Someone told me that there's a thing called market failure, but we hear a lot that the free market is perfect. Are market failures real? What are they?
Generally speaking, it is more efficient and drives more innovation for the government to stay out of economic affairs and allow free market forces to do their job. There are, however, a few specific problems which we encounter when there is a complete lack of regulation that keep the free market from being entirely effective. It is in these instances that the majority of modern economists will engineer a method to account for the market failure while leaving as much of everything else unaffected as possible. I urge you to remember as you’re going through this list that good economics is not the same as good politics. We don’t put economists in charge of our economy in this nation, we put lawyers in charge – people who make their living telling people what they want to hear. As a result, there’s a bit of a joke among economists that says, “The first law of economics is that there’s not enough stuff for everyone. The first law of politics is to ignore the first law of economics.” So, don’t confuse those policies in government motivated by greed and incompetence to drive your understand of what economic management should be.
That being said, below is a list of common market failures. Enjoy.
Externalities occur when the price you pay for something does not accurately represent the value received by others not party to the transaction. There are positive and negative externalities. Positive externalities are those things which add value to others who haven’t paid for it. For example, when you get vaccinated, you are paying only to protect yourself, but there are additional benefits since protecting yourself from illness also reduces the chances of those around you getting sick. Negative externalities are those things which cause negative value to people not party to the transaction, such as the effects of second-hand smoke. Good or bad, these secondary effects are not being accounted for in the value of the transaction because people influenced by that transaction are not party to market negotiations or exchanges. Generally speaking, we don’t always respond to this market failure. There have been times of response which impose a tax on negative externalities in order to account for the additional harm caused, and subsidies for positive externalities to account for the added benefit. This doesn’t always occur, however.
Public goods are those which have the trait of being non-excludable. This includes things like the military. There is simply no method to allow the free market to take over such services. A military cannot be formed or altered in time to respond to an attack, so it must plan ahead. Once created, there is no way to protect some people in a nation without protecting all people in a nation, nor should we try to create such a disparity in national defense. As a result, public goods, by nature, must be the result of economic planning. This is resolved by funding these goods with tax money.
If you were born prior to 2007, as I think most of you were, then you know what volatility looks like and can also recognize that it is not good for our economy. Volatility can be managed using a combination of proper fiscal and monetary policy. The business cycle naturally brings us through periods of economic boom and recession, often filled with bubbles, inflation, unemployment, and so forth. In order to understand how we manage volatility, we must first understand how all this looks. There are three forms each of unemployment and inflation:
Frictional Unemployment – This is the type of unemployment that occurs when people change jobs, change companies, change fields, and so forth. Since people frequently do not start a new job the instant the end their time at an old one, there is always a small amount of frictional unemployment going on at any given moment. Even during full employment, we still see about 2-4% unemployment, and frictional unemployment contributes to that. This type is seen as a good thing because it means that people are finding more effective ways to allocate their time and efforts in being more productive.
Structural Unemployment – This type of unemployment occurs through decreased demand for a particular good. For example, when the digital camera became commercially available, we saw a lot of film developers go out of work. If you’ve been paying attention to the gaming industry as of late, it would appear as though the XBOX might be going out of favor soon due to a series of bad product decisions, which would also count as structural unemployment as they fire people in order to remain cost effective in the face of reduced revenues. This type of unemployment is also seen during full employment and is seen as a good thing because it means the nation is innovating, competing, and responding properly to market forces. Yes, it sucks to lose your job, there’s no denying that, but it is necessary for growth to occur, so economists think of this as a type of “growing pains”.
Cyclical Unemployment – This was the type of unemployment describes by John Maynard Keynes and was, until the 1970s, thought to be the only type of unemployment. This type of unemployment occurs when aggregate supply exceeds aggregate demand. When this happens, we see high levels of surplus inventories and decreased spending. As a result of lower revenues and sustained costs associated with maintaining both high inventory levels as well as high production capacity, businesses will downsize in order to reduce those costs. Downsizing includes firing people. A company simply isn’t going to pay an employee that they don’t need – it’s inefficient. So, until those surplus inventories are consumed and demand increases to a point that pushes companies back into production, jobs will remain stagnant.
Cost Push Inflation – This occurs when the cost of production increases necessitating an increase in price. Say, for example, a drought occurs forcing farmers to pay for more irrigation water than normal, increasing the cost of food. Well, like the cost of energy, the cost of food impacts the price of everything else, so the increased cost of food or energy will create an increased cost for other businesses and people. If that cost increase is large or sustained enough, it will cause cost/price increases in everything else.
Demand Pull Inflation – This is the type of inflation described by John Maynard Keynes and was, until the 1970s, thought to be the only type. This occurs when aggregate demand exceeds aggregate supply. Recall that when demand increases, price also increases; so when demand exceeds supply, companies must increase production capacity by hiring more people, or offering higher wages to hire more efficient people, or purchasing new land and capital, and so forth. This increases costs and contributes to inflation.
Monetary Inflation – This occurs when a nation’s economic management is used specifically to cause inflation, either intentionally or otherwise. Unintentional inflationary policies have resulted in hyperinflation. Other times, it has been used to competitively devalue a currency against the currencies of other nations to increase demand for exports. In either case, monetary inflation is caused by monetary policy.
So, when we’re managing volatility across the economy, we have two broad categories of tools. First, fiscal policy refers to the taxation and spending of a government. Second, monetary policy refers to the supply and price of money (supply being altered through fractional reserve requirements and the production/destruction of currency, while price of money is controlled through interest rates). The goal of using the tools available in both of these is to manage the individual sources of unemployment and inflation in order to maintain smooth, sustainable growth sans volatility. Take, for example, the difference between the EU and US during their post-2008 responses. The EU went with austerity measures, ignoring the mechanics of cyclical unemployment, and they still have increasing rates of recession and unemployment. The US, by contrast, went with a bit of expansionary monetary policy (which they marketed as “quantitative easing”) and we’re improving. We could have improved even faster had congress not been deadlocked on a proper fiscal response, but that’s why we keep monetary policy in the hands of the federal reserve; we simply wouldn’t get anything economic policy accomplished if it was all in the hands of congress.
In every transaction you make, you will lack the information you need to make a perfectly informed and rational decision. It could be as mundane as satisficing behavior, wherein you don’t care to check every store’s coupons in order to get the best price-match. It could also be something more dramatic, such as an innate inability to shop around; if you’re in an ambulance having a heart attack, you’re not going to tell the driver, “No, don’t go to this one, there’s another one on the other side of town that’s cheaper.” This can also refer to information differentials between buyer and seller. Perhaps a buyer is aware of a value in a product unknown to the seller, such as with rare antiques. Perhaps the seller has more information, such as with the case of the lead point in toys being imported from China. In any case, this imperfect information leads to transactions that are not perfect in the market. Attempts to resolve this include disclosure laws, false advertising laws, and consumer protection laws. It still happens, though.
Off-Income Statement Costs (No market/common goods)
There are times when a company or person will consume things without paying for them simply because no market exists. I refer to these as off-income statement costs, because these are factors of production being consumed but which do not contribute to costs on the income statement of a business. For example, when the chemical and industrial plants in Southeast Michigan dumped their waste into the Rouge River, that river became unusable to drink, fish, swim, or use for any other purpose, at all. Ok, fine, it’s a factor of production, but it’s one that they didn’t pay for. Who ended up paying for the cost of the consumption of that factor of production? The taxpayers, as the city went in to clean up the water. It’s still not usable, but at least it doesn’t stink in the summer anymore. Like all demand, consumption of these goods for which there is no market also increases costs and reduces revenues; you need to go further to swim now, further to fish, and even, in many cases when this occurs, the very companies who dumped into the water now need to ship in clean water from elsewhere to provide something drinkable to employees, increasing the cost of operations. These off-income statement costs allow for the consumption of factors of production without accounting for the cost, which means the market is not working in these instances.
A natural monopoly occurs when a single company is capable of maintaining a non-competitive market. Sometimes this happens by through continued economies of scale. Sometimes this occurs when a company buys their competition, or participates in predatory pricing practices, or utilizes petty lawsuits to drive the competition out of business, or takes control of the supply for their factors of production, and so forth. These are all ways that companies can utilize natural market forces to their own benefit to limit free market competition. Some people will try to tell you that these methods aren’t “real capitalism”, but they are. These things, as well as such things as buying political corruption, are the natural product of the unrestricted free market, thus making them a form of market failure. To stop them requires a degree of planning. Don’t let people fool you into thinking that it doesn’t count just because they don’t like it. This particular form of market failure first started being seriously addressed by Teddy Roosevelt, who became known as the "Trust Buster", for his implementation of anti-trust laws.
Two economists are walking down the street and one of them sees a $100 bill on the ground. As he reaches to pick it up, the other says, “Don’t bother. If it were real, someone would have picked it up already.” This joke illustrates the ridiculousness of the efficient market hypothesis. The efficient market hypothesis states that the market responds instantly and perfectly to new information. It’s simply not true. Besides allowing room for investment arbitrage, we also end up with sticky markets, wherein wages or prices or other such things will not change instantly. We generally don’t really respond to this particular market failure. It’s true we like things to be efficient, but increasing efficiency in this respect will have more to do with overall advances in the way entire markets and their transactions are handled. There really isn’t a good way, right now, to fix this failure, and the failure really isn’t causing that much harm in inefficiencies, but it is technically a point in which the market does not work perfectly.
National Income Misallocation
This comes from MPC differentials. When you're poor, your marginal propensity to consume (the proportion of your income you spend) is something like 99.9% of everything you make, primarily on survival necessities like housing, food, utilities, etc. That money immediately contributes to the return on investment of someone who owns a business, who has a very high probability of making more money than them. Take any owner of a Wal-Mart, for example. That business hires people using that money, that's true, but over the course of the immense number of transactions that take place over the entire nation for years, the cash flows are gradually flowing in an upward direction. Some of it comes back in the form of investments. In fact, that's the primary way people become rich - they own the stuff that other people use in order to generate a return on investment. They'll invest in a company via stock, bonds, through venture capital, possibly as a silent partner. As you generate more income, your marginal propensity to consume goes down, and your marginal propensity to save (MPS; the proportion of income you save) goes up. That money is reinvested in ways that generate more money. Great, but not all of it is reinvested, and not enough of it is generating the multiplier effect necessary to maintain sustainable growth. As more money is stored in banks, more money must be kept in reserve in order to meet fractional reserve requirements especially during a boom when fractional reserve requirements are increasing in order to control inflation (which contributes to the steady real income, rather than cycling with the nation’s business cycle), and more money gets sent overseas into tax shelters, and so forth. The money that is reinvested tends to very much be traded among other investors, much of it going into tech that increases efficiency utilizing fewer people and fewer jobs but generating higher return on investment. Some of it creating jobs, but it’s insufficient, particularly when much of the time that money is spent to influence politics, causing policy that is contrary to good economic policy. That, and rampant ignorance. Why we hire lawyers to run an economy and not economists... I suppose they're just more charismatic. In any case, lobbyists, hard and soft campaign contributions, cushy jobs after out of office, insider information on investments, etc. All these things are used to take advantage of the greed and ignorance rampant in politics, and to engineer social opinion in a way that generates, you guessed it, higher returns on investment. The entire Tea Party movement can thank its existence to the Koch brothers, for example. The Mohawk Valley Formula was the first systematic method of turning public opinion against labor unions to break-up strikes. Things like that. This also has the impact of reducing power in labor negotiations for two reasons. First, it reduces the power of collective bargaining. Second, having little money and with few jobs available, people will accept anything out of desperation, most of them. Real wages have been stagnant for 98% of the population for decades, until 2008 when they went down. All the while, executive salaries are not only increasing, on average, but they're increasing at a faster rate than the corporations they run. They're getting paid more for performance. Another result of inability to invest among a large percentage of the population, is a lack of understanding regarding how. There is much less diversification of income streams among much of the population compared to those with the money to make it happen. Only about half of income for the top 98% comes from their job wages. The rest comes from investments and self-employment (eg. consulting, writing books, etc.) This makes the majority of people very dependent on their job, giving them little negotiating power when people are in competition for the same jobs. This lack of financial understanding also tends to result in bad financial decisions regarding spending, budgeting, investing, and borrowing. So, it's a massive cycle that results in an ever-increasing socioeconomic disparity. This is the difference between pre- and post-Great Depression economics. The philosophy of pre-Great Depression economics was that “supply created its own demand”, under the belief that people and companies would continue to invest in jobs so long as it generates a return on investment. As noted, that doesn’t work. Thanks to The New Deal, we came to understand that “demand creates its own supply”; I promise you, that so long as someone is willing to spend their money, there will always be someone available to profit from them, regardless of all other factors. Just look at the War on Drugs; the global drug trade is the second largest global industry (second only to weapons), yet despite all the resources being allocated to stopping supply, that supply persists so long as people generate the demand.
To fix this market failure, think of the economy as a huge engine with lots of moving pieces. Money is a measurement of value that facilitates transactions, allowing the pieces of the economy to move smoothly; it works like oil in an engine. When the money dries up from any sector in our national economy then, like an engine without oil, everything seizes. It happened during the Great Depression, and it happened in 2008. That’s why this particular market failure must be fixed with an oil pump – to keep things moving in way that maximizes growth. To accomplish this, we make the government pursue the same activities as capital investors – we pursue return on investment. A government doesn’t have a job it can rely on for income, so if income decreases it must do the entrepreneurial thing, and invest. The same is true even for people with jobs, really, as we should each be working to maximize the return on investment of our savings (if you’re generating 0% interest on your bank account, go shop around), but many people don’t realize that for the reasons listed earlier. In any case, a government is successful when its people and companies are successful. When this occurs, we’ll know it because tax revenues will increase without actually raising tax rates. So, if we want to stay out of national debt, we pursue that success. You see, no matter how much or little we spend as a nation, if we’re still generating negative returns on expenditures as we have been, it’s still going to drive us into debt, as it would any investor. So, in order to resolve this, the government would, in an uncorrupted system, continue to spend so long as it can generate positive returns on investment higher than that achieved by private sector investing. This will create growth that facilitates success for all sectors, such as through infrastructure for communication, transportation, energy, utilities, defense, and so forth. These are all things that facilitate growth; they create a lot of jobs with a very high multiplier, given that so much of every dollar spent is then re-spent to create business revenues (remember, high MPC with construction jobs), while also cutting costs because of the increased efficiency that results from utilizing the available public infrastructure. So, when done right, it can stimulate demand in the short term through employment measures, while increasing our total long-term production potential. Of course, the natural implication of this would be the creation of a body whose main focus is on increasing government efficiency; implement quality control, lean operations, minimize waste and optimize efficiency. To do that, it would continue to spend money until the savings it generates in improved efficiency is no longer greater than the cost, ensuring on, as is the trend, return on investment. This makes the old-and-should-have-been-dead-already argument of more or less obsolete, as we focus on better. This takes care of many other market failures, like public good and helps to manage volatility, as well.