You Found a Market Failure. So What?
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Economists love finding market failures and proposing solutions. Carbon is an externality. Tax it! Research has spillovers. Subsidize it. This firm is a monopolist. Break them up! Tax their profits! We instinctually go out searching for these market failures. And that’s great, at times.
So we economists go out and study a market, estimate a demand curve for some firm, and find that its demand curve slopes down. The firm has market power. Market failure?
What do I make of the existence of a market failure? As always, we need to think about magnitudes and trade-offs. Does it actually matter to anyone’s well-being? Can anything be done to reduce the market failure at a lower cost?
First, let’s take a step back and think about the benchmark that “market failures” are compared against. Is that really the standard we are expecting actual markets to reach? The correct answer, no, is overly basic but easy to forget.
When we say that there are no market failures in an economy, we are also saying that the economy is efficient. It is efficient in the strongest sense of the word: surplus is maximized, and God couldn’t come down, move goods around, and make anyone better off. Wow! That’s a high bar. Utopia. Or, as Harold Demsetz called it, Nirvana. Sure sounds nice.
The First Welfare Theorem says that competitive markets reach that extremely stringent benchmark. Once we frame the First Welfare Theorem that way, it is immediately obvious that we shouldn’t take it as applying literally to any market. No market is actually efficient by this metric.
But if achieving that efficient outcome is impossible on this side of Eden, failing to reach it cannot be some great indictment. I hate to break it to you, but we aren’t anywhere near Eden. I shouldn’t be surprised that my estimated demand curve isn’t perfectly flat.
Economists used to be obsessed with physics analogies, so let’s use one. Imagine the economy as some sort of spinning object. It keeps spinning if left to its own devices. But if there are “frictions” such as market power, externalities, or spillovers, that slows the economy down. Eventually, the economy grinds to a halt. The supposed job of the benevolent economist, like an engineer, is to remove those frictions. ( I say supposed because I don’t think that’s the job of the economist, but that needs to wait for another newsletter.)
In that analogy, the economy would keep moving along perfectly if it wasn't for those frictions. It would go on forever and ever.
Notice we’ve just described a perpetual motion machine. That’s impossible. Not “licking your elbow is impossible”. Impossible impossible. In Physics of the Impossible, Michio Kaku calls perpetual motion machines category “Class III Impiossibilies,” which are “more impossible” than time travel or traveling faster than the speed of light.
I don’t know about you, but I don’t get too upset at engineers when they can’t develop perpetual motion machines. You can always find a way to improve things if you know everything. That’s not the benchmark.
Instead, we ask, given your constrained knowledge and tools, can you make it better? Once we take constraints seriously, our ability to magically improve the world decreases. There may still be efficiency gains out there, but they aren’t as obvious as one would hope. $100 bills are rarely on the sidewalk. More likely, we are ignoring some costs in our model. If an externality is $5 but it would cost $10 to fix, is it really an externality?
There is an important difference between engineers and policy economists looking to fix problems. In business, lots of people can see that the product is working. Consumers buy it, and the firm makes money. Engineers are paid to find mistakes that no one else sees to improve the product.
The situation is different in the social sciences. There is not that immediate feedback on what is working. It’s not so directly in everyone’s face when economies are well-functioning. Everyone can find faults with the world, especially compared to Utopia. For example, many Gen Zers in the US think the economy is in shambles, despite the fact that they are the richest people ever to live (in expected income terms). In the social sciences, no profit and loss system provides such direct feedback (good or bad). Instead, finding the good things out in the world takes work.