Market Failures 

After reading the preceding section you may have the idea that we economist don’t agree on much.  However, we do agree on many things, including the idea that the market outcomes are not always perfect.  The argument for the market system is based on the idea that market outcomes are efficient, both allocatively and productively.  When they (market outcomes) are not efficient, we consider them failures.  So if a free market gives us too much of some one type of good (air pollution), or too few of another type of good (health care), we are either over-allocating or under-allocating our resources.  If the free market leaves some resources idle as happens in a recession we are productively inefficient.  In either case market failures generate productive and/or allocative inefficiency. This means that the market system has failed to deliver on what its advocates claim it does best…fully allocate resources efficiently.   

Types of Market Failures 

Public Goods A public good is something that provides a benefit to people, but because of its nature, we can’t exclude people from consuming it based on whether they pay for it or not.  This means that a person or firm can’t make a profit because they can’t effectively control who gets the product, so a free market won’t make the product in the first place.  The classic example is a lighthouse.  All ships will benefit from using it and would be willing to pay for it, but once it is in place there is no way of excluding non-payers from using it.  Rationally self-interested people would not continue to pay for something they can get without having to pay for it.  Therefore, no profit-seeking firm would build it in the first place.  This results in a free market under-providing these kinds of goods.  Think of your island signal fire. If your island used a market system, there would be no problem in devoting resources to fish or grub production because at the end of the day they could sell them.  But who would build and maintain the signal fire?  Whether you pay for it or not, you would be rescued when it drew the attention of the search plane.  So why would you pay for it?   I know many of you would because of your feeling of social responsibility, but there would be some of you who would not.  This is called a “free rider” problem.  As those who don’t pay for it get fatter on grubs and fish, an incentive not to pay would grow and fewer of you would continue to do so.  As a result the fire would get smaller and smaller until it became so small as to become useless.  As a consequence, you may not get rescued…a major goal.

Common Resources This problem is also known as the tragedy of the commons.  It comes from an observation of a predicament that developed in the manorial system in medieval Europe.  You see, back then villages were usually divided the available land into three parts, the lords, the peasants, and the commons.  Everyone had access to the commons.  So if you were a peasant and you had a pig or cow rather than grazing you own land, where you could grow valuable crops, you would prefer to graze the commons.  Why? Our old friend opportunity cost.  Your opportunity cost of grazing your pig on your land means that you can’t grow a crop.  Your opportunity cost of grazing your pig on the commons is nothing.  Everyone in the community is faced with the same condition and would most likely make the same choice.  In fact, when you realize that others will be grazing you may put out more animals sooner in order to get the most grazing possible.  What does this mean for the commons?  It will be overgrazed (the grass won’t be given time to recover) leading to an inefficient use of this resourse.  So the once bountiful commons will become a barren overgrazed patch of dirt.  What a tragedy.  This problem didn’t go away with the medieval period.  It explains why the buffalo and whales were hunted to near extinction, why public parks have more litter than people’s front yards and America’s deforestation of the nineteenth century.

Externalities  An externality means that there is some third, nonparticipating party to an exchange who is either involuntarily paying a cost or receiving a benefit.  Suppose you live downstream from a factory that makes widgets.  The factory, trying to keep the cost of production down, dumps its widget-waste into the stream.  This is good as far as the widget factory and the widget customers are concerned; they get a lower price and possibly higher profits.  But you would have to suffer the consequences of living next to a polluted stream.  You are external to (outside) the widget market, but you are paying some of the costs of that trade.  This negative externality results in the under-pricing of widgets and means that we will end up making and consuming too many of them.  If the externality was positive (like an educated workforce), prices would tend to be too high and result in too few of them being consumed and produced.   As in the first two market failures the, a system that rewards individuals and firms for maximizing gains regardless of the social impact leads to an inefficient use of resources. 

Equity   This failure is one of the more controversial ones and some orthodox economist wouldn’t include it as a market failure.  But as Karl Marx pointed out, a market system tends to end up with income being distributed unevenly. This is the opposite of what Adam Smith predicted.  Smith thought that as soon as someone became rich because their business was successful, others would inter the market and destroy the profits.  This doesn’t always happen.   Suppose I were to give all you classmates $50,000 and pay off all the classes debts at the end of this class and had you all come back at the end of five years.  What are the odds that you would all have the same amount of money?  I’m sure you would agree that they would be very low.  This is because each of you would do something different with your income.  Some might take a trip around the world.  Others would pay for their education.  Some might start a business.   Different choices, different outcomes.  Is this unfair?  Most of you would probably be OK with these differences.   

The key reason most of you would accept the differences is that you all started from the same place.  However, there are times when this unevenness does not seem fair.  For example, a five-year-old child commands a very low wage in an unfettered (unregulated) labor market.  This is not the child’s fault, but that child would be poor in a pure market society.  This is one of the reasons we still have the traditional institution of a family where the child receives “welfare” from his or her parents.  Currently, almost 25% of all children in the U.S. live in families that are below the official poverty level.  Because we feel that this is unfair, we engage in income re-distribution.  The government transfers income from income earning families to non- or low income earning families.  Recently those coming from the orthodox perspective have pointed out the problems associated with this intrusion into market outcomes.   Namely, it provides incentives to not work.  This incentive problem is at the core of the welfare reforms of the nineties. 

Critics of the orthodox perspective point out that the US has the most uneven distribution of income and wealth of the industrialized nations.  They also point to the wage gaps between men and women and people of color and whites   

Market Power.   Market power (sometimes called monopoly power) is when firms have the ability to influence price and output.  When firms have it, they tend to cut back production in order to drive up prices and increase profits.  The result is too few goods being produced in noncompetitive markets.  This is clearly allocatively inefficient.  Meanwhile where do the resources go that are no longer being used in the noncompetitive market?  As you’ve already discovered, our system has strong incentives to sell resources.  If you are a laid off worker you will soon be “out on the street” if you don’t find some work.  Where can you work if all the firms with market power are not hiring workers?  If you own some capital where are you going to put it to work if the noncompetitive sector is contracting?  Since the competitive sector has no barriers to entry, that is where these resources will go.   This means that too many goods will be produced in competitive markets.   Once again this is allocatively inefficient.   It also means that income is concentrated in the hands of those who have market power at the expense of those who do not.  This is because the exercise of market power increases the income of those with it and as resources crowd into competitive markets incomes will go down in those markets.   

Macroeconomic Stability.  As both Keynes and Marx point out, the market system has shown a tendency to go through periods of boom and bust called business cycles.  A boom is where there is rapid economic growth and high employment (like the 1990s).  A bust (recession) is where there is slow or negative economic growth and high unemployment (like what has been going on in Japan).  In this case we are mainly concerned with productive inefficiency. We are also talking about the economy as a whole, or the macroeconomy. 

Information. Free markets rely on consumers and producers to make rational decisions in order to attain efficiency.  Recall that rational means to weigh out the costs versus the benefits.  When a consumer buys something they are signaling that they think the good is worth the price (benefits outweigh the costs) so the resources devoted to producing it are being wisely used.  But this assumes that they are fully informed about what they are buying.  Sometimes consumers don’t have complete knowledge about what they are buying.    For instance, if you decide to buy a head of lettuce you may not know the much about how it was grown and brought to market.  If you had that information you may value it differently.  If it was grown in highly contaminated soil with lots of pesticides, chemical fertilizers and harvested by slave labor you may value it less than it if it was grown organically and harvested by well paid workers in decent working conditions.  An unscrupulous grocery store might just say that the lettuce was organically grown in order to get a higher price.  This might mean that the organic growers be driven out of business, even though people want their product.   This would be allocatively inefficient. 

The core problem in this failure is that consumers need to know about the products they are buying but may lack the resources and the expertise to be accurately informed about the service or product they are buying.   Do you have the time and expertise to fully inform yourself about the contents of the vitamins you buy or the qualifications of the dentist you see?  Most people don’t.  In the absence of government regulations there could be serious allocative problems within the economy.