibrium exists, then the allocation of resources in that equilibrium will be Pareto optimal (see Arrow, 1951, or Debreu, 1959). Market failure is said to occur when the conclusion of this theorem is false; that is, when the allocations achieved with markets are not efficient.