Market Failure: The Case Against Unfettered Markets

Conservatives and libertarians in the United States have long venerated free markets and laissez-faire economics as a governing force in modern society.  Free individuals in a free market, the theory goes, will create more prosperity more efficiently than when the government is involved.  This free-market worldview sees any form of government intervention – from taxes to subsidies, regulations to tariffs, and even investment and infrastructure – as distortion of the free market and the cause of many of our societal ails.

As a student of economics and public policy, I believe in free markets and consider myself a capitalist.  But both in theory and in reality, free markets have serious limits.  The term “free market” implies a functioning market that efficiently maximizes value.  In this essay, I will argue that many conservative free market advocates and their policies are ignorant of or ignore critical micro-economic free-market concepts, specifically the concept of “market failure”.  I will introduce various forms of market failure and show how these forms reduce market freedom, efficiency, value, and prosperity.  I will then discuss policy examples that are the subject of current political debate and that illustrate the importance of understanding the economic theories that explain why free markets alone will not maximize value, efficiency, and freedom as many believe.

My purpose is not to simply argue that government intervention is required to solve the problems associated with unfettered free markets.  I acknowledge that, while government intervention has the potential to address market failure, such intervention will almost always create its own inefficiencies that must also be evaluated.  Rather, my purpose is to argue that it is clearly, demonstrably, inarguably incorrect to assume that the free market can address these failures without some kind of intervention.  By extension, it is false to claim that less government intervention will always increase freedom and efficiency.  Political actors and policy approaches that fail to take this reality into account are many in number and are not based in fact.

(Note: Economics is a complex study.  The economic principles discussed below, while critical to policy discussions, are only an introduction and are far from exhaustive.  I have included some video clips at the bottom of this article that describe some topics in greater detail, but those too are introductory in nature.  While these topics are complex, I firmly believe that anyone with opinions about free markets, regulations, and the proper role of government should understand at least the basic concepts addressed in this essay.)

Free Markets and Market Failure

Free market economic theory is largely based on the idea that individual actors (persons, companies, buyers, seller, producers, etc.), acting rationally in their own individual interests, create a result that maximizes efficiency and overall benefit for all participants.  Supply of and demand for a good or service will result in a market price that reflects all the costs and benefits of a particular transaction, maximizing the benefit received by suppliers and demanders involved in the transaction.  Marginal value and marginal cost are equal at this price, and benefit is maximized for all.  As the theory goes, the more individual freedom in society, the more prosperity due to the “invisible hand” that guides markets to millions of prosperous transactions.  Unfortunately, this is where common understanding of economic theory ends.  Missing is an understanding or acknowledgment of the collection of concepts known as “market failure”.

Market failure refers to situations where the efficient outcome expected from free market transactions does not occur; Individuals, acting in their own self-interest, create a result which is sub-optimal and inefficient.  In other words, market failure is a situation where the free market outcome reduces the overall welfare of society.  Causes of market failure broadly fall into several categories, each discussed in their policy context below.  Understanding market failure is critical to understanding how the free market works and why free markets cannot properly function without intervention.

Externalities

“American families and small businesses now stand to face higher electricity bills, and they have this administration’s policies to thank” – John Boehner on EPA rules targeting mercury and other emissions from coal fired power plants

Part of the ostensible magic of the free market is its promise to create transactions that incorporate all of the costs and benefits involved, resulting in a market price and quantity for a good or service that optimize collective value and benefit for all market participants.  If the market price is higher or lower than this “allocatively efficient” price, then suppliers and demanders will buy and sell too much or too little of their good or service, and the optimal collective value is not achieved.  Externalities result in this type of inefficient pricing and resource misallocation.

Energy markets provide familiar examples: When you buy a gallon of gasoline, the market price of a properly functioning market would reflect all of the costs of supplying that gallon and all of the benefits of purchasing that gallon. But market transactions regularly fail to fully include the costs of supplying or consuming gasoline.  Because the full cost of supplying gasoline to the market is not reflected in the price of that gasoline, the resulting gasoline price is artificially low, which results in more gasoline consumption than is allocatively efficient.  In the example above, there are significant spillover costs, or “negative externalities”, that result from the transaction but are not reflected in the market price.  For example, direct taxpayer subsidies artificially reduce the cost of producing the gallon of gasoline.  Likewise, gasoline production and consumption result in huge environmental costs that end up in our health care bills.  There are myriad estimates of these external costs, but to site one study in California, air pollution (largely an externalized cost of the market for fossil fuels) costs the California economy  $28 billion in 2008, or approximately $800 per man, woman, and child.  Policy focus and discussion regarding gasoline prices should always acknowledge that gasoline prices are based on the failure of the market to properly account for these costs and that externalized costs should be included in the real price of gasoline.

Markets also fail to fully include the benefits of many goods and services.  These “positive externalities” include benefits that society receives from a particular transaction.  An example of this is the market for flu vaccinations.  The individual decisions to purchase flu vaccinations result in benefits for those individuals that, combined with the cost of producing the vaccines, result in a market price for the flu vaccine.  However, society also benefits from those individual decisions, and those benefits are not reflected in the market demand, resulting in a market clearing quantity that is too low.

The inefficiencies created by this form of market failure means that society is worse off due to the market’s inability to deal with externalities.  Reliance on the market in this case results in less prosperity than if markets correctly priced goods and services based on their full costs and benefits.  To address this form of market failure, governments implement policies to internalize the costs and benefits of producing/consuming various goods and services.  Pollution regulations, gasoline taxes, and subsidizing vaccinations are examples of this kind of policy.  As discussed later in this article, government intervention to address externalities also often results in inefficiencies, but it is incontrovertible that the free market result is inefficient due to this form of market failure.

Information Asymmetry

“Frankly, it seems to me that whether I’m buying an apple or a Big Mac from McDonald’s, if they want to sell it to me without any information, I have a perfect right to buy it.  This simply is not a federal issue.” Sam Kazman, general counsel for the Competitive Enterprise Institute, a free-market advocacy group.

For a free market transaction to result in an efficient outcome that maximizes value for all participants, information must be freely available to both the buyer and seller.  In real life, this is often not the case.  When one party in a transaction is privy to information denied to the other party, the resulting transaction is inefficient and reduces overall prosperity.  This form of market failure is called information asymmetry.

For example, assume that David wants to buy a car from Michelle in a free market.  Michelle, after much investigation has discovered that the car will soon need a new transmission, but withholds that information from David.  David purchases the car based on missing information for a price higher than he would have had he known about the transmission.  The market price derived in this example does not maximize value for David and is a form of market failure.  In response to this form of market failure, governments have established consumer protection laws, such as “lemon laws” that address the market-distorting asymmetry of information.  Non-governmental intervention can also address this form of market failure.  For example, social reviewing communities such as Yelp.com could warn David of Michelle’s devious practices, though that would be of little help to the first of Michelle’s customers.  This last point is often why non-governmental intervention is viewed as less preferable, since there is frequently some cost involved that society is unwilling to pay (for example, we prefer to outlaw toxic chemicals in children’s toys rather than to simply wait for companies whose products poison children to go out of business due to bad Yelp reviews).

Without intervention, information asymmetry in a free market can produce results that reduce the overall value and welfare of market participants and lead to an inefficient outcome.

Public Goods

“If you don’t pay the 75 dollars then that hurts the fire department. They can’t use those resources, and you’d be sponging off your neighbor’s resources.” – Glenn Beck scolding Gene Cranick of Obion County, TN, who sat dismayed while the South Fulton Fire Department watched his house burn down due to his failure to pay a $75 firefighting fee.

Another form of market failure is in regards to the under-provision of public goods.  Public goods, such as national defense, mosquito control, or lighthouses, are goods that are non-excludable (meaning market participants cannot be excluded from using them) and non-rivalrous (meaning that use by one market participant does not diminish use by another).  Markets fail to provide public goods due to the free-rider issue: it is in each individual’s self-interest in a free market not to pay for the public good, since it is non-excludable.  For example, markets cannot effectively provide national defense because it is not practical to exclude those who do not pay taxes.  Left to the market, national defense would not be adequately provided.   This form of market failure is the primary reason why governments typically intervene in the provision of public goods.

Tragedy of the Commons

Articles on republicans wanting to privatize: http://www.news-record.com/content/2012/02/17/article/gop_rush_to_privatize_demeans_our_public_assets

“We need to actually sell off some of our national parks”— Rep Cliff Stearns, (R-FL) who supports privatization of national parks.

Another form of market failure, called Tragedy of the Commons, refers to the market’s inability to deal with “common resources”.  Like public goods, common resources are non-excludable, but rivalrous, meaning that use by one market participant diminishes use by another.  A good example may be a forest used by surrounding individuals for firewood and building materials.  While it is in the collective interest of all surrounding individuals to limit harvesting of the forest to a level that maintains the long-term health of the forest, it is in each individual’s interest to take as much wood as they need.  Stated another way, each individual gets the full benefit of over-logging, but faces only a fraction of the cost.  Everyone over-logs and individual “rational” behavior results in overuse and collapse of the common resource.  Free markets thus fail to effectively manage common resources.

High Barriers to Entry and Tendency Towards Monopolies

“Someone has to stand up and call this what it is—a rigged system designed entirely to protect and perpetuate the two-party duopoly” – Spokesman of Governor Gary Johnson, on Johnson’s anti-trust lawsuit against the Democratic and Republican parties for not allowing third parties into the Presidential debates.  Johnson is the 2012 Libertarian Party candidate, whose party opposes government intervention in markets, including anti-trust laws.

In order for the free market to deliver on the promise of producing efficiency and maximizing value, competition must exist to the extent that no single supplier can control price.  To maintain a competitive market where suppliers are price takers, the cost of entry into a market must be sufficiently low to allow numerous suppliers into the market.

In reality, many markets move towards less competition, with high barriers to entry that result in a tendency towards monopolies.  This market tendency prevents market forces from efficiently allocating resources and the result is a reduction in value and prosperity.  Many governments attempt to address this by implementing anti-trust laws designed to prevent monopolies from forming.

Market Failure and Policy Issues – 5 Examples

As discussed above, there are a number of forms of market failure that impede the ability of markets to efficiently or effectively allocate resources to the detriment of society.  But what is the relevance of these concepts as it relates to today’s important policy issues?  Below, I discuss five policy examples and how understanding market failure will impact positions on those issues.

Energy Subsidies

Opponents of clean energy subsidies such as the 2.0 cents per kWh Wind Energy Tax Credit call such policies corporate cronyism and decry the distorting effect such subsidies have on electricity markets.  Without these subsidies, they argue, wind power could not compete with the market price of coal and natural gas powered electricity.  Let the market select winners and losers, they argue.

The fallacy in this policy position is that the market price of coal and natural gas do not correctly reflect the actual cost paid by society.  Due the negative externalities of coal and gas, the true cost of production and consumption is higher than the market price, and thus the price is artificially low.  As one very thorough study of these external costs conducted by the National Academies concluded, the price of coal power electricity actually costs society an additional 3.2 cents/kWh in addition to the market price.  Thus opposing a 2.0 cent per kWh subsidy while accepting the hidden 3.2 cent per kWh subsidy society currently pays in hidden costs for coal power is a fallacious position that pushes for less market freedom and efficiency.

Funding for K-12 Education

Education funding has not escaped the political malaise that has inflicted Washington, and opposition to increased education spending abounds even as the American education system continues to under-perform that of other countries.  Free market ideologues, including Mitt Romney, still advocate for privatization of the education system and decry government spending on education.

The market for K-12 education presents an example of how positive externalities distort a market.  Education markets have significant spillover benefits to society, from crime rate and poverty reduction to contribution to R&D and various health and fertility benefits, which are not reflected in the market price.  Because of this form of market failure, markets would under-provide education.  By subsidizing education, governments ensure that education is adequately provided and the spillover benefits maximized.

Posting of Nutritional Information in Restaurants

The food industry and their backers in the government have long opposed nutritional and ingredient labeling of food products.  From bakers who oppose labeling of sugar content to farmers groups who oppose labeling of genetically modified foods to restaurant groups who oppose labeling of restaurant menus, these industries fear the change in consumer behavior when provided with such information.  Theirs is a legitimate concern.

Due to information asymmetry, a form of market failure, suppliers of food products have more information about their products than do consumers.  This information asymmetry leads to a breakdown in the market as consumers make sub-optimal decisions about food consumption based on a lack of information.  With more information, consumers can make decisions that better reflect their individual preferences, and the resulting market outcome is more efficient and maximizes total value for market participants.  This is why health advocates have long pushed for policies that require the posting of nutritional information on food products.  In this example, laws requiring food labeling actually increases the freedom and efficiency of the market.  To oppose food labeling laws without an effective alternative to address the information asymmetry that results is thus to oppose a truly free market.

Insurance Exchanges

The idea for Insurance Exchanges where consumers can shop for and purchase health insurance across state lines was first popularized by the conservative Heritage Foundation in response to Hillarycare in the 1990s.  Since President Obama adopted this idea in his signature health care law, “Obamacare”, conservatives have opposed the idea as unnecessary government intervention into health insurance markets.

Insurance Exchanges are designed to address the lack of competition in the market for health insurance.  Due to the tendency towards monopoly, a form of market failure, health insurance markets in many states are dominated by one or a few insurance providers (ex. two providers control over 70% of the insurance market in 24 US States).  By opposing health insurance exchanges as unwelcome government intrusion, free market proponents are effectively arguing for markets that are less free.

National Parks

Free market theorists have long advocated for privatization of national parks (this is not the same as privatization of park management, a separate issue).  The argument goes that markets can do a better job of valuing parks and allocating park resources than can government.

National parks are both public goods and common resource.  As public goods, market failure results in an inability to effectively manage the allocation of the public good.  As common resources (to the extent that the park is used for harvesting of timber or other goods), market failure results in an over-use of the resource.  In both cases, intervention is required to preserve the sustainability and public access to national parks.  Even advocates of privatization of national parks (cited in the previous paragraph) agree that privitization may result in residential or other non-park development of privatized national parks.

The Case Against Unfettered Markets

“A new spirit of pragmatism surely requires that we discard the metaphor of market determinism — whole and entire. No more, let us bow and scrape before that altar. Markets have their place — they are a reasonably open and orderly way to assure the distribution of services and goods. They are not a general formula for the expression of social will and the working out of social problems.” – James K. Galbraith, “Towards a New Pragmatism

The analysis above is less a case for government intervention than it is a case against unfettered markets.  Due to the forms of market failure discussed in this essay, it is clear that markets often create results that do not increase freedom, well-being, and efficiency as expected by many free market advocates.  While one can devise non-market solutions to market failure that do not involve central governments, in each case the resulting collaboration required to address various forms of market failure has many of the characteristics of government.  For example, a neighborhood association may pool resources from residents in order to pay for mosquito control (since, as a public good, the market will not supply this good as discussed above).  However, it is questionable whether this arrangement is materially different or more effective than a similar effort by the local or state government.  In either case, it is folly to assume that the market will simply provide such a service, as markets cannot address market failure without some kind of intervention.  Understanding and considering the realities of market failure is thus critical to devising policies that deal with important issues ranging from energy to education to health care, and blind reliance on markets alone will without question result in less freedom and prosperity for our society.

 

 

 

 

Videos on Economic Topics Discussed:

 

Equilibrium & Efficiency in Competitive Markets

 

Negative Externalities

 

The Tragedy of the Commons

 

Monopolies

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One Response to Market Failure: The Case Against Unfettered Markets

  1. Impressive publish! STICK WITH IT!

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