Sunday, March 05, 2006


Sometimes, Markets Fail

If this blog's raison d'être is to expose economic fallacies, then I think we should remember a popular fallacy often committed by we market supporters--we forget that sometimes, markets fail.

I think the Erie Canal might be an example of such market failures. Here is an excerpt from David Gross' review of Peter Bernstein's recent book on the canal: Wedding The Waters.

The canal, which would ultimately follow the path of the Mohawk River from Albany inland, had to negotiate two big sets of falls and a larger set of obstacles. A private corporation chartered to build a canal—the Western Inland Lake Navigation Company—had difficulty raising money.

The Erie Canal was an engineering triumph, to be sure. But Bernstein notes that it was also an economic triumph. This was one of the first great American examples of network effects. Connecting more and more people through a system makes the individuals more productive and capable and makes the network itself a powerful economic force.

The canal made possible the settlement of the upper Midwest and transformed the nation's "primary axis from north-south to east-west." Clinton's ditch turned canal towns into seaports, the Hudson Valley into an industrial zone, and the Midwest into a breadbasket. In the quarter century after the wedding of the waters, the nation's growth rate rose to a whopping 4.6 percent a year, compared with 2.8 percent annually for the period from 1800 to 1825.

Left entirely to its own devices, the private sector likely never would have produced the Erie Canal, the railroads, the interstate highway system, or even the Internet.

Click here for the rest of the review

I don't know if the point about market failure is Gross' or Bernstein's, but I might have to agree. There are three possible reasons I think the market could have failed here.

1) Positive Externalities: Profit Maximzing Firms make decisions based solely on their "personal benifits". For things like a canal, there are social benifits that the firm will not benifit from, and when transaction costs are high fewer canals will be built than "socially optimal".

2) Imperfect Capital Markets: I have my doubts about how well capital markets in 19th century New York co-ordinated decisions between savers and borrowers. But that is a historical question and I might have a poor impression.

3) Hold-Out Problem: The canal is fairly long and after it has been started there is only a few directions it can go. This could lead opportunistic land owners to bid up the price of their land above its opportunity cost, which discourages building a canal. A similar problem can occur even if the company tries to acquire all the land before construction, if the land owners find out the canal firm's intent for the land. The government can get around these problems through the imperfect solution of eminent domain.

I'm not totally convinced about my third point. While Hold-Out can be a problem, there is a variety of ways for private companies to get around the problem. Click Here for a paper on the exageration of hold out problems.


Now I should point out that this doesn't mean that government SHOULD try to pick winners in the investment game. If we look at government programs that try to do this, the NIST Advanced Technology Program for example, we see that this approach can lead to a lot of wasted money. But I think we should recognize the fact that markets are not perfect. Anything less is pure fallacy. :)

I agree that markets are not perfect -- nothing is.

But, I am not sure if you can say that markets fail, since we only know that things exist as they do after the government has intervened and created it.

We can never know what would of happened and whether or not the amrket would of creating things like they are today.

And if markets do fail, is private market failure a "greater good" than government failure, since there is no check on or corrective mechanism to "fix" it.

It's a thought
How exactly is "Market Failure" determined? Does that simply mean that in some particular circumstance, the market didn't maximize utility? Or not provide the socially optimal outcome?

How can something with no pre-determined direction or goal "fail" to achieve it?
Well, in the same way we can't "prove" markets work. That is the unfortunate thing of not being able to preform controlled experiments on the economy.

But I would agree that it doesn't follow that the government should step in every instance of market failure (though I personally believe it should step in sometimes, like to provide national defense).

I would also point out that my criteria for failure might be suspect, since it is based upon traditional Kaldor-Hicks definition of efficiency. That might be too "utilitarian" for somepeople.

But inspite of all these points, we can still conclude that it is possible for individual markets to tend toward a position where people as a whole are not aswell off as they would be if certain problems were not present (like those I listed).

Whether the Erie Canal is an example of market failure, I'm not sure, but I think it is a strong candidate.
If the goal of the market is to "tend toward a position where people as a whole..." are better off, then you're right; markets can fail.

If there is no goal, I don't see how "failure" is really possible.

If we can't (externally) determine the goals of other human beings, how can we determine the goals of the aggregate of human behavior that the market represents?
1) Like I said, you might have a different criteria for failure, but that doesn't change the outcomes of the market.

2) If there is no goal, then there is no reason to evaluate markets at all (that I can see).

But let me say that goals can concern other things than outcomes.
One potential goal for the market might be to enable free trade among individuals. And its responce to market outcomes would be to argue "but they are free and that is the only thing that matters!!!!"

Personally, I wouldn't buy that argument. It is a political slogan, and not a workable criteria for evaluating markets. But that is one example.
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One potential goal for the market might be to enable free trade among individuals. And its responce to market outcomes would be to argue "but they are free and that is the only thing that matters!!!!"

Explain that for me a little bit more. I am not sure if I fully understand.
In my public policy class we started with Kaldor-Hick and efficiency, then slided down towards notions of distributional effects and "justice" and the trade-offs between equity and efficiency.

We then pointed out how markets purportedly "fail". Under all of those arguments (assymetric information, transaction costs, externalities, and others) they never looked at the long run. All of the arguments were static and not dynamic in any way.

It would seem that when a proper analysis of market failure is done it will atleast look at more than one period of time and take out predetermined conclusion that there is a market failure if any of these "reasons of failure" exist.

I think this is an interesting topic that gets very little actual discussion.
I was just trying to think of "potential goals" for the market that were not dependent on market outcomes (outcomes as measured by quantities produced).

I thought another goal might be to provide people with a way of freely exchanging goods, the market being evaluated on how "much freedom" it gives its participants.

Maybe that's a bad example. But my only point is goals don't have to be outcome-specific. But, then agin, Jenna might mean something different when she's talking about goals.
I agree on your point that this is a static criteria, and that does pose some problems. I know that is a common Austrian critique of mainstream Welfare Economics. But I think it is often exagerated.

No one really believes that the market starts and ends in our little supply-demand-model. Like McElroy would say, these are stories describing how the world works.

Our professors go to great pains to illustrate this fact. They constantly tell us that markets only tend toward equilibrium and they try to add some dynamism using stories of how equilibrium is obtained over time (ussually an auctioneer story) and by using comparative statics (before-and-after static stories) to show how equilibriums can change.

In the end, if an individual markets tend toward equilibrium, and that equilirum is characterized as less than "socially optimal" (so defined), then it is easy to say that market will tend toward a less than socially optimal outcome.

This characterization is directional and not necc. static.
Now I have to admit market failure is very difficult to prove in the real world, but then again, so is everyhting.
Taking from Prof. Cordato's comments at lunch, here is a good question:

How do you define market success?

Also, here is a little addition to this discussion. It is from Sheldon Richman's blog Free Association.
Also, Rothbard on the "Myth of Efficiency".
In response to your first question, I suppose a "success" would be the opposite of failure. ;) meaning that the market tends toward an "optimal" outcome.


Nice Rothbard article, but I think his critiques are far less damning than they seem at first.

Let me see if I can paraphrase him correctly.

1) Cost-benefit calculations are not a substitute for ethical deliberation.

2) It is impossible to objectivley make welfare comparisons between people. So the concept of efficiency is useless.

With regards to number one, I've made the same argument myself. With regards to two, let's say I thought he was 100% correct (some days I do). That still wouldn't change my mind about efficiency. I might simply put on my Coase-hat and argue that using efficiency estimates to justify daily interventions with the market is unwise, but that the concept of efficiency and the other tools of welfare economics can inform how we construct our institutional structure.

On other days, I believe that we can find examples of where the market has failed by estimating costs and benefits. It is a rare occassion, but I think an example like the Erie Canal is a good candidate. Like I said, this all depends on my mood, which is either encouraged or discouarged by the cost-benefit analysis I see on the job.
Can't you "construct our institutional structure" without making interpersonal utility comparisons?

Why not just make an institution designed to protect justice: life, liberty, and property?

No need to actually compare interpersonal utility. I think my statement might be confusing. I only ment that institutions (like the legal system) might be better for settling these disputes and achieveing "socially optimal" outcomes than the cost-benifit-guided redistributions that Rothbard pretends "mainstream economists" long for.

Maybe Coase's nobel lecture will give you a flavor of what I'm talking about.

As far as life, liberty, and property go, that might be a viable approach, but that isn't what I'm arguing. I am only saying that one can still agree with Rothbard's two major criticisms and STILL find efficiency an appropriate (or at least informative) criteria.
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