Market failure

Market failure is a situation where, in any given market, the quantity of a product demanded by consumers does not equate to the quantity supplied by suppliers. This is a direct result of a lack of certain economically ideal factors, which prevents equilibrium. Public goods are one of the examples of a market failure.

Market failure and public goods
When Paul Samuelson first formalized public-goods theory, it was at a time when many economists subscribed to what Harold Demsetz has called the nirvana approach to public theory. Demonstrating some "market failure" with respect to an abstract optimum was considered sufficient to justify State action. Economists assumed that the costless, all-knowing, and benevolent State could simply and easily correct any failure.

Since then, economists have become far more realistic. Demonstrating "market failure" is no longer sufficient. To justify State action, one must show that the State has the capacity and the incentive to do a better job than the market can do.

Economists within the field of public choice have come to the realization that the free-rider incentive does not only arise for market enterprises. The free-rider incentive can arise for any group, especially political groups wanting to influence State policy.

Assume that a fairly large group of people wishes to change some State policy — for instance, repeal a tax. If enough people contribute money, time, or other resources to bringing about the tax's repeal, they will succeed and all be better off. The money saved in taxes will more than reimburse them for the effort. Unfortunately, once the tax is repealed, even those who did not join our campaign will no longer have to pay it. They will be free riders on this political efforts.

Just as in the case of a non-excludable good in the market, every potential beneficiary of the tax repeal has an incentive, from the perspective of economic self-interest, to try to be a free rider. If enough of them act according to this incentive, the tax will never be repealed. This result can be called a "political failure," completely analogous to the "market failure" caused by non-excludability.

The democratic State makes it much easier to enact policies that funnel great benefits to small groups than to enact policies that shower small benefits on large groups. Because of this free-rider induced "political failure," the State has the same problem in providing non-excludable goods and services as the market—with one crucial difference. When a group successfully provides itself a public good through the market, the resources it expends pay directly for the good. In contrast, when a group successfully provides itself a public good through the State, the resources it expends only pay the overhead cost of influencing State policy. The State then finances the public good through taxation or some coercive substitute.

Moreover, the group that campaigned for the State-provided public good will not in all likelihood bear very much of the coerced cost of the good. Otherwise, they would have had no incentive to go through the State, because doing so then costs more in total than simply providing themselves the good voluntarily. Instead, the costs will be widely distributed among the poorly organized large group, who may not benefit at all from the public good.

This makes it possible for organized groups to get the State to provide bogus public goods, goods and services which in fact cost much more than the beneficiaries would be willing to pay even if exclusion were possible and they could not free ride. In this manner, the State generates negative externalities. Rather than overcoming the free-rider problem, the State benefits free loaders, who receive bogus public goods at the expense of the taxpayers.

Failure of contracts
In standard theory, if one party to a contract executes his part by delivering as agreed, the other party's optimal course of action is to take the delivery and walk away without delivering his part. The first party knows this and correctly concludes that his best course of action is not to deliver. The second party knows that this is the case. Therefore the parties will not contract and the mutually advantageous exchange of deliveries will not take place.

It used to be thought that in a small-scale, 'face-to-face' society, say the village cattle market, no third-party enforcer is necessary, because no party to an exchange could risk to default and face loss of reputation and even retaliation in some unpleasant form. In large groups of 'faceless' contracting parties, on the other hand, each could default with impunity.

However, there are no anonymous contracts. Where thousands of faceless customers stream through the checkout counters of a supermarket, they have a contract with the bank who issued their credit card, and the card company has a contract with the supermarket, each party to each contract being duly named and identified. In wholesale trading dealers in the same trade know a good deal about their counterparties half a world away and if they do not, their bankers and brokers do. Default risk is shifted, often to specialised intermediaries, to whomever will assume it at the least cost because they will be best able to minimise it. For relevant purposes, the wide world is a face-to-face society, or at any rate functions much like one.

The other fact of life that standard market failure theory does not get right is that while many market exchanges are done in the form of one-off contracts that are fully executed once each party has made one delivery, many more—probably the greater part of aggregate market exchanges—is not. It is run on continuing contracts providing for repeated executions, often an indefinite number of times.

The example that first springs to mind is the labour contract, where the employee agrees to render some service week by week, month by month, and the employer agrees to pay him at regular intervals, for a period or until either party terminates the contract by giving due notice. Similar contracts with repeated delivery often govern the supply of parts and materials to manufacturers and the supply of finished goods to commerce. They typically run for an indefinite yet uncertain duration.

Unlike the one-off kind, such contracts do not obey the logic of the prisoners' dilemma where 'take the money and run', i.e. deliberate default, is the best strategy. Defaulting on any given delivery at any link of the chain of deliveries breaks the chain and normally wrecks the contract. Therefore it pays only if the gain made by defaulting on a single delivery outweighs the present value of all future gains that would accrue if the contract went on to its indefinite term.

This conclusion parallels the deduction, made by numerous theorists and therefore known as the Folk Theorem, that mutual cooperation through a series of indefinitely repeated games, each of which has the structure of a prisoners' dilemma, is a possible equilibrium.

Links

 * IP: It’s a market failure argument by Jeffrey Tucker, February 2009
 * Airport Congestion: A Case of Market Failure? by Murray Rothbard (Chapter 52 from Making Economic Sense)
 * Why Externalities Are Not a Case of Market Failure (pdf) by Brian P. Simpson, March 2003
 * The Evolution of Eminent Domain: Market Failure or an Effort to Limit Government Power and Government Failure? (pdf) by Bruce L. Benson, 2008
 * The Limits of Market Organization edited by Richard R. Nelson reviewed by Robert Murphy, 2006
 * The Theory Of Market Failure Edited by Tyler Cowen reviewed by Jeffrey A. Tucker, July 1989
 * Why Market Failure Fails by Michael S. Rozeff, July 2006
 * Airport Congestion: A Case of Market Failure? by Murray Rothbard (Chapter 52 from Making Economic Sense)
 * Why Externalities Are Not a Case of Market Failure (pdf) by Brian P. Simpson, March 2003
 * The Evolution of Eminent Domain: Market Failure or an Effort to Limit Government Power and Government Failure? (pdf) by Bruce L. Benson, 2008
 * The Limits of Market Organization edited by Richard R. Nelson reviewed by Robert Murphy, 2006
 * The Theory Of Market Failure Edited by Tyler Cowen reviewed by Jeffrey A. Tucker, July 1989
 * Why Market Failure Fails by Michael S. Rozeff, July 2006
 * The Theory Of Market Failure Edited by Tyler Cowen reviewed by Jeffrey A. Tucker, July 1989
 * Why Market Failure Fails by Michael S. Rozeff, July 2006