465. Market failures

There is a range of market failures and here I can only review a few. Perhaps the most perverse failure is when the two core virtues of markets are destroyed: freedom and variety of choice and initiative, and selecting out failures. Destruction of freedom occurs in monopolies and in the command economies of large firms. Persistence of failures occurs, for example, with large banks that are ‘too big to fail’, and in large corporations where top managers are ‘too megalomaniac to fail’, impregnable and intolerant to criticism, keeping failures hidden or propped up with internal cross-subsidies.

A widely known failure lies in so-called externalities, such as environmental degradation and damage to health (negative externalities) and so-called public goods, such as parks and street lighting (positive externalities). One reason why they are difficult to include in markets is that they are non-excludable: it is difficult to exclude users who do not pay. An example is roads, but here, with toll roads one can restrict use to those who pay, at the cost of constructing tollbooths at limited entry and exit points.

There is a range of problems that violate the assumption in market theory of full information and rationality, and independence between autonomous agents and their choices and actions. In preceding items I discussed limits to rationality, as in framing, and problems of herding, which yield financial and other bubbles that burst, and in prisoners’ dilemmas in which economic actors lock each other up in conduct that yields adverse effects (as in too risky investments).

In particular, there are problems of limited or asymmetric information. An important case is the phenomenon of adverse selection. This arises prominently in insurance, when risks are hard to judge by the insurer, such as a risk of skiing, say. The people most at risk have the highest need for insurance. Knowing this, the insurer could raise his premium, but then most seekers of insurance drop out, leaving only the worse risks. The result is that there is no price at which buyers and sellers can agree. Either the risk for a number of cases or the premium is too high.

A requirement for perfect competition is the absence of economies of scale, by which larger firms produce more cheaply than small ones. In fact, such effects are ubiquitous, in various forms, and they give an impulse to concentration of markets in a small number of large firms that can limit competition.

On a global scale, there are exploitation of labour and adverse economic and societal structural effects on developing countries. National policies for justice and human rights lack grip because multinationals are footloose, able to migrate to where conditions are least restrictive. Corporations far outrun the capability of governments to restrain them. Markets unleash forces that can become impossible to control.

Another adverse effect is that expectations on capital markets impose a short term perspective, and a focus on the interests of shareholders, whereby long term interests and public interests such as protecting the environment, are neglected. Investors and managers squeeze too much from the firm, reducing spending on innovation, to increase cash flow, which reduces innovative capability.

In the following item in this blog I will discuss the important problem of transaction costs.