Professor Joe's Blog Lecture: Market Failure 101

Today, I have to read my stuff for Representation, come up with a term paper proposal for that class, and start my statistics homework on maximum likelihood estimation. I should probably also exercise.

Ok, topic today: market failure, 101.

One useful lens through which to view societies is through a "3 failures" framework. This is just a heuristic. It's sort of like social contract theory; nobody actually believes that there was some primordial time when humans got together and said "ok, we're gonna give up some power in exchange for some security. Ready? Go!" This 3 failures framework is sorta like that.

So, in this framework, each sector (private, public, and nonprofit) has certain types of things that it's good at, and certain types of things that it's bad at. The idea is that each sector sort of plugs the holes where the other two sectors fall short. Conceptually, it's easiest to start with markets.

So, what are markets good for? Lots of things. Economists on the left and the right, from Adam Smith to John Maynard Keynes, generally agree that a perfectly competetive market maximizes the social utility that can be extracted from a given set of resources. Another word for this is "pareto optimality." Nobody could be made better off without making somebody worse off. And, "as if by an invisible hand," this all happens automatically. Simply by humans making self-interested rational decisions, the social utility function is maximized. No central planning necessary (which is good, because with 300 million people, it's virtually impossible for a central planner to predict what everyone's gonna want).

The problem lies in the densely packed phrase, "perfectly competetive." There are a long lists of assumptions that have to hold for this outcome to be guaranteed. They are (if memory serves me correctly):

1. well-defined property rights
2. a predictable legal system to enforce contracts
2. perfect information for all parties on the quality and quantity of goods
3. No barriers to entry or exit from the market

When one or more of these conditions do not hold, the market is no longer guaranteed to reach a pareto efficient outcome. There are a certain subset of these circumstances that are referred to by the buzzword of "market failure." I'm gonna sketch out what those are.

Regarding property rights, there are two characteristics that can classify any kind of good or service. These are its degree of rivalry and its degree of excludability. A prototypical private good (your shoes, for instance) are both rivalrous and excludable. Rivalrous means that, when you use the shoes, it's impossible for anybody else to use them (obviously...two people can't wear the same shoes at the same time). Also, they excludable; even when you're not wearing your shoes, it's easy to keep people from taking them. So, when a good is rivalrous and excludable, the property rights surrounding it are very clearly defined (which is one of the necessary condtions for reaching pareto efficiency).

However, not all goods are rivalrous or excludable. A rivalrous but non-excludable good is often called a "common pool good." A non-rivalrous but excludable good is often called a "toll good." And a non-rivalrous, non-excludable good is often called a "pure public good." Let me see if i can find a good two x two table to post as an illustration...ok, here's one.

For these goods, the market will not automatically produce efficient outcomes. The common pool resource will be overused, because it's not excludable (fisheries, for example). This is often referred to as the "tragedy of the commons." The toll-good...i actually forget what the problem with these are, but I remember there is some distortion in supply and demand. And finally, the public good will just not be provided by the market. Why? Because everyone benefits for it, regardless of whether or not they pay for it. This is known as the "free rider problem," or a "collective action problem."

Elinor Ostrom (who helped found my program) just won the Nobel Prize in economics for her work on common pool resources and the management thereof (she stakes out a middle position between privatization and government takeover of the resource, looking at effective community management strategies). For pure public goods, the government needs to provide the good. That's not to say that government has to PRODUCE the good, but at the very least, government has to at least pay for it. The market will not spontaneously produce a pure public good.

Ok, this is getting pretty long. I'll stop there for now. I'll move onto externalities, information asymmetry, moral hazard, adverse selection, and natural monopolies next time.

Conclusion: markets often work well, but for some kinds of goods, they don't, and sometimes total social utility can be increased if government provides those goods (though this is not guaranteed either).