17 Oct 2008

Is the Current Mess a Sign of "Market Failure"? Stealing from Myself

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I realize this is lazy, but oh well. I just wrote a fairly comprehensive email to some colleagues, complaining about the ease with which people are throwing around the term “market failure” to describe our current mess. Besides the fact that (in my opinion) there were all sorts of government policies that caused/exacerbated the situation, there is also the fact that the charge is a sloppy use of terminology. And now we go to the email–and I’ve even left in the asterisks, rather than switching it to italics, to retain the authentic “email feel”:

“Market failure” has a very specific meaning in economics. It means that people in the market aren’t taking full account of the social benefits and costs of their actions, and so aren’t producing the optimal amount. E.g. if a car manufacturer is dumping chemicals in the river, and yet doesn’t have to pay fines for it, then it will produce too many cars. Or if a vaccine producer only counts the revenues it gets from people who buy the product, and not the benefits of people who don’t get infected by the customers of the vaccine company, then not enough vaccine doses are produced. So a government fine can address the former, and a government subsidy can address the latter. (I’m not endorsing this analysis, just reminding us what “market failure” means in economic theory.)

Now if an entrepreneur thinks people will like polka dot cars and so he produces 10,000, but can only sell 2,000 profitably and has to unload the rest as scrap metal, he has wasted resources but it’s not a “market failure” in the technical sense. It’s a failure, and it happened in the market, but it’s due to poor foresight. A bureaucrat controlling the economy could make the same mistaken forecast. It’s not because of some systemic problem with incentives.

So back to the current mess: Just because some firms screwed up is not per se evidence of “market failure.” If it were, you could point to every bankrupt business and say, “See? The free market doesn’t work, let’s elect Obama.”

Now obviously, the fact that *so many* major firms all screwed up royally *at the same time* leads us to suspect there is some systemic bias involved. But my point is that “market failure” is not synonymous with “failure in the market.”

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