Definition of market failure

Question

I’m working with the definition that a market failure is a Pareto inefficient outcome in a free market.

I’ve recently read a piece of analysis that looks to demonstrate the occurrence of a market failure in a particular infrastructure related market.

The analysis builds a model of the particular infrastructure market.

It then establishes the level of infrastructure build that is commercially viable. Call this the baseline scenario.

Next it artificially forces in further build in the infrastructure market beyond what is deemed commercially viable (the baseline scenario). Call this the intervention scenario.

Finally, it established that in the intervention scenario the public value of the further build is greater than the private cost.

It concludes by claiming that as the public value is greater than private cost, this demonstrates the existence of a market failure.

Is this definition of a market failure - one where public value exceeds private cost - equivalent to the Pareto inefficient outcome definition?

Answer 1

Is this definition of a market failure - one where public value exceeds private cost - equivalent to the Pareto-inefficient outcome definition?

This is an example of Pareto-inefficiency.

The word equivalent is too strong, because there are model frameworks that don't use the concept of public value; e.g.; general equilibirum theory uses utility functions but Pareto-inefficiency is still possible.

There are also different cases of Pareto-ineffeciency that have to do with market power or information asymmetry rather than public goods/externalities. Though in these situations you will usually also have a type of good for which "public value" exceeds the private cost or where private cost exceeds "public value". (Quotes are necessary because this is not an explicit concept in these cases, but it has its equivalent.)

Answer 2

the definition that a market failure is a Pareto inefficient outcome in a free market.

This is not correct. It is not possible for there to be a Pareto inefficient equilibrium in a free market. A free market has a pareto space that will always naturally progress to an optimum. Unconditionally.

A market failure is actually states that are more optimal than pareto optimums. They are market failures precisely because they are more optium than the best the free market can do (which are the pareto optimums).

where public value exceeds private cost

This is also not a sufficient definition for market failure. You must not only construct some public system that creates better value, but you must also show that the public system is likely to be stable and not devolve into something that produces less value or causes harm. Eg, you can't just say "if we force everyone to do X, things will be more optimal." You could just as easily say "if everyone freely decides to do X, things will be more optimal". Neither is realistic. You must come up with a system that will naturally evolve to some expected value.

In short, being able to conjur up a utopian system that does better than the free market is meaningless unless you can actually make that system happen.

The 3 types of market failures are:

1. Externalities
2. Anti-competitive markets
3. Suboptimal initial resource allocation

All three are situations where the optimal solution resides outside of the pareto frontier.