Market Failure lets the Market Succeed

[I_Ryan]

In the original post of a recent thread on this forum, Neoclassical asked whether we “believe in market failure” or not. He didn’t define it. He just asked whether we “believe in” it or not.

Most of the responses at least in the beginning showed that they had no idea what Neoclassical meant when he used the term, though he decided to go ahead and accuse them of dogmatism and so on anyway, using the reasonableness of what his definition was as the criterion.

The definition that he eventually gave, which everyone seemed to ignore for the next few pages, came from a speech by David Friedman, the relevant part of which I have transcribed below:

@David Friedman

One of the problems in a lot of technical fields is that you have terms that sound self-explanatory. So, if I say something is a public good, and you’re not an economist, you’ll think you know what I mean, and you’ll be wrong, because public goods aren’t actually goods that are produced publicly, it’s a technical term in economics that we’ll probably come back to sometime in this talk. Similarly, I think that in full of people who think they understand the theory of relativity, except for the mathematical details. 'Cause, right, the theory of relativity means that everything is relative, I understand that.

And the particular term that I want to talk about today is “market failure”, because “market failure” sounds self-explanatory, it sounds as though it’s about markets and about their failing, but in fact, while it is about a kind of failure, it’s not particularly about markets. And what I want to do is to try to explain what market failure is, why it is legitimately used by people that we disagree with as an argument against laissez faire, but why I think it is an even stronger argument against the alternatives to laisse faire. That is, I want to argue that market failure is a way in which human arrangements work less well than we would like, but it is more of a problem for political than for market.

And I will start with my favorite, simple example of market failure. I want you to imagine it’s about a thousand years ago, and probably about a thousand miles east of here, across the ocean, and you are one of a line of several thousand men with spears, on foot, and your spears are all pointing that way, and the reason your spears are all pointing that way is that there are a few thousand other men on horseback, and they have spears too, and they’re coming this way. And you do a very quick cost-benefit calculation, and you say to yourself, if all of us stand and plant our spears and hold our position, if we’re lucky, we can break their charge, and, if we break their charge, some of us will die, but most of us will live, on the other hand, if we run away, horses run faster than we do, so I ought to stand. I’m sorry, I made a mistake, I said “we”. I don’t control him and him. If everybody else stands, and I run, the chance of us breaking the charge is only very, very slightly reduced, because I’m one man out of five thousand, on the other hand, I won’t be one of the ones that gets killed. If everyone else runs and I stand, I am dog meat. Whatever they are going to do, I am betetr off running. Everybody makes this calculation, all of us run, and most of us die.

Welcome to the dark side of rationality. That’s what market failure is. Market failure is those situation where individual, rational behavior doesn’t lead to group rational behavior. In the extreme case would be where everybody takes the action which is in his rational self-interest, and everybody else is worse off than if they had taken a different example.

One of the most common arguments that Austrian School economists make when they are talking about politics is that cartels are unsustainable on a free market because it is always in the individual self-interest of all of them to cheat on the cartel. It is in the same self-interest to drop their price slightly below the cartel price and make tons of profits that way that got them into it in the first place, so that means that we don’t need a government to prevent cartels. Though it is in the self-interest of all of the people in the cartel together to keep the cartel going, it it is the individual self-interest of each person to do things that will be the downfall of the cartel.

Now what I find ironic about this is that it is a perfect example of market failure, if you use the definition of David Friedman, which is the one that Neoclassical was using in that thread. We don’t need to fear market failure, because it apparently is one of the things that we have to invoke just to be able to respond to one of the most common objections to getting rid of goverment, and establishing an unhampered market, which is that cartels would take over if we were to not have a government to put them down.

Market failure is market success. Maybe we should think about not using the term “market failure”, because it is an incredibly misleading and ridiculous way to refer to this sort of thing.

[DD5]

Friedman’s example of market failure is nonsensical.

It means absolutely nothing except that in the study of human action, i.e., the market, man is not omniscient and omnipresent but possess a human mind only. How can that be considered a market failure?

On the contrary, the market is a process that alleviates the limitation of the human mind and constantly innovates in order to solve precisely problems like the one Friedman is alluding to. An organized Army would plant their spears and brake the charge. That is an empirical fact, which is why horses charging is more of a Hollywood fetish and not a common war tactic of ancient warfare (I actually studied this crap years ago).

If we take Friedman’s definition seriously, then we must conclude that the market is in constant perpetual failure all the time. There is always some inefficiency due to our lack of telepathic and omniscient abilities.

[Amanojack]

@DD5

An organized Army would plant their spears and brake the charge.

The word organized seems key. Friedman tells it to the audience in a way that gets them to imagine they are soldiers suddenly thrust into this situation. “And what are YOU going to do now?!”

Well of course real life is rarely like that. Organizations establish themselves over time, even in a natural order or anarchy. To accept Friedman’s example at face value as an argument for the state is to tantamount to requiring that anarchy perform right this minute in the event that the state were to suddenly dissolve, with no time for any businesses and systems to establish themselves to meet consumer needs. Held to the same standard of instant performance, the state fails even more miserably, as the setting up of its systems to handle “market failure” takes far longer.

[I_Ryan]

None of what you wrote was relevant to the point of this thread, but I responded to it anyway.

@DD5

Friedman’s example of market failure is nonsensical.

Let’s see if you substantiate that.

@DD5

It means absolutely nothing except that in the study of human action, i.e., the market, man is not omniscient and omnipresent but possess a human mind only.

Not really, it was a lot more specific than that.

@DD5

How can that be considered a market failure?

It is just a term. If you think the term is inexpedient, great. But whether he used a good term isn’t relevant to whether his example made sense.

@DD5

On the contrary, the market is a process that alleviates the limitation of the human mind and constantly innovates in order to solve precisely problems like the one Friedman is alluding to. An organized Army would plant their spears and brake the charge. That is an empirical fact, which is why horses charging is more of a Hollywood fetish and not a common war tactic of ancient warfare (I actually studied this crap years ago).

Great, I don’t think that he would disagree with that.

@DD5

If we take Friedman’s definition seriously, then we must conclude that the market is in constant perpetual failure all the time. There is always some inefficiency due to our lack of telepathic and omniscient abilities.

Who cares? If we take the definition of “entrepreneurial error” seriously, we must conclude that entrepreneurs make errors a lot. Why is that relevant to whether it makes sense to say that entrepreneurs make errors?

[Snowflake]

The last time I started a thread like this, people basically said the public goods problem was hogwash because garbage collection is not a public good. So…

Anyway, good point in the OP. I would go further to say that any market failure (even the “bad”) kind sends a signal to entrepreneurs in the form of higher prices to try to fix the failure somehow…

[DD5]

@Sieben

Anyway, good point in the OP. I would go further to say that any market failure (even the “bad”) kind sends a signal to entrepreneurs in the form of higher prices to try to fix the failure somehow..

So now market failure simply means loss. Profit & Loss is equivalent to market success and market failure. Sure, you have to redefine the term as is commonly used so that it meets your original hypothesis.

Certainly, Friedman’s example doesn’t allude to “loss” as oppose to profit when he is discussing market failure. You don’t resort to a prisoner’s dilemma to explain the profit & loss system.

[Snowflake]

Doesn’t any example or definition of market failure imply that a firm could make profit by providing the service somehow?

[cporter]

@Sieben

I would go further to say that any market failure (even the “bad”) kind sends a signal to entrepreneurs in the form of higher prices to try to fix the failure somehow…

I think the issue with the term is that, generally, it is used to describe an action or group of actions that are unoptimal, inefficient, or outright destructive but cannot be corrected within the framework of “the market”. It’s like a shorthand form of “the market process is a failure in these circumstances”. It’s a meta-concept in relation to the market; it is about the market process itself and not about successes and failures of actors within the market.

So, when someone uses the term market failure people automatically tack the other implications of systemic market failure to the end of your argument. Is that fair? I don’t know.

[DD5]

Doesn’t any example or definition of market failure imply that a firm could make profit by providing the service somehow?

Then the logical implication of that would be that the market is in a constant perpetual state of failure since its real “equilibrium” state is actually constant change, i.e., never ending profit opportunities. Now do you really think there is any value or point in attributing the term “market failure” to what is practically its permanent state?

I think the answer to that is the answer to your question.

[Snowflake]

@DD5

Now do you really think there is any value or point in attributing the term “market failure” to what is practically its permanent state?

I don’t think it has any good philisophical meaning. It might serve as a good subjective distinction between things that aren’t really a big deal and easy to fix, like if a merchant chooses the wrong price for bananas, versus everyone dieing because of poor coordination.

Regardless, I think we agree. Its a superfluous concept to a priori economics.

[Caley_McKibbin]

There are better things to do than look for silver linings under ugly rocks.