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The concept of market failure was originally presented by economists as a normative explanation of why the need for government expenditures might arise. Gradually, the concept has taken on the form of a full‐scale diagnostic tool frequently employed by policy analysts to determine the exact scope and nature of government intervention. For some time, economists have known that the market failure idea is conceptually flawed. The authors of this article demonstrate why this is so, employing concepts drawn from the perspective of transaction costs. In a review of empirical studies, they further show how the market failure diagnostic leads analysts to make generalizations that are not supported by facts. Transaction cost analysis helps to explain the underlying processes involved. © 1999 by the Association for Public Policy Analysis and Management.

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