The anatomy of market failure

The paretian maximization-of-welfare problem has embedded within it a set of constants, 'duals' or shadow prices, which have all the analytical characteristics of prices, wages, rents, and interest rates. Implied in this analysis is the notion that decentralized market calculations correctly account for all 'economic' costs and benefits. Duality can fail in 5 ways: by existence--no set of relative market prices will accurately reflect the maximization of a welfare function by being equated to a set of marginal rates of substitution; by signal--the price system guides profit-maximizing entrepreneurs into a position of profit minimum or local profit maximums rather than the maximum maximorum; by incentive--the price system allows negative profits in some desired industries; by structure--if self-policing perfect competition is not present, then prices do not lead to pareto optimality; and by enforcement--if there is some arbitrary legal or organizational imperfection in the market which prevents introduction of proper accounting prices for inputs or outputs into maximization decisions. These five modes are due to three possible causes of market failure: ownership externalities, technical externalities, and public goods externalities. Economic discussions of water often invoke the technical, ownership and public goods externalities in the analysis of pricing and valuing of water uses. This article presents a comprehensive classification scheme for markets, that like the water market, require public intervention in their functioning. (sokoloff-rutgers)