Market failure arguments are a poor guide to policy
19 June 2019
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Welfare
Regulation
20 June 2019
Tax and Fiscal Policy
19 November 2024
“Market failure” is constantly used by capitalism’s critics as justification for government spending, taxes and regulation. In policy areas ranging from schooling to the consumption of sugary drinks, claims that uncontrolled markets fail to achieve socially optimal outcomes empower advocates of various government policies to argue that intervention is economically necessary and beneficial. Yet there is a gap between how market failure is used in public debate and how modern academic economists think about the efficacy of markets.
Advocates of intervention often implicitly define market failure using the theoretical framework presented in introductory economics textbooks. Markets are said to fail if they are not perfectly competitive, with prices equating to the marginal cost of production. This broad analysis is widely accepted by policymakers, too; a UK government document states that:
“Economic efficiency depends on a number of key assumptions: markets being complete, markets being perfectly competitive, and all agents in the market making decisions based on full information. If any of these assumptions do not hold true, the market allocation of resources will not be efficient.”
Given that few markets can ever approach this ideal, market failure defined thus is ubiquitous and the scope for government intervention unlimited. Most commonly, markets are said to underprovide public goods and fail to account for how production or consumption affects third parties (which economists refer to as positive or negative externalities).
Proponents of intervention jump from diagnosis to the assumption that government can correct market failures by providing goods or services or by imposing taxes, regulations, bans or mandates. Indeed, thinking of market failure as an aberration from perfect competition implies that markets can be perfected through targeted intervention. The expansive definition of market failure is thus crucial in justifying interventionist policies.
But academic economists have long recognised the inadequacy of this framework. Models of perfect competition are not, in fact, guides to the real world. They can sometimes be useful for heuristic purposes, allowing comparison of real outcomes against some imagined ideal. But finding deviations from some imagined perfect world is not reason enough for intervention.
One reason for this is “government failure”. Just as perfect competition is unrealistic, believing markets to be perfectible by intervention requires highly questionable assumptions to be made about government. To identify and account for market failures requires policymakers to be rational, consistent, fully informed, and not self-interested or beholden to vested interests, but focused solely on maximising social welfare. Clearly, these assumptions rarely if ever hold.
Often, too, bad outcomes arise not because markets fail but because they are absent. Clear property rights and contracts can open the way for mutually beneficial trade. The Nobel Prize–winning economist Ronald Coase (1960) famously observed that, in the absence of transaction costs, externality problems could be traded away in markets. His work had two implications. First, simply taxing or subsidising various activities based on who caused them would often not lead to efficient results. Second, rather than trying to replicate some theoretical ideal market through taxes or subsidies, governments should assess means of reducing transaction costs. Only if this proves difficult or does not work at all should direct interventions be used. Even then, careful cost–benefit analysis should try to find the intervention with the biggest net social benefits.
Accordingly, economists today broadly understand market failure in a simpler way: “the failure of the market to bring about results that are in the best interests of society”. As the economist and libertarian theorist David Friedman has written, there are situations in markets where “individual rationality does not lead to group rationality”. To spell this difference out clearly: on the one hand, the definition of market failure often used by policy advocates judges markets against a theoretical world of perfect competition. On the other hand, good economic analysis now compares outcomes from an intervention against actual realistic alternatives, rather than an “unattainable and unidentifiable ideal”.
Sadly, public debates are still dominated by the rudimentary understanding of market failure and the belief that government can easily correct market inadequacies.
This post is an edited extract from an article in the June 2019 issue of Economic Affairs. The full article can be downloaded here.
Advocates of intervention often implicitly define market failure using the theoretical framework presented in introductory economics textbooks. Markets are said to fail if they are not perfectly competitive, with prices equating to the marginal cost of production. This broad analysis is widely accepted by policymakers, too; a UK government document states that:
“Economic efficiency depends on a number of key assumptions: markets being complete, markets being perfectly competitive, and all agents in the market making decisions based on full information. If any of these assumptions do not hold true, the market allocation of resources will not be efficient.”
Given that few markets can ever approach this ideal, market failure defined thus is ubiquitous and the scope for government intervention unlimited. Most commonly, markets are said to underprovide public goods and fail to account for how production or consumption affects third parties (which economists refer to as positive or negative externalities).
Proponents of intervention jump from diagnosis to the assumption that government can correct market failures by providing goods or services or by imposing taxes, regulations, bans or mandates. Indeed, thinking of market failure as an aberration from perfect competition implies that markets can be perfected through targeted intervention. The expansive definition of market failure is thus crucial in justifying interventionist policies.
But academic economists have long recognised the inadequacy of this framework. Models of perfect competition are not, in fact, guides to the real world. They can sometimes be useful for heuristic purposes, allowing comparison of real outcomes against some imagined ideal. But finding deviations from some imagined perfect world is not reason enough for intervention.
One reason for this is “government failure”. Just as perfect competition is unrealistic, believing markets to be perfectible by intervention requires highly questionable assumptions to be made about government. To identify and account for market failures requires policymakers to be rational, consistent, fully informed, and not self-interested or beholden to vested interests, but focused solely on maximising social welfare. Clearly, these assumptions rarely if ever hold.
Often, too, bad outcomes arise not because markets fail but because they are absent. Clear property rights and contracts can open the way for mutually beneficial trade. The Nobel Prize–winning economist Ronald Coase (1960) famously observed that, in the absence of transaction costs, externality problems could be traded away in markets. His work had two implications. First, simply taxing or subsidising various activities based on who caused them would often not lead to efficient results. Second, rather than trying to replicate some theoretical ideal market through taxes or subsidies, governments should assess means of reducing transaction costs. Only if this proves difficult or does not work at all should direct interventions be used. Even then, careful cost–benefit analysis should try to find the intervention with the biggest net social benefits.
Accordingly, economists today broadly understand market failure in a simpler way: “the failure of the market to bring about results that are in the best interests of society”. As the economist and libertarian theorist David Friedman has written, there are situations in markets where “individual rationality does not lead to group rationality”. To spell this difference out clearly: on the one hand, the definition of market failure often used by policy advocates judges markets against a theoretical world of perfect competition. On the other hand, good economic analysis now compares outcomes from an intervention against actual realistic alternatives, rather than an “unattainable and unidentifiable ideal”.
Sadly, public debates are still dominated by the rudimentary understanding of market failure and the belief that government can easily correct market inadequacies.
This post is an edited extract from an article in the June 2019 issue of Economic Affairs. The full article can be downloaded here.
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