Clearing up some confusion about ‘market failure’

Over at the Adam Smith Institute blog, Jan Boucek has a typically pugnacious article slapping down the Prime Minister for relying on ‘market failure’ as an excuse to meddle in the operations of the financial markets and the remuneration packages of leading city executives.

I sympathise with a lot of what Jan says, but I felt that the article lacked clarity on a couple of key issues.

Firstly, it seems to blur the distinction between ‘the market’ and ‘the markets’ – a very common error in current discourse. The market is an economic concept that describes the myriad of choices and exchanges that take place between people every day; the markets are the very real institutions created for handling major financial transactions. It is not clear to me that this article acknowledges that distinction. This manifests itself primarily in the title and main theme: indeed, as Jan (and at least one commentator) does tacitly acknowledge, the financial markets are so shaped by government intervention that it would be a surprise if they did correspond to a model market.

And that brings me to the second problem: the suggestion that markets don't fail when they ‘respond rationally, quickly and often brutally to conditions as they find them’. While that description is true, it has little bearing on the concept of market failure. Market failure typically refers to situations where the effects one would expect to see in a theoretical market economy do not in fact manifest themselves in real life. As the great man himself would be - and perhaps was - the first to point out (though without using these terms) markets fail because of factors such as monopoly and externality – monopolies undermine competition and so markets do not clear; externalities enable costs to be passed onto third parties and prevent all beneficiaries contributing to the production of goods. Information asymmetry is often presented as another source of market failure.

Now, to be fair to Jan, that precision of language is hardly prevalent among the politicians he is criticising. When they speak of market failure, it seems almost as though market success is defined by a number of uneconomic measures such as social justice, or even (that ultimate weasel-word) fairness. Thus, David Cameron can say with genuine conviction:

‘Where you’ve got a market failure, and to me this is a market failure, we saw between 1998 and 2010 the average pay of FTSE executives go up four times… excessive growth in payment, unrelated to success, that is frankly ripping off the shareholder and the customer and is crony capitalism and is wrong, and is also I think (the key point) payments for failure… I think makes people’s blood boil…that’s what is wrong, that’s what needs to change, and that is what we will be addressing this year.’

Whether it is wrong, whether it needs to change, and indeed whether it makes people’s blood boil may be important to politicians, but it is not, under any circumstances, market failure. There is no evidence of monopoly provision of chief executives, or of externalities that allow the cost of paying people vast sums of money to be born by those who do not benefit. Even the information asymmetry issue is exaggerated: it is not that shareholders cannot know what executives are worth, but that they choose not to exercise effective oversight. And market failure is never defined by the ‘failure’ of market participants to do what is expected of them.

The whole question of market failure is, in fact, a contentious one. A different article entitled ‘Markets Don't Fail’ might have taken an Austrian approach and questioned the neo-classical assumptions of market failure, which assume that perfect markets and perfect competition (even if never realised in practice) can be modelled and so used as a yardstick against which to measure a reality that is equally definable econometrically. It would also have questioned whether, if such imperfections were identified, it is the role of politicians to intervene to correct these failures, even where they result from individual choice.

Few people would question whether monopolies should be broken up, and I am sure that most would welcome mechanisms to internalise externalities. But government intervention to correct the effects that politicians perceive to result from market participants acting differently from how the models say we should act? That’s a pretty flimsy mandate for giving politicians power over our lives.

I made a very similar point in a blog on 9 January. The concept of "market failure" is a debatable one as it derives from the neoclassical ideal of perfect competition, but Tom is right to point out that it has a textbook definition on which students at all levels could set Mr Cameron right. Less prominent in textbooks is "government failure" which is probably much more important in reality. Interventions based on misunderstandings such as those propagated by Messrs Cameron and Cable are not going to achieve the results they hope for. Then no doubt they'll be calling for something draconian. It is all very disappointing. Frankly I am beginning to feel that the previous government understood some aspects of markets better than this lot!

It should be pointed out that there can be good economic reasons for monopolies to emerge under free-market conditions. The danger comes when governments create artificial barriers to entry that shut out competition.

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