“Market failure”: you keep using that term. I do not think it means what you think it means.

Lynne Kiesling

Steve Horwitz’s column in The Freeman today is a great explication of why the phrase “market failure” is so problematic, and so often misused and abused in public policy analysis when employed to criticize market outcomes. Steve does a good job of explaining the origins of the phrase in the standard textbook case of “perfect competition”: in equilibrium that simple benchmark model, resources are allocated to their highest-valued use, all Pareto-improving trades have occurred, and while firms have earned inframarginal profit, the marginal profit at the equilibrium level of output is zero. More simply, all gains from trade have been exploited and no one has left any money on the table. Thus, the argument goes, in applying that model to reality when we see outcomes that deviate from that and do have misallocation or some unrealized gains from trade, the logical conclusion is that the market has failed to enable agents to achieve that optimal outcome.

Steve highlights two reasons why this interpretation is incorrect; the first reason is a misunderstanding of the nature of competition and the market process as it operates in real conditions of the knowledge problem, imperfect foresight, differentiated products, small numbers of agents, etc. People making the above critique of markets expect a threshold of unrealistic perfection, and consequently make an unfair comparison of a simplified benchmark model with the complications and nuances of a real-world application. I encounter this argument all the time in electricity regulation, which is predicated precisely on this type of false, over-simplified argument, and has a century’s worth of regulatory institutions built upon the false presumption that achieving such a static outcome in reality is possible.

One thing I particularly like about Steve’s argument is how he points out that these cognitive-epistemological characteristics of the real world are features, not bugs, with respect to how market processes create value and gains from trade:

… these sorts of imperfections (a better term than “failure”) are not only part and parcel of real markets; they also are what drive entrepreneurship and competition to find ways to improve outcomes.  In other words, what markets do best is enable people to spot imperfections and attempt to improve on them, even as those attempts at improvement (whether successful or not) lead to new imperfections.  Once we realize that people aren’t fully informed, that we don’t know what the ideal product should look like, and that we don’t know what the optimal firm size is, we understand that these deviations from the ideal are not failures but opportunities.  The effort to improve market outcomes is the entrepreneurship that lies at the heart of the competitive market.

Thus the value of markets is not that they will achieve perfection, but that they have endogenous processes of discovery that enable people to correct the market’s imperfections.  Just as it’s the very friction of the soles of our shoes on the floor that enable us to walk, it is the imperfections of the market that encourage us to find the new and better ways to do things.

He then counters a second aspect of the “market failure” argument: this argument is typically coupled with a recommendation for some form of government intervention or regulation to “correct” the perceived failure. But if market processes in realistic contexts have imperfections, don’t government intervention and regulation have imperfections too? The relevant comparison is between the results of market institutions and government institutions in realistic contexts, not in simplified blackboard theory.

I would add a third point to this analysis. Often when I encounter the “market failure” argument I make a quick riposte of “markets don’t fail, they fail to exist”, which is the Coase/transactions cost response. Transactions costs interfere with the ability of parties to find mutually beneficial trades, thus impeding optimal resource allocation and the creation of maximum gains from trade. Transactions costs lead to missing markets, as in the case of environmental pollution and other common-pool resource situations. This driver of so-called “market failure” complements Steve’s process-oriented argument and reinforces his points … and it implies that one high-priority objective of public policy should be to reduce transactions costs, not to impose regulations that are intended to “correct” market failures but have little realistic hope of doing so effectively.

[Thanks to Aeon Skoble for the Princess Bride hook I used in the title.]

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7 thoughts on ““Market failure”: you keep using that term. I do not think it means what you think it means.

  1. I liked this post, Lynn, and will read the article.

    To note that the free market concept is an idealized abstraction I like to say “There is no free lunch. There is no free love. There are no free markets.”

  2. The pundits’ and the common man’s definition of market failure is: an outcome I don’t like. It’s much simpler than the economic definition and is infinitely flexible. I also happen to believe many so called market failures are actually regulatory failures and political failures. (But that’s because I often don’t like the outcome of regulatory or political processes.)

  3. I have thought for a long time that to become a practicing psychologist, one should not be fresh out of university and try to tell others how to solve their mental problems. One ought to have either a number of years of other work experience, or maybe a few years in the army to get a solid enough mind-set.

    Similarly, for an economist, owning and running a corner shop for a few years, or selling and buying used cars should cure the budding academic from a belief in the possibility or even desirability of perfect knowledge, rational behaviour, or equilibrium. I wonder how long it would take to reeducate Paul Krugman with such therapy.

    As a physicist by training I am taken aback by two claims. First of all that one could actually obtain equilibrium, or think in terms of equilibrium in a dynamic system, unless one is prepared to wait for a very, very, very long time after the last change was applied. But since society contains people that are born, die and act, one cannot wait for 10, 20 or 50 years for some kind of end state to be arrived at.

    Secondly, it is claimed that the mechanical view of economics comes from the physical sciences. Where it does come from is from a misunderstanding of physics. Physicists all know that what they are studying are tiny fragments of reality, one or two particles at the time, or in my case (solid state physics), atoms that are lined up in very precise patterns. To find an exact solution for one or two particles can help with the understanding of larger systems, but to make predictions for how larger systems will evolve over time is out of the question (apart from special cases).

    A physicist joke about progress in this science says that

    Already with classical mechanics, it was recognised that the three-body problem was too difficult to solve exactly. With the arrival of quantum mechanics, the two-body problem became too difficult. With the arrival of quantum electrodynamics, the one-body problem became too difficult to solve exactly. With the advent of quantum chromodynamics, the vacuum problem also became too difficult to solve exactly.

  4. Pingback: “Market failure”: you keep using that term. I do not think it means what you think it means. « Daniel J. Smith

  5. “As you wish…”

    So why do we tolerate the term “perfect competition” to describe an equilibrium situation? Not only does it not exist in real life, but it is a condition of stasis that seems anything but livable by real agents. Why not give it a semi-pejorative term such as “simple competition.” Rather than “imperfections” being departures from “perfection,” we’d have “complexities” being departures from “simple.” At least this would avoid the problem of having to defend “imperfections” as being good things. Complexities themselves are neither inherently good nor inherently bad, but facts of life, some of which are opportunities. We wouldn’t be a planet of 7 billion people (not to mention other species) without them.

  6. D.O.U.G.,

    I agree with you, well put. One should rather look at markets where something akin to “perfect competition” reigns as a symptom that something is fundamentally wrong. A state of perfect competition shows that the area is devoid of creativity.

    Also “equilibrium” means death and talking about it is a sign of lack of comprehension. This is also a fundamental misunderstanding about nature. There is no such thing as equilibrium in nature. Like on the stock market, there is massive amount of movement, but we only see the overall result that looks like some kind of “balance”. But remove a predator and a number of species will explode in numbers. Darwin calculated the rate of growth of elephants, the most slowly reproducing species he could think of. If one continues calculating from where he left off using computers, one finds that eventually, without any baby elephants dying, the whole earth becomes a sphere of elephants, expanding outwards at the speed of light.

  7. Pingback: Market Failure, Behavioral Economics edition | Optimal Behavior

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