The Truth About "Free Markets" and "Market Failure"

[I]t is possible to conceive of better worlds that the one in which we live. But the problem is to devise practical arrangements which correct defects in one part of the system without causing more serious harm in other parts.

—Ronald Coase, "The Problem of Social Cost"

These days everyone has an opinion as to what's wrong with "free markets" and what government should go about it.

On one end of the spectrum are those who remain persuaded that government intervention in the economy inevitably distorts private incentives, and thus that "free markets" function best when they are left alone. In other words, "If it ain't broke, don't fix it."

On the other end are these who believe that government must act assertively to curb market excesses and rein in corporate power. In other words, "It is broke. Fix it now."

A technocratic middle reconciles these two extreme viewpoints by invoking the concept of "market failure." The logic is presumably simple: a role for government exists if, and only if, a market failure exists. The burden to policy lies in establishing the nature of the market failure, and then specifying the mechanisms by which it can be corrected.

Unfortunately, none of these three rules of thumb is of much use as a guide to policy making in a world where markets are as temperamental as a tent-full of toddlers and market failures are as abundant as a bankrupt banker's bonus bag.

This is a problem. To illustrate with an analogy, let's say that the issue under consideration were treating cancer, instead of fixing markets. Suppose scientists understood what cancer is, and how to treat it. What if, instead of working with a definition based on science, every doctor decided to make up her own definition of cancer. For one doctor, it would be any illness that makes people suddenly lose weight. For another, it would be any illness resulting in death. Using the first definition, healthy people would be treated with chemotherapy. Using the second, treatment would only be offered to patients when already dead. Not good.

Similarly economists know what market failure means. However, at least some legislators in charge of its treatment exhibit a persistent disregard for the term's correct definition. As a consequence, where some may see potential government programs everywhere they turn, others only see them when conducting economic post-mortems--of which we have witnessed more than the usual number in the two years.

In its usage by economists, market failure is a concept that is defined in terms of "perfect competition." Contrary to caricature, perfection in this context here means a state of the world that is fundamentally unattainable, not one that is ultimately desirable. The conditions defining perfect competition are numerous: everyone is small relative to the market (no monopoly); all information is public (no secrets); there is no uncertainty or inter-dependency (no surprises); and transactions costs costs are zero (no lawyers). In another words, a fantasy land.

The entire point of creating such an idealized, fundamentally unrealistic model of markets was to provide a stable point of reference for the study of the real world, in all of its astounding diversity and complexity. Indeed, after the early 1970s, economists more or less stopped studying perfect competition. There was nothing left to study. Attention turned almost entirely to another topic: market failure. And what is market failure? Quite simply every situation that isn't perfect competition.

The first takeaway, then, is that the "market failure" test for government intervention is a misleading one. Market failures so permeate economic reality that "correcting" every one of them to arrive at a frictionless, riskless, perfectly efficient alternate reality is a dangerous fantasy.

The second takeway is those who seek naively to equate "free markets" with economic efficiency are engaged in horse-and-buggy reasoning that has no place in any serious, 21st century discussion of economic challenges and their solution. From the standpoint of economic theory backed up by decades of empirical analysis, there is absolutely no reason to presume that "free markets"--markets in which, for example, business opportunities exist and companies pursue them--are "efficient." This is because, under conditions of rigorously defined "perfect competition," business opportunities simply do not exist; there are no proverbial $20 bills lying on the sidewalk. Consequently, even in the total absence of any government intervention, substantial inefficiencies in market outcomes are to be expected whenever participants in markets don't share the same information, the practices of firms differ, and the environment is characterized by significant uncertainties.

To paraphrase the Nobel laureate Ronald Coase, well-designed policy must begin with a situation approximating that which actually exists. The situation that exists in any real-world market is one rife with "market failures." From such a starting point, a change in the market environment created by government may move the market either towards, or away from, efficiency (to say nothing of equity!). It certainly is possible to conceive of worlds in which market failures were less dominant. But the problem is to devise practical arrangements which correct defects in one part of the system without causing more serious harm in other parts.

Unsure? Ask your doctor.

(More to follow on the closely related topic of why "business-friendly" and "entrepreneur-friendly" environments are not the same.)