Sunday, June 8, 2008

Market Failure

Economists have always been clamoring for a free market. Right from Adam Smith's Invisible Hand metaphor in The Wealth of Nations, government intervention has been tagged as 'unneeded'. Of course, there are a few practitioners (Cynics among us will scoff at this usage. For such, economics has always been a science for the idle mind) who say that a little intervention is needed for optimality. Most of these few use the argument of market failure.

So what really is market failure? Simply put, it means an exchange where the market-determined 'price' is not the best price for the buyers and sellers. This obviously doesn't happen all the time. In fact, it doesn't happen most of the time. The price that is set as a result of free trade between buyers and sellers usually maximizes satisfaction. But there are specific types of exchanges, goods with specific properties, which negate this assertion. I shall try to describe a few of them.

Public Goods: Public goods are not necessarily goods produced by the government. Rather, they mean goods that you cannot exclude anyone from using. For example, let's take a highway. Once it is built, anyone can use it. Suppose a supplier of roadways (a civic constructor) were to offer the road in a market. Whoever wants to use it would have to contribute for it. Naturally, this would give users an incentive to understate their need for the road, as others would be paying too. Ultimately, the price offered by the buyers would not be acceptable to the seller, and the road would not get built. This results in market failure. In economic and coffee-table conversations, this type of problem is called the free rider problem.

Externalities: Externalities mean effects of some action which are not taken into account in pricing that action. A couple of examples might help elucidate this particularly esoteric statement. Let's say that I try to build a house in a particular neighborhood. Let's also assume that the neighborhood is a little decrepit, and the house I am building is not. Then, it wouldn't be too far a leap of faith to say that my house increases the neighborhood's value. This is called a positive externality, i.e. one where there is a positive unintended effect. Now, because this effect is not taken into account in the market-driven price of the house, fewer houses will be constructed than is optimal. Similarly, consider the effect of pollution. Any task that creates pollution has a negative externality attached. The market price of such an activity only considers its immediate benefit to the buyer, and not the damage to society as a whole. Therefore, more of this activity will be done than is optimal for society. The government has to impose restrictions, or establish tariffs. The carbon-trading scheme that was created in the Kyoto Protocol is a very pertinent example of intervention to address market failure.

Non-Competitive Markets: This is a far easier example to understand, for most of us have come across terms like monopoly, oligopoly, etc. before. Briefly put, any market that does not have perfect competition allows either buyers or sellers to decide price, rather than a decision in tandem. The government might have to step in sometimes to prevent cartelization or monopolies, where sellers can extract supernormal rents.

Macroeconomic Stability: Sometimes, the market sells too much of a good. Macroeconomic instability can result from such behavior. For instance, let's say that the consumers in India want a particular good that is manufactured only in the USA. Therefore, the product is imported indiscriminately. But buying this product requires dollars, which would deplete the foreign exchange reserve of the country. In extreme cases, this will seriously affect the monetary security of a country, implying that governments need to regulate this flow.

Goods with no market: At a very basic level, a market trade takes place when two guys meet, and each one of them has an item that the other guy wants. In today's world, one of the two items is money. But in ancient times, barter was the system used with, obviously, limited success. Such a situation is called a double coincidence of wants by economist David Freidman. Now, unless such a coincidence takes place, trading is near impossible, and a lot of effort is spent in finding the opposite party to the transaction. A simple analogy is of marriage. A guy can't marry a girl unless she wants to marry him too, and I'm sure most of you will agree that finding the right match is very tough indeed (marriage is also a definitive example for the verity that the grass is always greener on the other side, but I digress). In economic terms, consider a situation where a railroad operator has to decide whether to build a railway line to an area in the countryside. Given that there is no economic activity there, no one will be ready to provide him capital without hefty payback. At the same time, a mining company is evaluating an option to set up a coal mine in the very same area. They won't receive capital on favorable terms either, given that there is no transport available from that area. Thus, unless someone pushes these guys into each other, some potential for economic profit is lost. This is something that intervention can do, and actually does every once in a while.

These are a few of the main motivations for market intervention. I do not intend to imply that the government is the best medium for such interventions, or indeed that it usually gets it right. But sometimes, reliance on the market to work things out perfectly has its price.