How is a market failure corrected?

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Imperfect market outcomes are corrected through a reallocation of resources or change in incentive structure. Economists have different opinions about the nature of market failures and what (if any) measures need to be taken to prevent or correct them.

What is a Market Failure?

It's impossible to identify a solution for market failure without clearly identifying what market failure is and why it persists. The common interpretation of market failure – failure to live up to the standards of perfect competition in general equilibrium economics – can be identified in many, if not all, markets.

Price equilibrium is a moving target, however. Think of all the firms and consumers in a market as runners in a race, except that the finish line keeps moving left, right, up and down.

A more realistic interpretation of market failure is a scenario in which economic participants are not properly incentivized to push markets toward a more efficient outcome. This is where most academic economic literature is concentrated.

Possible Corrections

Using the broad, perfect-competition definition, market failures are corrected by allowing competing entrepreneurs and consumers to push the market further toward equilibrium over time. Markets tend toward equilibrium constantly, never quite reaching it. This is because of limitations in human knowledge and changing real-world circumstances.

Some economists and policy analysts propose a litany of possible interventions and regulations to compensate for perceived market failures. Tariffs, subsidies, redistributive or punitive taxation, disclosure mandates, trade restrictions, price floors and ceilings, and many other market distortions have been justified on the basis of correcting inefficient outcomes.

Other economists argue that markets are recognizably imperfect, but market failure is improperly framed. Rather than asking if markets fail relative to some ideal (perfect competition), they contend that the question should be whether markets perform better than any other process that humans might invoke.

Free market economists, including Milton Friedman and F.A. Hayek, argue that markets are the only known discovery process proven to be capable of adjusting correctly to inefficiencies. They contend that regulation interferes with this discovery process, making inefficiencies worse rather than better.

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