I freely admit that I have a faith in free markets that few possess. Yet anyone who believes that markets are perfectly efficient or result in an optimal condition or some kind of utopia is utterly naive. Such conditions don’t exist in the real world. However, it is equally wrong to believe that market failures are common, an assumption made by mainstream economists today.
There are two problems with the mainstream view that market failures are common. The first problem stems from the mainstream definition of a “market failure.” Economists define a market failure as anytime an outcome is less than perfectly efficient. Perfection is a pretty high bar. And I’m sure you can also appreciate that equating the word “failure” to anything less than utter perfection is a little bit unfair, demonstrating both mainstream economics’s misunderstanding of markets and its inherent anti-free market bias.
The second problem is to identify a “market failure” in situations where no market actually exists. As we’ll see in a minute, this is more frequently the case when discussing so-called market failures such as externalities and public goods.
What do economists mean by market failures? There’s a number of broad categories and I’ll very briefly address the ones that are most common. First, that individuals are irrational. As I’ve already discussed in Myth #1, this is viewed as a market failure justifying government action.
A second type of market failure is what is knows as information asymmetry. For example, if I am a used-car salesman and you are in the market to purchase a used car, I clearly have more information about the cars I have to sell than you have about the car you might buy. That I might be less than scrupulous and sell you a lemon of a car is considered a market failure and justifies to most economics government involvement in this transaction through regulation. Yet, there are plenty of free market solutions that do a much better job than the government of dealing with information asymmetries. These include reputation, branding and marketing, consumer agencies, consumer reviews, civil/tort law and insurance.
Simply put, information asymmetry is the every day state of the world. It is impossible (except in silly economic models) for all parties in a transaction to have perfect information. But as long as a transaction is fully voluntary to all involved parties, information asymmetry does not represent a market failure.
Another commonly assumed market failure is the natural monopoly. Monopoly is indeed the enemy of free markets. Yet, in a free market, there is no such thing as a natural monopoly. Over the long-term (and that long-term need not be very long), the free market will always provide incentives for innovation that will result in substitutes and break a short-term monopoly. This is true even for industries requiring substantial investment and exhibiting substantial economies of scale, such as transportation (e.g. roads and railways), utilities and telecommunications networks. The only monopolies that can subsist are those that are government created, government sponsored, government subsidized or government itself.
A fourth category of market failure about which economists are fond of speaking is externalities and public goods. A prime example of an externality is over-fishing, which is sadly all too common in waters that have no ownership. Paradoxically, inefficiencies cause by over-fishing is viewed by economists as a market failure when it should be viewed as a failure of government to create a market. You cannot have a market failure when you have no ownership of the underlying assets. Timber is a good example. Where forests have no private ownership you see over-foresting. Where forests are owned by private enterprises you do not.
There is no question that externalities such as over-fishing, environmental damage, pollution and global warming are big issues to communities large and small. But to use these examples to shout “market failure” in the absence of a market is wrong and unfair.
That last type of market failure that I’ll briefly mention is the economy’s ability to recover from an economic downturn. That the economy does not return to full employment is viewed by mainstream economists as another failure of free markets. We’ll discuss this issue in greater depth later on, but as a preview, I note that this view incorporates three errors: 1) not understanding the true cause(s) of the downturn, 2) not appreciating that government intervention inhibits the market from recovering and 3) faith in a very silly economic concept called equilibrium.
Before I leave this post, I want to answer the question, “so what.” Why does it matter whether something represents a market failure or a failure to have a market? It matters not so much in the classification of economic phenomena, for that is semantic, but in the remedies proposed.
Anytime economists spot what they believe to be (correctly or more than likely incorrectly) a less-than perfect economic outcome, they immediately point to government as the savior, usually in the guise of more regulation. They rarely ask themselves whether a much better outcome would be to create a market where none existed. And even in cases where that might not be possible, they infrequently bother to ask, or properly analyze, whether the government “solution” would result in even worse efficiency or outcome than the supposedly market failure itself. But that’s a story for another post.