Economic Theory

Do markets fail?

If somebody were to start an engineering textbook by saying that the maximum theoretical speed of a perfect car was the speed of light and that a car that travelled at any speed lower than that was a ‘failed car’ or suffered from ‘car failure’, you would probably think that it was an unhelpful way of presenting the topic – and you would be right.

Yet, a common approach in economics teaching is to lay out the preconditions of a so-called perfect market (full information, no transactions costs, no externalities and so on) and then look at how markets, in practice, deviate from that textbook model. We then call those deviations ‘market failures’ because they imply that all opportunities for welfare maximisation have not been taken. This is despite the fact that it is impossible to have a perfect market, just as it is impossible to have a ‘perfect car’.

Because markets are deemed to fail according to the textbook model, the concept is then used to justify different forms of government intervention. For example, consider this statement by the former regulatory body for financial markets, the Financial Services Authority (the body that presided over financial regulation at the time of the financial crash) made in 2003:

‘In meeting our objectives in a manner consistent with the principles of good regulation, we have adopted a regulatory approach based on correcting market failure…There are, however, numerous cases where unregulated financial markets will not achieve the best outcome due to some form of market failure, making action on our part necessary.’

The word ‘necessary’ is especially interesting in this statement because all markets suffer from the problem of market failure as defined in the textbooks – just as all cars travel at less than the speed of light – and thus there would appear to be no limit on the extent of regulatory intervention that the FSA believed it needed to use to try to perfect the market. The market failure doctrine is not simply a problem in economics textbooks, it is used to determine public policy.

Government failure?

In some A-level syllabuses, the concept of market failure is balanced by that of ‘government failure’ – the idea that, for various reasons, the government might not be able to perfect markets through regulatory intervention. However, though this provides balance, it is not a helpful phrase to use. We cannot expect governments to perfect markets – it is simply beyond their capacity. As such, governments do not fail if they do not perfect markets. The lessons of public choice economics tell us that regulators may act in their own interests, or may get ‘captured’ by the industries that they are trying to regulate so that the actions of regulators do not contribute to increasing overall welfare and improving market outcomes. Regulators might be risk averse and over-regulate markets or they may have cognitive biases that lead them to regulate markets through ‘rule writing’ which simply raises costs without improving outcomes. Furthermore, Austrian economics suggests that, if a market is ‘imperfect’ in some way, governments and regulatory bureaus simply cannot know what the outcome of a perfect market would have been had it existed.

For these reasons and others, governments cannot perfect markets and the concept of ‘government failure’ is just as unreasonable as that of ‘market failure’.

Achieving better outcomes, not perfect outcomes

The obsession with the market failure approach to policy analysis is relatively new and can probably be ascribed to Pigou. The obvious example is the idea of the optimal tax to deal with pollution. If a factory owned by one individual pollutes the air or land of other individuals, the argument goes that the problem can be solved with an optimal tax on the factory’s activities to bring marginal social costs into line with marginal social benefits. Again, this is reflected in A-level and undergraduate economics syllabuses.

However, we do not know what that tax should be. How can a government minister know the social cost caused by a pollutant? People’s preferences for different economic goods are only revealed by the prices they pay in market transactions. Different people will have different preferences. Some people might have a strong preference for clean air; others might prefer dirty air if allowing more pollution allows them to be a little bit more wealthy in other ways. The government could only have the information to work out the optimal tax if it had all information about the costs and benefits of all potential uses of economic resources. If it had that information, then centrally planning the economy more generally would work. And yet we know that central planning is a catastrophe.

There is a better way of dealing with these problems. Instead of focusing on market imperfections and government regulation and taxation to correct those imperfections we might think about which set of institutions and policies generally produces the best result – not a perfect result but the best result. In the case of externalities we might want to consider the set of policies that will lead to the parties causing harm and the parties who are harmed coming to an agreement that leads to better outcomes.

Let us take land-use planning as an example. At the moment, people in the South East of England tend to oppose more development because it reduces their environmental amenities, leads to more road congestion and so on. On the other hand, people regard new houses in the South East as incredibly valuable compared with other uses for the same land such as farming. Land with planning permission for building is worth about 100 times land with planning permission only for agriculture. So there is a conflict: builders want to build and existing residents want to prevent building. There is a social cost from building more houses but a huge potential welfare gain too.

Since 1948 we have resolved this conflict by giving powers to regulators in local government to take decisions about development using a bureaucratic process that is influenced by interest groups. This leads to some perverse outcomes, one of which is that houses that might have a minor impact (minor social cost) on nearby villages do not get built even though the private gains might be huge. If only those who gained could compensate those who lost, there could be much better outcomes.

Instead of this process of regulators trying to dictate who should and should not have permission to build, what if we were to bring those parties that gain together with potential parties who might lose? Builders, who gain hugely from turning agricultural land into building land, reflecting the value their customers put on new houses, could use some of that gain to directly compensate those who lost their environmental amenities. This could be done at a very local level as the number of people affected by housing developments is normally quite small. Localities that valued their environmental amenities highly might refuse compensation, and the builder can build near people who value their environmental amenities less.

Good, better, best – but not perfect

There are many more examples of how we might improve economic outcomes by looking at the institutional framework rather than looking to regulators to pull levers, but what is the general approach that should be taken?

We should do two things. Instead of saying: ‘this is a market failure, we should give power to a regulator to pull the lever marked “X” to perfect the market’ we should look to improve institutions, to extend markets so that economic agents have a good chance of taking into account the costs and benefits of different courses of action. As in the planning example, this might involve better definition of existing property rights so that parties can work out a solution in a way that best takes account of costs and benefits. The outcome may not be perfect, but it will be better.

Secondly, so-called market failures are not generally failures of markets. They normally involve incomplete markets. In the planning example, under current law, there is no market in environmental amenities. If I get some benefit from the farmland at the back of my house, is that a property right of mine or not? Under our current land-use planning regime, it is in a kind of limbo. On the one hand the farmer cannot simply build on his field without permission. On the other hand, he cannot be stopped from building once he has permission. In lots of areas (for example, land-use planning, fishing rights, environmental pollution) the problem is that property rights do not exist in the relevant resource so nobody has an incentive to use the resource efficiently or come to agreements with others to compensate them for the ‘social costs’ of their actions.

Failure to treat this subject properly is a major impediment to economics being useful in solving public policy problems.

This article will be published in the October 2014 edition of EA Magazine.

Academic and Research Director, IEA

Philip Booth is Senior Academic Fellow at the Institute of Economic Affairs. He is also Director of the Vinson Centre and Professor of Economics at the University of Buckingham and Professor of Finance, Public Policy and Ethics at St. Mary’s University, Twickenham. He also holds the position of (interim) Director of Catholic Mission at St. Mary’s having previously been Director of Research and Public Engagement and Dean of the Faculty of Education, Humanities and Social Sciences. From 2002-2016, Philip was Academic and Research Director (previously, Editorial and Programme Director) at the IEA. From 2002-2015 he was Professor of Insurance and Risk Management at Cass Business School. He is a Senior Research Fellow in the Centre for Federal Studies at the University of Kent and Adjunct Professor in the School of Law, University of Notre Dame, Australia. Previously, Philip Booth worked for the Bank of England as an adviser on financial stability issues and he was also Associate Dean of Cass Business School and held various other academic positions at City University. He has written widely, including a number of books, on investment, finance, social insurance and pensions as well as on the relationship between Catholic social teaching and economics. He is Deputy Editor of Economic Affairs. Philip is a Fellow of the Royal Statistical Society, a Fellow of the Institute of Actuaries and an honorary member of the Society of Actuaries of Poland. He has previously worked in the investment department of Axa Equity and Law and was been involved in a number of projects to help develop actuarial professions and actuarial, finance and investment professional teaching programmes in Central and Eastern Europe. Philip has a BA in Economics from the University of Durham and a PhD from City University.

5 thoughts on “Do markets fail?”

  1. Posted 15/05/2014 at 19:19 | Permalink

    From the opening paragraphs, it is curious to reflect upon the notion of ‘perfect markets’ which, at least according to one school of economics, should be considered an oxymoron: for according to the dynamic nature of markets — with ever-constant change with respect to consumer demand, the supply of differing (and new) goods and services, subjective needs and desires, and entrepreneurial and informational flux — a market can, by definition, never be perfect. At most, it can be a really good marketplace, with a wide variety of goods and services on tap (with various price levels and corresponding levels of labour competency), or a really bad marketplace.

    A ‘perfect’ marketplace, where all demands are satisfied, with nothing left to sell and nothing left to buy, ceases to be a marketplace at all.

    Market failure, then, is less an absolute category of damnation than a (hopeful) process of development; whereas government failure, with exceptions, has the reserve effect: little room for improvement, with the flaws built into the system —unless privatisation were an option. As Arthur Seldon wrote in The Dilemma of Democracy:

    The historians persistently overlook three self-defeating tendencies of government that claims to be armed with the cures for market imperfection. First, their remedies are begun too soon. Second, they are endemically operated too far. Third, they are continued too long. The total effect is that governments cannot be adjusted to the advancing superiorities of the market. Crucially, their measures cannot be withdrawn when the market makes them superfluous.

  2. Posted 16/05/2014 at 19:46 | Permalink

    Thankyou very muh for covering this! Economics at A level is terrible. It is supposed to be Keynesian but its even worse!

  3. Posted 17/05/2014 at 17:02 | Permalink

    This is something I’ve thought about before but my own analogy was with an alarm clock. Since markets do not have as their purpose many of the things they are accused of failing to do, it seems very odd to say that they have failed in not doing these things – when I get woken by my alarm in the morning I do not protest at my regular experience of ‘alarm clock failure’ when it ‘fails’ to make me a cup of coffee as well!

  4. Posted 19/05/2014 at 19:20 | Permalink

    Maybe governments cannot ‘perfect’ markets, but surely they can still fail? Suppose a government sets out to maintain the purchasing power of money, but instead the value of money (as best as can be measured) falls by more than 90 per cent in a fairly short period. Isn’t that a ‘failure’? Suppose a government undertakes to put on an Olympic Games for £2 1/2 billion, but in the event it costs about £10 billion. Isn’t that a ‘failure’? Suppose a government sets out to establish a system of schooling that will provide an adequate education for children, but even after many years the state schooling system turns out about 20 per cent of children at the end of their 12 or so years in the system who are essentially illiterate. Isn’t that a ‘failure’?

  5. Posted 15/06/2014 at 09:08 | Permalink

    Market collapse as a concept is neither good nor bad. It may just represent the decline of the market for that service or good. In my simple world, I see a failure to value the small, independent and resilient virtues that many markets have – as they are hung out to dry on the quest towards globalisation through efficiency of scale and scope.

    So, consider the market for electricity. I am somewhat impressed that during the second world war, reports suggest that despite massive bombing, the lights, in general, stayed on. Since that period, we have built national grids and made ever larger centralised production facilities. The results of small failures now can have far reaching effects. When New York lost power to the whole city made great news. The root cause turned out to be a failure of a fuse in Canada.

    Markets do need to search for perfect efficiency, but measuring efficiency needs also to take on some kind of valuation of risk and cost of failure. Markets when they fail have the opportunity to do so gracefully. Financial crises each have their own personality. The most notable quality of the 2008 credit crisis was not perhaps the magnitude of the trigger event, but the resulting contagion.

    This is the art we must aim for – designing in capacity to fail. I personally would like to see a critical 3 market approach for every systemically sensitive market. This would allow one party to fail and the others to pick up the slack. The role of the regulator would be to start another player after the collapse by skewing the rules in their favour to diminish the now incumbent duopoly. The knowledge that the players could fail would encourage markets to self regulate with a focus of survival.

    This may not shave the last 10% of price off the goods for consumers in the short term, but it may go some way to preventing massive systemic losses, provide mutual regulation and oversight within industries and so on. Digital markets and infrastructures are now cheap and the costs are not that high. Where a national or global market is the right choice, then the role of the regulator must be to stress test regularly whether or not the underlying market infrastructures are resilient. Whether this be electric wires, sewers, silt in rivers, or more exotic derivatives.

    There just has to be a better way.

    Regards, Cliff.

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