We now examine four situations in which the free market fails to achieve
allocative efficiency—market power, externalities, non-rivalrous and non-
excludable goods, and asymmetric information. Many of these market
failures provide a justification for government intervention in markets.
We then discuss other reasons for government intervention that are not
based on market failure—chief among these is intervention to achieve a
more equitable distribution of income.
Market Power
Market power is inevitable in any market economy for three reasons.
First, in many industries economies of scale are such that there is room
for only a few firms to operate at low costs, each having some ability to
influence market conditions. Second, in many industries, firms sell
differentiated products and thus have some ability to set their prices.
Third, firms that innovate with new products or new production
processes gain a temporary monopoly until other firms learn what the
innovator knows. As we saw in Chapters 10 , 11 , and 12 , firms that
have market power will maximize their profit at a level of output at which
price exceeds marginal cost. The result is allocatively inefficient, even
though it is the inevitable outcome of the kinds of innovation that raise
living standards over the long term.
This last reason sets up a conflict between achieving allocative efficiency
at any given moment and encouraging economic growth over time.
Government policymakers clearly take the dynamic view of competition.