Market Failure Introduction

The idealized competitive model … will, through the “invisible hand”, distribute goods in such a way that no one could be better-off without making someone worse-off. Economic reality, however, rarely corresponds perfectly to the assumptions of the idealized competitive model.

David L Weimer and Aidan R Vining, Policy Analysis: Concepts and Practice (3rd Edition)

Let me explain what this series is, by first explaining what it is not. I’m not going to be covering what most people think of as the fundamentals of economics (but are rather less central to economics than most people suppose): stuff like unemployment, GDP or inflation. Instead, I’m going to be talking about some of the core economic concepts I think everyone should know so as to better participate in civil society. These concepts collectively go by the name Market Failures, and they outline the ways some markets fail to work properly, and what can be done about it. What does it mean to say a market is working or not? And why should we be letting economists decide that? That’s going to be the first topic.

I hope this series will be of value to people of all political persuasions. While it will address the debate as to whether the government should or shouldn’t intervene in a range of policy issues, but more importantly I intend to focus on the best ways of intervening in a given problem. Too often I see debates around policy issues that collapse into the standard partisan dichotomy – where the debate simply becomes “government good, markets bad” versus “markets good, government bad” with little attempt to figure out where specifically the market and/or government might be going wrong, or what either is doing right. Indeed policy arguments often have no sense of what it means for the market or government to go wrong or right, which is guaranteed to produce horrible confusion.

The perspective I want to convey in this series is one where markets are a tool that performs a particular job, and most of the time when the tool stops working properly the best course of action is to work out why the tool isn’t working and fix it, rather than stubbornly insisting the tool is perfect, or declaring the tool is worthless and should be replaced with one of one’s own devising. Conversely there are situations in which people try to use markets for things that markets are not able to do, and the best course of action is to work around markets to achieve your goals, while leaving them to do what they do well. What I hope to teach you in this series is:

  • How to identify when a market has failed.
  • A guide as to what the failure(s) are likely to be.
  • The best solutions to each type of market failure, based on the work of economists who have studied these failures.

Each class of market failure will be getting a post of its own so we can go into each one in depth, and I’ll be running a weekly schedule. I already have the posts written, so I should actually be able to maintain that schedule.

Here’s an outline of the content of future posts, I’ll add links to this post as each one is released:

  1. Ideal Markets
  2. Externalities
  3. Imperfect Competition
  4. Collective Action Problems
  5. Imperfect Information and Risk
  6. Behavioural Economics
  7. Government Failure
  8. Policy Goals other than Allocative Efficiency

Tune in tomorrow for the first post on what a perfect market would look like, and why you should care.


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James is a government policy analyst, and lives in Wellington, New Zealand. His interests including wargaming, computer gaming (especially RPGs and strategy games), Dungeons & Dragons and scepticism. No part of any of his posts or comments should be construed as the position of any part of the New Zealand government, or indeed any agency he may be associated with.

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51 thoughts on “Market Failure Introduction

  1. I find the concept of “market failure” curious on a couple different levels. On the one hand, to speak of failure implies the existence of some exemplar of success that the failure can be compared to. But nothing is perfect, so in particular, any actually existing market will certainly exhibit one or more of the recognized failure modes to some extent and the only real question is in what manner and to what degree a particular market is failing versus the binary of success or failure.

    But it seems to me that the larger issue is philosophical. To speak of success or failure is empty without reference to a telos, some optimal or desired outcome. You can point to allocative efficiency (i.e., Pareto efficiency) as a purely instrumental, technical telos in an attempt to avoid more subjective normative considerations. But I believe any such attempt fails since the Pareto formulation itself is a normative concept.

    Having said all that, I look forward to this series and the ensuing discussion.

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    • It’s like saying “physics failure”.

      Oh, the spaceship blew up instead of taking you to Mars?

      “It must be a physics failure!”

      It seems so silly when we put it in such a way… but there it is. Something that, had we understood, we could have avoided.

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      • Jaybird: It’s like saying “physics failure”.

        Pretty much.

        I got into this with Hanley about the time I first started hanging out around here. (Briefly, since he was rather… vehement. .. in his defense of fellow academicians apparently, and I wasn’t inclined to push the point. ) My point then and now is that it seems specious to speak of the success or failure of a thing which isn’t designed to do… well, anything in particular really. Libertarians in particular speak of markets like some kind of force of nature, pre-existent to formal institutions.

        Well, you can’t really have it both ways. Either markets are some naturally emergent phenomenon, like evolution or orbital dynamics, in which case the concepts of failure and success simply don’t apply, or markets are deliberately designed human institutions and success or failure can be assigned relative to the design goals.

        My own view is a hybrid. That economic markets are a natural feature of human interaction with no telos other than that which we impose in the interest of non-economic moral side-constraints. And it’s the achievement of those moral side considerations which constitute our basis for the judgement of success or failure.

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        • Well, you can’t really have it both ways. Either markets are some naturally emergent phenomenon, like evolution or orbital dynamics, in which case the concepts of failure and success simply don’t apply, or markets are deliberately designed human institutions and success or failure can be assigned relative to the design goals.

          I think that they’re closer to the latter than not, and I think at a minimum, the willingness for people to transact with one another, trust in the system, is a basic metric of success or failure. When there’s a lack of faith in the system, you get October 2008.

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        • Running with the orbital mechanics a bit:

          If I insert a ball into a stable orbit, the laws of physics will keep it in that orbit unless & until it is perturbed out of that orbit. But a ball in a stable orbit is of limited value.

          Sticking a space station in that orbit is much more useful, but also much more susceptible to perturbations & thus the orbit must be constantly monitored and adjusted (with gyros & reaction thrusters). If I do my engineering & orbital mechanics calcs right, those adjustments can be small & infrequent.

          If I’m sloppy, they’ll be much more dramatic.

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        • Well, you can’t really have it both ways. Either markets are some naturally emergent phenomenon, like evolution or orbital dynamics, in which case the concepts of failure and success simply don’t apply, or markets are deliberately designed human institutions and success or failure can be assigned relative to the design goals.

          I think that it’s more likely that we’re using the same term to refer to two different things. (And people jump between the two definitions in the same paragraph (or same breath) without noting (or noticing) that they’ve jumped between meanings.)

          They call both the map and the territory “the market”.

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      • It’s more like a degenerate case of something – we have a model that works in the simple case, where you don’t need to account for a certain kind of change (for example, maybe fine structure just doesn’t need to be accounted for in some application, or you think it doesn’t need to be accounted for). But then that model stops working (as well) when you notice that actually the thing you were looking at is degenerate, and could actually be any of three things and you need to account for all three (and maybe the state you were originally looking at is actually impossible!).

        It makes a lot more sense to fix the model than to throw it out in favor of a model that fails harder, is what I’m saying.

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        • It makes a lot more sense to fix the model than to throw it out in favor of a model that fails harder, is what I’m saying.

          Oh, absolutely.

          If you don’t change the model, you’re going to find yourself with another disaster on your plans. But the disaster is not evidence of the forces not working. It’s evidence of the model not working.

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  2. If you write out a bunch of differential equations describing the dynamic behavior of an airplane–incorporating all the airplane’s responses to different airflow conditions and movements–you find something interesting.

    “fly straight and level” is a stable state; if you’re flying straight and level and you pitch up, aerodynamic forces develop that cause the aircraft to pitch back down. If you roll right and take your hands off the stick, the aircraft will automatically level off. And so on.

    But there are other stable states, ones where the aircraft is constantly moving. The “dutch roll” is one, where the aircraft oscillates back and forth. There’s also the spin, which you hear about a lot, but it isn’t made clear that spinning is a stable state. If you are in a spin and you take your hands off the stick, you keep spinning. You need to take action, sometimes pretty significant action, to break out (known as “spin recovery”.)

    So while a properly-trimmed aircraft flying straight and level will keep doing that, it’s also the case that a spinning aircraft will keep doing that–following the same laws that keep the straight-and-level aircraft in that condition.

    And you can argue “we should not be in a spin”, and that’s true, but claiming “the laws of aerodynamics cannot be used to describe where we are or what’s happening” is not.

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    • Those stable states are design targets, by the way. An airplane will fly straight & level because it is designed to fly straight & level (i.e. engineers make the effort to have all the aerodynamic forces & moments balance). When you do the stability analysis, you make sure those stable states are achievable, even if they aren’t ideal, at least on aircraft where you don’t want the humans inside to be vomiting all over the place.

      IIRC the F-16 was not stable in a lot of ways, and required a great deal of computer help to fly, but it was maneuverable as all hell.

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  3. “government good, markets bad”

    Is anyone within visual range of the mainstream actually arguing this? This sounds like a rehash of dorm bull sessions from fifty years ago, which in turn hadn’t been connected to any political reality since before World War II. My more recent experience is that the observation that the market is really good for some things, but not so good for others, will bring down condemnations for being the reincarnation of Lenin.

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    • If they are, it’s because they’ve been recently exposed to markets which are selling humans or their deaths, or the ability to stitch humans together into incredibly strange chimeras.

      …. you know, the internet? the pictures are out there.

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    • “Is anyone within visual range of the mainstream actually arguing this?”

      Um, damn near everyone?

      Unless you consider “the banks nearly ruined this country, we need to regulate them more stringently!” to not be “government good, markets bad”, in which case, um,

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      • That’s an example of the ole “comma-but” logic, yeah?

        “I think markets are good, but government…”

        “Stop right there! You comma-butted! Your deeply held dislike of markets has been revealed.”

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      • Unless you consider “the banks nearly ruined this country, we need to regulate them more stringently!” to not be “government good, markets bad”, in which case, um,

        The mainstream arguments focused a more refined and accurate version of the markets bad, government good argument:

        Systemic risk bad, regulation to minimize systemic risk from small groups of private actors good. The best mainstream arguments understood this problem.

        Unfortunately, too may libertarians and conservatives missed the boat on that given their endorsement of the batshit stupid theory that Fannie, Freddie and the Community Reinvestment Act caused the crisis.

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        • I’m not sure what you’re effortposting about, because you’re agreeing with me that “governments good, markets bad” is a mainstream argument.

          I’m not actually addressing the validity of that argument, I’m pushing back on Richard’s apparent claim that it’s a bizarre fringe-position strawman.

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          • I’m not actually addressing the validity of that argument, I’m pushing back on Richard’s apparent claim that it’s a bizarre fringe-position strawman.

            Don’t push too hard. You’ll strain something and still be wrong. Richard has it right. If anything, the “governments good, markets bad” meme came from right-leaning circles to describe people that correctly identified the causes. It was as stupid then as it is now.

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    • At the highest level, perhaps not (although one can only say “I’m in favour of markets, but” so many times before that person should be considered anti-market). But with regard to specific markets, it comes up pretty often (if not in those exact words). Bear in mind also, that I’m not just thinking of the US here either.

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      • Is anyone nowadays advocating central planning of production levels of shoes and garden hoes and automobiles, rather than leaving it to the market? My understanding is that even the putatively Communist states have long since given up on such things. But I could be wrong about this.

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          • I prefer the concept of “In the long run, we’re all dead”.

            When it comes to market solutions, time-span and criticality are rather important. If, for instance, the market will eventually clear the problem with a high level of efficiency BUT in the interim there’s a great deal of death, pollution, whatever — then it may be worth accepting a less efficient solution in return for a less traumatic process for solving it.

            Admittedly, from my CS background — I’m used to judging things as trade-offs. I can write a fast algorithm that’ll get me a decent solution, or a slow one that’ll get me the best solution. Which one to use? Depends on what it’s for!

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        • I recall someone who would have been considered pretty far left 40-odd years ago (though I have forgotten exactly who) saying that markets are terrific at producing things consumers can evaluate for themselves and pay for with their own money. You reminded me of one of his examples. Since you mentioned shoes, he said that, for example, the market for clothing works pretty damn well. It produces a wide variety of clothes at various combinations of quality and price, and puts decent clothing within the reach of all but the most destitute. For them, the problem is not the clothing market system, but sheer destitution, which should be dealt with directly, by providing either money or clothing. To the extent that the industry uses some dangerous chemical or dye that the consumer can’t realistically be expected to detect, there is a basis for some safety regulation, but that’s about it. And this was from someone who thought the fashion industry and the resources and energy that go into it at the expense of more useful pursuits was obscene. Even he advocated leaving the clothing market largely alone.
          But where the consumer can’t really judge what he is getting, or is paying for it out of someone else’s pocket, like housing or healthcare, markets, he held, have many deficiencies.
          So, no, almost nobody is opposed to markets in general.

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  4. Looks like an interesting series.

    Based on my observations of the US economy since the mid-80s, it occurs to me that there are very significant non-economic values embedded in “Pareto efficiency”. If the rising tide lifts the largest boats a lot and the smallest boats only a little, is this really the society we want? Since economic power has, since forever, equated to political power, should we not be concerned about market outcomes which persistently allocate larger shares to those who already have the most? What ever happened to the estate tax, anyway?

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  5. What’s with all these recent front-page blurbs starting with “In which?” Why would anyone use “In which” when “Wherein” is an option?

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