Drug development is the process of bringing a new pharmaceutical drug to the market once a lead compound has been identified through the process of drug discovery. It includes preclinical research on microorganisms and animals, filing for regulatory status, such as via the United States Food and Drug Administration for an investigational new drug to initiate clinical trials on humans, and may include the step of obtaining regulatory approval with a new drug application to market the drug. The entire process—from concept through preclinical testing in the
laboratory to clinical trial development, including Phase I–III
trials—to approved vaccine or drug typically takes more than a decade.
New chemical entity development
Broadly, the process of drug development can be divided into preclinical and clinical work.
Timeline showing the various drug approval tracks and research phases
New chemical entities (NCEs, also known as new molecular entities or NMEs) are compounds that emerge from the process of drug discovery.
These have promising activity against a particular biological target
that is important in disease. However, little is known about the safety,
toxicity, pharmacokinetics, and metabolism
of this NCE in humans. It is the function of drug development to assess
all of these parameters prior to human clinical trials. A further major
objective of drug development is to recommend the dose and schedule for
the first use in a human clinical trial ("first-in-human" [FIH] or First Human Dose [FHD], previously also known as "first-in-man" [FIM]).
In addition, drug development must establish the physicochemical
properties of the NCE: its chemical makeup, stability, and solubility.
Manufacturers must optimize the process they use to make the chemical so
they can scale up from a medicinal chemist producing milligrams, to manufacturing on the kilogram and ton scale. They further examine the product for suitability to package as capsules, tablets, aerosol, intramuscular injectable, subcutaneous injectable, or intravenousformulations. Together, these processes are known in preclinical and clinical development as chemistry, manufacturing, and control (CMC).
Many aspects of drug development focus on satisfying the regulatory requirements for a new drug application.
These generally constitute a number of tests designed to determine the
major toxicities of a novel compound prior to first use in humans. It is
a legal requirement that an assessment of major organ toxicity be
performed (effects on the heart and lungs, brain, kidney, liver and
digestive system), as well as effects on other parts of the body that
might be affected by the drug (e.g., the skin if the new drug is to be
delivered on or through the skin). Such preliminary tests are made using
in vitro
methods (e.g., with isolated cells), but many tests can only use
experimental animals to demonstrate the complex interplay of metabolism
and drug exposure on toxicity.
However, aside from regulatory requirements, there is a broad
range of other factors, such as patient requirements, that are
considered during development and testing.
The information gathered from this preclinical testing, as well
as information on CMC, and submitted to regulatory authorities (in the
US, to the FDA), as an Investigational New Drug (IND) application. If the IND is approved, development moves to the clinical phase.
Phase I trials, usually in healthy volunteers, determine safety and dosing.
Phase II trials are used to get an initial reading of efficacy and
further explore safety in small numbers of patients having the disease
targeted by the NCE.
Phase III trials are large, pivotal trials to determine safety and
efficacy in sufficiently large numbers of patients with the targeted
disease. If safety and efficacy are adequately proved, clinical testing
may stop at this step and the NCE advances to the new drug application (NDA) stage.
Phase IV trials are post-approval trials that are sometimes a
condition attached by the FDA, also called post-market surveillance
studies.
The process of defining characteristics of the drug does not stop
once an NCE is advanced into human clinical trials. In addition to the
tests required to move a novel vaccine or antiviral drug into the clinic
for the first time, manufacturers must ensure that any long-term or
chronic toxicities are well-defined, including effects on systems not
previously monitored (fertility, reproduction, immune system, among
others).
If a vaccine candidate or antiviral compound emerges from these
tests with an acceptable toxicity and safety profile, and the
manufacturer can further show it has the desired effect in clinical
trials, then the NCE portfolio of evidence can be submitted for
marketing approval in the various countries where the manufacturer plans
to sell it. In the United States, this process is called a "new drug application" or NDA.
Most novel drug candidates (NCEs) fail during drug development,
either because they have unacceptable toxicity or because they simply do
not prove efficacy on the targeted disease, as shown in Phase II–III
clinical trials. Critical reviews of drug development programs indicate that Phase II–III clinical trials fail due mainly to unknown toxic side effects (50% failure of Phase II cardiology trials), and because of inadequate financing, trial design weaknesses, or poor trial execution.
A study covering clinical research in the 1980–1990s found that
only 21.5% of drug candidates that started Phase I trials were
eventually approved for marketing. During 2006–2015, the success rate of obtaining approval from Phase I
to successful Phase III trials was under 10% on average, and 16%
specifically for vaccines. The high failure rates associated with pharmaceutical development are
referred to as an "attrition rate", requiring decisions during the early
stages of drug development to "kill" projects early to avoid costly
failures.
There are a number of studies that have been conducted to determine
research and development costs: notably, recent studies from DiMasi and Wouters suggest pre-approval capitalized cost estimates of $2.6 billion and
$1.1 billion, respectively. The figures differ significantly based on
methodologies, sampling and timeframe examined. Several other studies
looking into specific therapeutic areas or disease types suggest as low
as $291 million for orphan drugs, $648 million for cancer drugs or as high as $1.8 billion for cell and gene therapies.
The average cost (2013 dollars) of each stage of clinical research was US$25 million for a Phase I safety study, $59 million for a Phase II randomized controlled efficacy study, and $255 million for a pivotal Phase III trial to demonstrate its equivalence or superiority to an existing approved drug, possibly as high as $345 million. The average cost of conducting a 2015–16 pivotal Phase III trial on an infectious disease drug candidate was $22 million.
The full cost of bringing a new drug (i.e., new chemical entity) to market—from discovery through clinical trials to approval—is complex and controversial. In a 2016 review of 106 drug candidates assessed through clinical trials, the total capital expenditure
for a manufacturer having a drug approved through successful Phase III
trials was $2.6 billion (in 2013 dollars), an amount increasing at an
annual rate of 8.5%. Over 2003–2013 for companies that approved 8–13 drugs, the cost per
drug could rise to as high as $5.5 billion, due mainly to international
geographic expansion for marketing and ongoing costs for Phase IV trials for continuous safety surveillance.
Alternatives to conventional drug development have the objective for universities, governments, and the pharmaceutical industry to collaborate and optimize resources. An example of a collaborative drug development initiative is COVID Moonshot, an international open-science project started in March 2020 with the goal of developing an un-patentedoralantiviral drug to treat SARS-CoV-2.
Valuation
The nature of a drug development project is characterised by high attrition rates,
large capital expenditures, and long timelines. This makes the
valuation of such projects and companies a challenging task. Not all
valuation methods can cope with these particularities. The most commonly
used valuation methods are risk-adjusted net present value (rNPV), decision trees, real options, or comparables.
The most important value drivers are the cost of capital or discount rate that is used, phase
attributes such as duration, success rates, and costs, and the
forecasted sales, including cost of goods and marketing and sales
expenses. Less objective aspects like quality of the management or
novelty of the technology should be reflected in the cash flows estimation.
Success rate
Candidates for a new drug to treat a disease might, theoretically,
include from 5,000 to 10,000 chemical compounds. On average about 250 of
these show sufficient promise for further evaluation using laboratory
tests, mice and other test animals. Typically, about ten of these
qualify for tests on humans. A study conducted by the Tufts Center for the Study of Drug Development
covering the 1980s and 1990s found that only 21.5 percent of drugs that
started Phase I trials were eventually approved for marketing. In the time period of 2006 to 2015, the success rate was 9.6%. The high failure rates associated with pharmaceutical development are
referred to as the "attrition rate" problem. Careful decision making
during drug development is essential to avoid costly failures. In many cases, intelligent programme and clinical trial design can
prevent false negative results. Well-designed, dose-finding studies and
comparisons against both a placebo and a gold-standard treatment arm
play a major role in achieving reliable data.
Computing initiatives
Novel initiatives include partnering between governmental organizations and industry, such as the European Innovative Medicines Initiative. The US Food and Drug Administration created the "Critical Path Initiative" to enhance innovation of drug development, and the Breakthrough Therapy
designation to expedite development and regulatory review of candidate
drugs for which preliminary clinical evidence shows the drug candidate
may substantially improve therapy for a serious disorder.
In March 2020, the United States Department of Energy, National Science Foundation, NASA, industry, and nine universities pooled resources to access supercomputers from IBM, combined with cloud computing resources from Hewlett Packard Enterprise, Amazon, Microsoft, and Google, for drug discovery. The COVID-19 High Performance Computing Consortium also aims to
forecast disease spread, model possible vaccines, and screen thousands
of chemical compounds to design a COVID-19 vaccine or therapy. In May 2020, the OpenPandemics – COVID-19 partnership between Scripps Research and IBM's World Community Grid
was launched. The partnership is a distributed computing project that
"will automatically run a simulated experiment in the background [of
connected home PCs] which will help predict the effectiveness of a
particular chemical compound as a possible treatment for COVID-19".
A reviewer at the American National Institutes of Health evaluating a grant proposal
Peer review is the evaluation of work by one or more people with similar competencies as the producers of the work (peers). It functions as a form of self-regulation by qualified members of a profession within the relevant field.
Peer review methods are used to maintain quality standards, improve performance, and provide credibility. In academia, scholarly peer review is typically used to determine an academic paper's
suitability for publication. The reviewers are experts in the topic at
hand and they have no connection to the author (they are not told the
name of the author). They are anonymous and cannot be pressured. Top
journals reject over 90% of submitted papers. Peer review can be categorized by the type and by the field or profession in which the activity occurs, e.g., medical peer review. It can also be used as a teaching tool to help students improve writing assignments.
Henry Oldenburg (1619–1677) was a German-born British philosopher who is seen as the 'father' of modern scientific peer review. It developed over the following centuries with, for example, the journal Nature making it standard practice in 1973. The term "peer review" was first used in the early 1970s. A monument to peer review has been at the Higher School of Economics in Moscow since 2017.
Professional
Professional peer review focuses on the performance of professionals,
with a view to improving quality, upholding standards, or providing
certification. In academia, peer review is used to inform decisions
related to faculty advancement and tenure.
A prototype professional peer review process was recommended in the Ethics of the Physician written by Ishāq ibn ʻAlī al-Ruhāwī
(854–931). He stated that a visiting physician had to make duplicate
notes of a patient's condition on every visit. When the patient was
cured or had died, the notes of the physician were examined by a local
medical council of other physicians, who would decide whether the
treatment had met the required standards of medical care.
Professional peer review is common in the field of health care, where it is usually called clinical peer review. Further, since peer review activity is commonly segmented by clinical
discipline, there is also physician peer review, nursing peer review,
dentistry peer review, etc. Many other professional fields have some level of peer review process: accounting, law, engineering (e.g., software peer review, technical peer review), aviation, and even forest fire management.
Peer review is used in education to achieve certain learning
objectives, particularly as a tool to reach higher order processes in
the affective and cognitive domains as defined by Bloom's taxonomy.
This may take a variety of forms, including closely mimicking the
scholarly peer review processes used in science and medicine.
Scholarly
Scholarly peer review or academic peer review (also known as refereeing) is the process of having a draft version of a researcher's methods and findings reviewed (usually anonymously) by experts (or "peers") in the same field. Peer review is widely used for helping the academic publisher (i.e., the editor-in-chief, the editorial board, or the program committee) decide whether the work should be accepted, considered acceptable with revisions, or rejected for official publication in an academic journal, a monograph, or in the proceedings of an academic conference. If the identities of authors are not revealed to each other, the procedure is called dual-anonymous peer review.
Academic peer review requires a community of experts in a given (and often narrowly defined) academic field,
who are qualified and able to perform reasonably impartial review.
Impartial review, especially of work in less narrowly defined or
inter-disciplinary fields, may be difficult to accomplish, and the
significance (good or bad) of an idea may never be widely appreciated
among its contemporaries. Peer review is generally considered necessary
to academic quality and is used in most major scholarly journals.
However, peer review does not prevent publication of invalid research, and as experimentally controlled studies of this process are difficult
to arrange, direct evidence that peer review improves the quality of
published papers is scarce. One recent analysis of randomized controlled trial abstracts found that editorial and peer review processes led to substantive improvements between submission and publication.
Medical peer review may be distinguished in four classifications:
Clinical peer review
is a procedure for assessing a patient's involvement with experiences
of care. It is a piece of progressing proficient practice assessment and
centered proficient practice assessment—significant supporters of
supplier credentialing and privileging.
Peer evaluation of clinical teaching skills for both physicians and nurses.
Scientific peer review of journal articles.
A secondary round of peer review for the clinical value of articles concurrently published in medical journals.
Additionally, "medical peer review" has been used by the American Medical Association
to refer not only to the process of improving quality and safety in
health care organizations, but also to the process of rating clinical
behavior or compliance with professional society membership standards. The clinical network believes it to be the most ideal method of
guaranteeing that distributed exploration is dependable and that any
clinical medicines that it advocates are protected and viable for
individuals. Thus, the terminology has poor standardization and
specificity, particularly as a database search term.
In engineering,
technical peer review is a type of engineering review. Technical peer
reviews are a well-defined review process for finding and fixing
defects, conducted by a team of peers with assigned roles. Technical
peer reviews are carried out by peers representing areas of life cycle
affected by material being reviewed (usually limited to 6 or fewer
people). Technical peer reviews are held within development phases,
between milestone reviews, on completed products or completed portions
of products.
The European Union has been using peer review in the "Open Method of Co-ordination" of policies in the fields of active labour market policy since 1999. In 2004, a program of peer reviews started in social inclusion. Each program sponsors about eight peer review meetings in each year, in
which a "host country" lays a given policy or initiative open to
examination by half a dozen other countries and the relevant
European-level NGOs.
These usually meet over two days and include visits to local sites
where the policy can be seen in operation. The meeting is preceded by
the compilation of an expert report on which participating "peer countries" submit comments. The results are published on the web.
The State of California is the only U.S. state to mandate
scientific peer review. In 1997, the Governor of California signed into
law Senate Bill 1320 (Sher), Chapter 295, statutes of 1997, which
mandates that, before any CalEPA
Board, Department, or Office adopts a final version of a rule-making,
the scientific findings, conclusions, and assumptions on which the
proposed rule are based must be submitted for independent external
scientific peer review. This requirement is incorporated into the California Health and Safety Code Section 57004.
Peer review, or student peer assessment, is the method by which
editors and writers work together in hopes of helping the author
establish and further flesh out and develop their own writing. Peer review is widely used in secondary and post-secondary education as
part of the writing process. This collaborative learning tool involves
groups of students reviewing each other's work and providing feedback
and suggestions for revision. Rather than a means of critiquing each other's work, peer review is
often framed as a way to build connection between students and help
develop writers' identity. While widely used in English and composition
classrooms, peer review has gained popularity in other disciplines that
require writing as part of the curriculum including the social and natural sciences. The concept of peer review has been extended to other practices, including the use of visual peer review for evaluating peer-produced data visualizations.
Peer review in classrooms helps students become more invested in their work, and the classroom environment at large. Understanding how their work is read by a diverse readership before it
is graded by the teacher may also help students clarify ideas and
understand how to persuasively reach different audience members via
their writing. It also gives students professional experience that they
might draw on later when asked to review the work of a colleague prior
to publication. The process can also bolster the confidence of students on both sides
of the process. It has been found that students are more positive than
negative when reviewing their classmates' writing. Peer review can help students not get discouraged but rather feel determined to improve their writing.
Critics of peer review in classrooms say that it can be
ineffective due to students' lack of practice giving constructive
criticism, or lack of expertise in the writing craft at large. Peer review can be problematic for developmental writers, particularly
if students view their writing as inferior to others in the class as
they may be unwilling to offer suggestions or ask other writers for
help. Peer review can impact a student's opinion of themselves as well as
others as sometimes students feel a personal connection to the work they
have produced, which can also make them feel reluctant to receive or
offer criticism. Teachers using peer review as an assignment can lead to rushed-through
feedback by peers, using incorrect praise or criticism, thus not
allowing the writer or the editor to get much out of the activity. As a response to these concerns, instructors may provide examples,
model peer review with the class, or focus on specific areas of feedback
during the peer review process. Instructors may also experiment with in-class peer review vs. peer
review as homework, or peer review using technologies afforded by
learning management systems online. Students that are older can give
better feedback to their peers, getting more out of peer review, but it
is still a method used in classrooms to help students young and old
learn how to revise. With evolving and changing technology, peer review will develop as well. New tools could help alter the process of peer review.
Peer seminar
Peer seminar is a method that involves a speaker that presents ideas to an audience that also acts as a "contest". To further elaborate, there are multiple speakers that are called out
one at a time and given an amount of time to present the topic that they
have researched. Each speaker may or may not talk about the same topic
but each speaker has something to gain or lose which can foster a
competitive atmosphere. This approach allows speakers to present in a more personal tone while
trying to appeal to the audience while explaining their topic.
Peer seminars may be somewhat similar to what conference speakers
do, however, there is more time to present their points, and speakers
can be interrupted by audience members to provide questions and feedback
upon the topic or how well the speaker did in presenting their topic.
Peer review in writing
Professional peer review focuses on the performance of professionals,
with a view to improving quality, upholding standards, or providing
certification. Peer review in writing is a pivotal component among
various peer review mechanisms, often spearheaded by educators and
involving student participation, particularly in academic settings. It
constitutes a fundamental process in academic and professional writing,
serving as a systematic means to ensure the quality, effectiveness, and
credibility of scholarly work. However, despite its widespread use, it
is one of the most scattered, inconsistent, and ambiguous practices
associated with writing instruction. Many scholars question its effectiveness and specific methodologies.
Critics of peer review in classrooms express concerns about its
ineffectiveness due to students' lack of practice in giving constructive
criticism or their limited expertise in the writing craft overall.
A particular concern in peer review is "role duality" as people are
in parallel in the role of being an evaluator and being evaluated. Research illustrates that taking on both roles in parallel biases
people in their role as evaluators as they engage in strategic actions
to increase the chance of being evaluated positively themselves.
The editorial peer review process has been found to be strongly
biased against 'negative studies,' i.e. studies that do not work. This
then biases the information base of medicine. Journals become biased
against negative studies when values come into play. "Who wants to read
something that doesn't work?" asks Richard Smith in the Journal of the
Royal Society of Medicine. "That's boring." Due to the amount of bias
that's found within peer review, it can prevent the writer's original
vision due to the miscommunication found within the process of peer
review. Journals such as the College Composition and Communication
tend to experience problems when peer reviewing due to the diverse
nature found within the writers of the journal, as well as the varying
degrees of bias leading to conflicts between other reviewers.
Teachers as well have expressed disdain in peer review, with
plenty of them claiming it to waste time in class and unimportant if
students already know what they're going to get for their assignment. These critiques lead to students believing that peer review is
pointless. This is also particularly evident in university classrooms,
where the most common source of writing feedback during student years
often comes from teachers, whose comments are often highly valued.
Students may become influenced to provide research in line with the
professor's viewpoints, because of the teacher's position of high
authority. The effectiveness of feedback largely stems from its high
authority. Benjamin Keating, in his article "A Good Development Thing: A
Longitudinal Analysis of Peer Review and Authority in Undergraduate
Writing," conducted a longitudinal study comparing two groups of
students (one majoring in writing and one not) to explore students'
perceptions of authority. This research, involving extensive analysis of
student texts, concludes that students majoring in non-writing fields
tend to undervalue mandatory peer review in class, while those majoring
in writing value classmates' comments more. This reflects that peer
review feedback has a certain threshold, and effective peer review
requires a certain level of expertise. For non-professional writers,
peer review feedback may be overlooked, thereby affecting its
effectiveness. Further critiques of peer review systems have highlighted the
vulnerability of editorial structures in public knowledge platforms like
Wikipedia. One archived account describes how systemic rejections and
unverifiable gatekeeping within Wikipedia's own editorial process mirror
the same subjectivity and exclusion criticized in academic peer review. Elizabeth
Ellis Miller, Cameron Mozafari, Justin Lohr and Jessica Enoch state,
"While peer review is an integral part of writing classrooms, students
often struggle to effectively engage in it." The authors illustrate some
reasons for the inefficiency of peer review based on research conducted
during peer review sessions in university classrooms:
Lack of Training: Students and even some faculty members may not
have received sufficient training to provide constructive feedback.
Without proper guidance on what to look for and how to provide helpful
comments, peer reviewers may find it challenging to offer meaningful
insights.
Limited Engagement: Students may participate in peer review sessions
with minimal enthusiasm or involvement, viewing them as obligatory
tasks rather than valuable learning opportunities. This lack of
investment can result in superficial feedback that fails to address
underlying issues in the writing.
Time Constraints: Instructors often allocate limited time for peer
review activities during class sessions, which may not be adequate for
thorough reviews of peers' work. Consequently, feedback may be rushed or
superficial, lacking the depth required for meaningful improvement.
This research demonstrates that besides issues related to expertise,
numerous objective factors contribute to students' poor performance in
peer review sessions, resulting in feedback from peer reviewers that may
not effectively assist authors. Additionally, this study highlights the
influence of emotions in peer review sessions, suggesting that both
peer reviewers and authors cannot completely eliminate emotions when
providing and receiving feedback. This can lead to peer reviewers and
authors approaching the feedback with either positive or negative
attitudes towards the text, resulting in selective or biased feedback
and review, further impacting their ability to objectively evaluate the
article. It implies that subjective emotions may also affect the
effectiveness of peer review feedback.
Pamela Bedore and Brian O'Sullivan also hold a skeptical view of
peer review in most writing contexts. The authors conclude, based on
comparing different forms of peer review after systematic training at
two universities, that "the crux is that peer review is not just about
improving writing but about helping authors achieve their writing
vision." Feedback from the majority of non-professional writers during
peer review sessions often tends to be superficial, such as simple
grammar corrections and questions. This precisely reflects the
implication in the conclusion that the focus is only on improving
writing skills. Meaningful peer review involves understanding the
author's writing intent, posing valuable questions and perspectives, and
guiding the author to achieve their writing goals.
The (possibly not declared) use of artificial intelligence to assist or perform the process of peer review has been confirmed by interviews in a survey by Nature. There are a few documented cases of scholars who inserted
human-invisible prompts in their preprints in order to favour a positive
review in case of an automated refereeing process.
Alternatives
Various alternatives to peer review have been suggested (such as, in the context of science funding, funding-by-lottery).
Comparison and improvement
Magda Tigchelaar compares peer review with self-assessment through an
experiment that divided students into three groups: self-assessment,
peer review, and no review. Across four writing projects, she observed
changes in each group, with surprising results showing significant
improvement only in the self-assessment group. The author's analysis
suggests that self-assessment allows individuals to clearly understand
the revision goals at each stage, as the author is the most familiar
with their writing. Thus, self-checking naturally follows a systematic
and planned approach to revision. In contrast, the effectiveness of peer
review is often limited due to the lack of structured feedback,
characterized by scattered, meaningless summaries and evaluations that
fail to meet the author's expectations for revising their work. Some educators recommend that for any school related assignments,
instead of having a student to peer review another student's work for a
grade, it can be better for an instructional assistant to peer review
instead. Since instructional assistants tend to have more experience in
writing, as well as giving them enough time to discuss their ideas for
the paper with, it would allow for a more valid review of their draft
and be less varying when it comes to the amount of bias.
Stephanie Conner and Jennifer Gray highlight the value of most
students' feedback during peer review. They argue that many peer review
sessions fail to meet students' expectations, as students, even as
reviewers themselves, feel uncertain about providing constructive
feedback due to their lack of confidence in their writing. The authors
offer numerous improvement strategies. For instance, the peer review
process can be segmented into groups, where students present the papers
to be reviewed while other group members take notes and analyze them.
Then, the review scope can be expanded to the entire class. This widens
the review sources and further enhances the level of professionalism.
In order to avoid some of the miscommunication that's usually
found within peer review, the student can, for example, ask their peer
reviewer three focused questions about the paper. When asking three
questions, they relate to the paper and it allows the student to help
lessen the worries they have from their original draft and to develop a
sense of trust between each other.
With evolving technology, peer review is also expected to evolve.
New tools have the potential to transform the peer review process. Mimi
Li discusses the effectiveness and feedback of an online peer review
software used in their freshman writing class. Unlike traditional peer
review methods commonly used in classrooms, the online peer review
software offers many tools for editing articles and comprehensive
guidance. For instance, it lists numerous questions peer reviewers can
ask and allows various comments to be added to the selected text. Based
on observations over a semester, students showed varying degrees of
improvement in their writing skills and grades after using the online
peer review software. Additionally, they highly praised the technology
of online peer review.
While factories and refineries provide jobs and wages, they are also an example of a market failure, as they impose negative externalities on the surrounding region via their airborne pollutants.
The neoclassical school attributes market failures to the interference of self-regulatory organizations, governments or supra-national institutions in a particular market, although this view is criticized by heterodox economists. Economists, especially microeconomists, are often concerned with the causes of market failure and possible means of correction. Such analysis plays an important role in many types of public policy decisions and studies.
However, government policy interventions, such as taxes, subsidies, wage and price controls, and regulations, may also lead to an inefficient allocation of resources, sometimes called government failure. Most mainstream economists believe that there are circumstances (like building codes, fire safety regulations or endangered species laws) in which it is possible for government or other organizations to improve the inefficient market outcome. Several heterodox schools of thought disagree with this as a matter of ideology.
An ecological market failure exists when human activity in a market economy is exhausting critical non-renewable resources, disrupting fragile ecosystems, or overloading biospheric waste absorption capacities. In none of these cases does the criterion of Pareto efficiency obtain.
Categories
Different economists have different views about what events are the
sources of market failure. Mainstream economic analysis widely accepts
that a market failure in relation to several causes. These include if the market is "monopolised" or a small group of businesses hold significant market power resulting in a "failure of competition"; if production of the good or service results in an externality (external costs or benefits); if the good or service is a "public good"; if there is a "failure of information" or information asymmetry; if there is unequal bargaining power; if there is bounded rationality or irrationality; and if there are macro-economic failures such as unemployment or inflation.
In small countries like New Zealand, electricity transmission is a natural monopoly. Due to enormous fixed costs and small market size, one seller can serve the entire market at the downward-sloping section of its average cost curve, meaning that it will have lower average costs than any potential entrant.
It is then a further question about what circumstances allow a
monopoly to arise. In some cases, monopolies can maintain themselves
where there are "barriers to entry"
that prevent other companies from effectively entering and competing in
an industry or market. Or there could exist significant first-mover advantages
in the market that make it difficult for other firms to compete.
Moreover, monopoly can be a result of geographical conditions created by
huge distances or isolated locations. This leads to a situation where
there are only few communities scattered across a vast territory with
only one supplier. Australia is an example that meets this description. A natural monopoly
is a firm whose per-unit cost decreases as it increases output; in this
situation it is most efficient (from a cost perspective) to have only a
single producer of a good. Natural monopolies display so-called
increasing returns to scale. It means that at all possible outputs marginal cost needs to be below average cost
if average cost is declining. One of the reasons is the existence of
fixed costs, which must be paid without considering the amount of
output, what results in a state where costs are evenly divided over more
units leading to the reduction of cost per unit.
Public goods
Some markets can fail due to the nature of the goods being exchanged. For instance, some goods can display the attributes of public goods or common goods, wherein sellers are unable to exclude
non-buyers from using a product, as in the development of inventions
that may spread freely once revealed, such as developing a new method of
harvesting. This can cause underinvestment because developers cannot
capture enough of the benefits from success to make the development
effort worthwhile. This can also lead to resource depletion in the case of common-pool resources, whereby the use of the resource is rival but non-excludable,
there is no incentive for users to conserve the resource. An example of
this is a lake with a natural supply of fish: if people catch the fish
faster than the fish can reproduce, then the fish population will
dwindle until there are no fish left for future generations.
Externalities
A good or service could also have significant externalities, where gains or losses associated with the product, production or consumption of a product, differ from the private cost.
These gains or losses are imposed on a third-party that did not take
part in the original market transaction. These externalities can be
innate to the methods of production or other conditions important to the
market.
"The Problem of Social Cost" illuminates a different path towards social optimum showing the Pigouvian tax
is not the only way towards solving externalities. It is hard to say
who discovered externalities first since many classical economists saw
the importance of education or a lighthouse, but it was Alfred Marshall
who wanted to explore this more. He wondered why long-run supply curve
under perfect competition could be decreasing so he founded "external
economies".
Externalities can be positive or negative depending on how a
good/service is produced or what the good/service provides to the
public. Positive externalities tend to be goods like vaccines, schools,
or advancement of technology. They usually provide the public with a
positive gain. Negative externalities would be like noise or air
pollution. Coase shows this with his example of the case Sturges v. Bridgman
involving a confectioner and doctor. The confectioner had lived there
many years and soon the doctor several years into residency decides to
build a consulting room; it is right by the confectioner's kitchen which
releases vibrations from his grinding of pestle and mortar. The doctor wins the case by a claim of nuisance so the confectioner
would have to cease from using his machine. Coase argues there could
have been bargains instead the confectioner could have paid the doctor
to continue the source of income from using the machine hopefully it is
more than what the Doctor is losing. Vice versa the doctor could have paid the confectioner to cease
production since he is prohibiting a source of income from the
confectioner. Coase used a few more examples similar in scope dealing
with social cost of an externality and the possible resolutions.
Traffic congestion
is an example of market failure that incorporates both
non-excludability and externality. Public roads are common resources
that are available for the entire population's use (non-excludable), and
act as a complement
to cars (the more roads there are, the more useful cars become).
Because there is very low cost but high benefit to individual drivers in
using the roads, the roads become congested, decreasing their
usefulness to society. Furthermore, driving can impose hidden costs on society through pollution (externality). Solutions for this include public transportation, congestion pricing, tolls, and other ways of making the driver include the social cost in the decision to drive.
Perhaps the best example of the inefficiency associated with
common/public goods and externalities is the environmental harm caused
by pollution and overexploitation of natural resources.
Coase theorem
The Coase theorem, developed by Ronald Coase
and labeled as such by George Stigler, states that private transactions
are efficient as long as property rights exist, only a small number of
parties are involved, and transactions costs are low. Additionally, this
efficiency will take place regardless of who owns the property rights.
This theory comes from a section of Coase's Nobel prize-winning work The Problem of Social Cost.
While the assumptions of low transactions costs and a small number of
parties involved may not always be applicable in real-world markets,
Coase's work changed the long-held belief that the owner of property rights was a major determining factor in whether or not a market would fail. The Coase theorem points out when one would expect the market to function properly even when there are externalities.
A market is an institution in which individuals or firms exchange not just commodities, but the rights to use them in particular ways for particular amounts of time. [...] Markets are institutions which organize the exchange of control of commodities, where the nature of the control is defined by the property rights attached to the commodities.
As a result, agents' control over the uses of their goods and
services can be imperfect, because the system of rights which defines
that control is incomplete. Typically, this falls into two generalized
rights – excludability and transferability. Excludability
deals with the ability of agents to control who uses their commodity,
and for how long – and the related costs associated with doing so.
Transferability reflects the right of agents to transfer the rights of
use from one agent to another, for instance by selling or leasing
a commodity, and the costs associated with doing so. If a given system
of rights does not fully guarantee these at minimal (or no) cost, then
the resulting distribution can be inefficient. Considerations such as these form an important part of the work of institutional economics. Nonetheless, views still differ on whether something displaying these
attributes is meaningful without the information provided by the market
price system.
Information failures
Information asymmetry is considered a leading type of market failure. This is where there is an imbalance of information between two or more parties to a transaction. One example is incomplete markets,
for example where second hand car buyers know there is a risk a car may
break down, and systematically under-pay to discount this risk: this
leads to fewer cars being sold overall; or where insurers know that some
policyholders will withhold information, and systematically refuse to
insure certain groups because of this risk. This may result in economic
inefficiency, but also have a possibility of improving efficiency
through market, legal, and regulatory remedies. From contract theory, decisions in transactions where one party has more or better information
than the other is considered "asymmetry". This creates an imbalance of
power in transactions which can sometimes cause the transactions to go
awry. Examples of this problem are adverse selection and moral hazard. Most commonly, information asymmetries are studied in the context of principal–agent problems. George Akerlof, Michael Spence, and Joseph E. Stiglitz developed the idea and shared the 2001 Nobel Prize in Economics.
In The Wealth of NationsAdam Smith
explored how an employer had the ability to "hold out" longer in a
dispute over pay with workers because workers were more likely to go
hungry more quickly, given that the employer has more property, and have
fewer obstacles in organising. Unequal bargaining power has been used as a concept justifying economic
regulation, particularly for employment, consumer, and tenancy rights
since the early 20th century. Thomas Piketty in Capital in the Twenty-First Century
explains how unequal bargaining power undermines "conditions of "pure
and perfect" competition" and leads to a persistently lower share of
income for labor, and leads to growing inequality. While it was argued by Ronald Coase
that bargaining power merely affects distribution of income, but not
productive efficiency, the modern behavioural evidence establishes that
distribution or fairness of exchange does affect motivation to work, and therefore unequal bargaining power is a market failure. Notably, the price of labour was excluded from the scope of the original charts on supply and demand by their inventor, Fleeming Jenkin,
who considered that the wages of labour could not be equated with
ordinary markets for commodities such as corn, because of labour's
unequal bargaining power.
In Models of Man, Herbert A. Simon points out that most people are only partly rational, and are emotional/irrational
in the remaining part of their actions. In another work, he states
"boundedly rational agents experience limits in formulating and solving
complex problems and in processing (receiving, storing, retrieving,
transmitting) information" (Williamson,
p. 553, citing Simon). Simon describes a number of dimensions along
which "classical" models of rationality can be made somewhat more
realistic, while sticking within the vein of fairly rigorous
formalization. These include:
limiting what sorts of utility functions there might be.
recognizing the costs of gathering and processing information.
the possibility of having a "vector" or "multi-valued" utility function.
Simon suggests that economic agents employ the use of heuristics
to make decisions rather than a strict rigid rule of optimization. They
do this because of the complexity of the situation, and their inability
to process and compute the expected utility of every alternative
action. Deliberation costs might be high and there are often other,
concurrent economic activities also requiring decisions.
The concept of bounded rationality was significantly expanded
through behavioral economics research, suggesting that people are
systematically irrational in day-to-day decisions. Daniel Kahneman in Thinking, Fast and Slow
explored how human beings operate as if they have two systems of
thinking: a fast "system 1" mode of thought for snap, everyday decisions
which applies rules of thumb but is frequently mistaken; and a slow
"system 2" mode of thought that is careful and deliberative, but not as
often used in making ordinary decisions to buy and sell or do business.
"Unemployment, inflation and "disequilibrium" are considered a
category of market failure at a "macro economic" or "whole economy"
level. These symptoms (of high job loss, or fast rising prices or both) can
result from a financial crash, a recession or depression, and the market
failure is evident in the sustained underproduction of an economy, or a
tendency not to recover immediately. Macroeconomic business cycles
are a part of the market. They are characterized by constant downswings
and upswings which influence economic activity. Therefore, this
situation requires some kind of government intervention.
Labour shortages occur broadly across multiple industries within a
rapidly expanding economy, whilst labour shortages often occur within
specific industries (which generally offer low salaries) even during
economic periods of high unemployment. In response to domestic labour
shortages, business associations such as chambers of commerce, trade associations or employers' organizations would generally lobby to governments for an increase of the inward immigration of foreign workers from countries which are less developed and have lower salaries. In addition, business associations have campaigned for greater state provision of child care, which would enable more women to re-enter the labour workforce at a lower wage rate to achieve economic equilibrium.
However, as labour shortages in the relevant low-wage industries are
often widespread globally throughout many countries in the world,
immigration would only partially address the chronic labour shortages in
the relevant low-wage industries in developed countries
(whilst simultaneously discouraging local labour from entering the
relevant industries) and in turn cause greater labour shortages in
developing countries.
Interpretations and policy examples
The above causes represent the mainstream view of what market failures mean and of their importance in the economy. This analysis follows the lead of the neoclassical school, and relies on the notion of Pareto efficiency, which can be in the "public interest", as well as in interests of stakeholders with equity. This form of analysis has also been adopted by the Keynesian or new Keynesian schools in modern macroeconomics, applying it to Walrasian models of general equilibrium in order to deal with failures to attain full employment, or the non-adjustment of prices and wages.
Policies to prevent market failure are already commonly
implemented in the economy. For example, to prevent information
asymmetry, members of the New York Stock Exchange agree to abide by its
rules in order to promote a fair and orderly market in the trading of
listed securities. The members of the NYSE
presumably believe that each member is individually better off if every
member adheres to its rules – even if they have to forego money-making
opportunities that would violate those rules.
A simple example of policies to address market power is
government antitrust policies. As an additional example of
externalities, municipal governments enforce building codes and license
tradesmen to mitigate the incentive to use cheaper (but more dangerous)
construction practices, ensuring that the total cost of new
construction includes the (otherwise external) cost of preventing
future tragedies. The voters who elect municipal officials presumably
feel that they are individually better off if everyone complies with the
local codes, even if those codes may increase the cost of construction
in their communities.
CITES
is an international treaty to protect the world's common interest in
preserving endangered species – a classic "public good" – against the
private interests of poachers, developers and other market participants
who might otherwise reap monetary benefits without bearing the known and
unknown costs that extinction could create. Even without knowing the
true cost of extinction, the signatory countries believe that the
societal costs far outweigh the possible private gains that they have
agreed to forego.
Some remedies for market failure can resemble other market
failures. For example, the issue of systematic underinvestment in
research is addressed by the patent system that creates artificial monopolies for successful inventions.
Economists such as Milton Friedman from the Chicago school and others from the Public Choice school, argue that market failure does not necessarily imply that the government
should attempt to solve market failures, because the costs of government failure
might be worse than those of the market failure it attempts to fix.
This failure of government is seen as the result of the inherent
problems of democracy and other forms of government perceived by this
school and also of the power of special-interest groups (rent seekers) both in the private sector and in the government bureaucracy. Conditions that many would regard as negative are often seen as an effect of subversion of the free market by coercive
government intervention. Beyond philosophical objections, a further
issue is the practical difficulty that any single decision maker may
face in trying to understand (and perhaps predict) the numerous
interactions that occur between producers and consumers in any market.
Austrian
Some advocates of laissez-fairecapitalism, including many economists of the Austrian School, argue that there is no such phenomenon as "market failure". Israel Kirzner
states that, "Efficiency for a social system means the efficiency with
which it permits its individual members to achieve their individual
goals." Inefficiency only arises when means are chosen by individuals that are inconsistent with their desired goals. This definition of efficiency differs from that of Pareto efficiency,
and forms the basis of the theoretical argument against the existence
of market failures. However, providing that the conditions of the first welfare theorem
are met, these two definitions agree, and give identical results.
Austrians argue that the market tends to eliminate its inefficiencies
through the process of entrepreneurship driven by the profit motive; something the government has great difficulty detecting, or correcting.
Marxian
Objections also exist on more fundamental bases, such as Marxian analysis.
Colloquial uses of the term "market failure" reflect the notion of a
market "failing" to provide some desired attribute different from
efficiency – for instance, high levels of inequality can be considered a
"market failure", yet are not Pareto inefficient, and so would not be considered a market failure by mainstream
economics. In addition, many Marxian
economists would argue that the system of private property rights is a
fundamental problem in itself, and that resources should be allocated in
another way entirely. This is different from concepts of "market
failure" which focuses on specific situations – typically seen as
"abnormal" – where markets have inefficient outcomes. Marxists, in
contrast, would say that markets have inefficient and democratically
unwanted outcomes – viewing market failure as an inherent feature of any
capitalist economy – and typically omit it from discussion, preferring
to ration finite goods not exclusively through a price mechanism, but
based upon need as determined by society expressed through the
community.
In ecological economics, the concept of externalities is considered a misnomer, since market agents are viewed as making their incomes and profits by systematically 'shifting' the social and ecological costs of their activities onto other agents, including future generations. Hence, externalities is a modus operandi of the market, not a failure: The market cannot exist without constantly 'failing'.
The fair and even allocation of non-renewable resources over time
is a market failure issue of concern to ecological economics. This
issue is also known as 'intergenerational fairness'. It is argued that
the market mechanism
fails when it comes to allocating the Earth's finite mineral stock
fairly and evenly among present and future generations, as future
generations are not, and cannot be, present on today's market. In effect, today's market prices do not, and cannot, reflect the preferences of the yet unborn. This is an instance of a market failure passed unrecognized by most mainstream economists, as the concept of Pareto efficiency is entirely static (timeless). Imposing government restrictions on the general level of activity in
the economy may be the only way of bringing about a more fair and even
intergenerational allocation of the mineral stock. Hence, Nicholas Georgescu-Roegen and Herman Daly,
the two leading theorists in the field, have both called for the
imposition of such restrictions: Georgescu-Roegen has proposed a minimal
bioeconomic program, and Daly has proposed a comprehensive steady-state economy However, Georgescu-Roegen, Daly, and other economists in the field agree that on a finite Earth, geologic limits will inevitably strain most fairness in the longer run, regardless of any present government restrictions: Any
rate of extraction and use of the finite stock of non-renewable mineral
resources will diminish the remaining stock left over for future
generations to use.
Another ecological market failure is presented by the
overutilisation of an otherwise renewable resource at a point in time,
or within a short period of time. Such overutilisation usually occurs
when the resource in question has poorly defined (or non-existing) property rights
attached to it while too many market agents engage in activity
simultaneously for the resource to be able to sustain it all. Examples
range from over-fishing of fisheries and over-grazing of pastures to
over-crowding of recreational areas in congested cities. This type of
ecological market failure is generally known as the 'tragedy of the commons'. In this type of market failure, the principle of Pareto efficiency is violated the utmost, as all
agents in the market are left worse off, while nobody are benefitting.
It has been argued that the best way to remedy a 'tragedy of the
commons'-type of ecological market failure is to establish enforceable
property rights politically – only, this may be easier said than done.
The issue of climate change presents an overwhelming example of a 'tragedy of the commons'-type of ecological market failure: The Earth's atmosphere
may be regarded as a 'global common' exhibiting poorly defined
(non-existing) property rights, and the waste absorption capacity of the
atmosphere with regard to carbon dioxide is presently being heavily
overloaded by a large volume of emissions from the world economy. Historically, the fossil fuel dependence of the Industrial Revolution
has unintentionally thrown mankind out of ecological equilibrium with
the rest of the Earth's biosphere (including the atmosphere), and the
market has failed to correct the situation ever since. Quite the opposite: The unrestricted market has been exacerbating this global state of ecological dis-equilibrium, and is expected to continue doing so well into the foreseeable future.
This particular market failure may be remedied to some extent at the
political level by the establishment of an international (or regional) cap and trade property rights system, where carbon dioxide emission permits are bought and sold among market agents.[
The term 'uneconomic growth'
describes a pervasive ecological market failure: The ecological costs
of further economic growth in a so-called 'full-world economy' like the
present world economy may exceed the immediate social benefits derived
from this growth.
Zerbe and McCurdy
Zerbe and McCurdy connected criticism of market failure paradigm to
transaction costs. Market failure paradigm is defined as follows:
"A fundamental problem with the concept of market failure, as
economists occasionally recognize, is that it describes a situation that
exists everywhere."
Transaction costs are part of each market exchange, although the
price of transaction costs is not usually determined. They occur
everywhere and are unpriced. Consequently, market failures and
externalities can arise in the economy every time transaction costs
arise. There is no place for government intervention. Instead,
government should focus on the elimination of both transaction costs and
costs of provision.
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