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.]