Market Failure

- Why Should I Care?

Markets are not perfect, and the reason has to do with the type of product delivered. When products are based on long-lasting infrastructure, unit-based pricing does not work. Further, a private-market system may provide enough of this product if society deems it to be a public good.

Classical supply and demand theory does not account for this. Communities, organizations, and governments can argue they have a reason to intervene in the economy, and you should know that you have a say about that because you might have to pay for it, and you might also benefit from it.

- This Lecture Has 2 Parts

• 3 Kinds of Market Failures
• Government Intervention

- What is Market Failure?

Market failure theory was first proposed by Paul Samuelson, a famous economist, in 1954. It is a simple theory that argues some types of industries will just never be competitive, and furthermore, some types of products will never be produced by the private sector. In these cases, we have an economic argument to refute classical theory, and argue an intervention from the government to regulate flawed markets, or even for government to produce for the people.

Economists say there is a market failure when the free-market cannot produce enough quantity of a product, or at a reasonable price to consumers. We can identify markets where failure is more prevalent by qualifying goods and services into four categories. This is done by asking two questions:

Is there rivalry?

If I eat this, did I take it away from someone? Rivalry means that the product cannot be shared. Sometimes it disappears when consumed. Sometimes the object is still there, but it's occupied and not available for others. You might have to wait your turn. In this case congestion is the manifestation of rivalry.

For example, a cup of coffee is rival, because you can’t drink your neighbours’ cup, especially if he is done with it. But a golf course is non-rival because you can use it even if someone else is using it at the same time. Non-rival products are usually based on durable infrastructure, such as roads, telephone networks, ski hills and schools. Their fixed costs are usually high compared to the variable costs of production. Rival goods are usually sold individually, at the marginal unit cost price, or the cost of producing the last unit produced. Non-rival goods are usually sold in bundles, at average unit price, such as a subscription price.

Is there excludability?

Can you block me out of the market with a price tag? Excludability means that a seller has the means to make people pay. In contemporary language, we refer to monetization. Is there a way to make money with this product? For example, a movie theatre is excludable because you have to pay to get in. A public school is not excludable because everyone gets in for free.

A famous example of this is the Walt Disney's strategy of buying massive lots of land in Florida for his second theme park. The first theme park was in California. One of Disney's gripes was that some people had bought homes on the limits of the park, and could enjoy the fireworks for free. When he built the Florida theme park, he bought thousands and thousands of acres of land (using dubious numbered companies to avoid speculation on land prices), so that no one could live near enough the park to enjoy any of its benefits for free.

There are four kinds of markets and only one of them functions really well. Luckily, many industries fall under this well-oiled category, the Pure Private Good. These goods are both rival and excludable.

Market Failure Theory

• Definitions
  1. Rivalry: people will fight for a product because it disappears once it is consumed.
  2. Excludability: suppliers can control who gets to consume their product by charging a price.
     
     
• Assumptions
  1. Markets exist and function well.
  2. Governments protect private property and contracts.
  3. Non-rival production usually entails important fixed costs.
     
     
• Hypotheses
  1. Lack of rivalry reduces the level of competition.
  2. Without excludability, there cannot be private markets.

• Predictions
  1. Eliminating rivalry and/or excludability leads to market failure.
  2. Governments may have to intervene in markets if production is deemed socially important.
  3. Common Pool Resources will not be priced, unless regulated
     
  4. Private Goods will tend to be sold at marginal prices, unitary
     
  5. Club Goods will tend to be sold at average prices, subscriptions
  6. Public Goods will be provided by the State, paid through taxes

• 3 Kinds of Market Failures

Samuelson used these two criteria of rivalry and excludability to make up four categories of industrial structure. One of these four categories is not a form of market failure. This is the pure private good. In this case, when goods are both rival and excludable, private enterprise is well positioned to offer the product at fair prices. The profit incentive is sufficient to provide adequate quantities on the market. Of course, whether or not this is executed in the economy also depends on market conditions such as the availability of inputs and processes, demand, and cultural factors. This category also applies to resources which are held privately, such as a private ownership of farms, forests, or mineral claims.

The mildest market failure is considered to be club good category. Private enterprise can be very active on these markets, but the provision of service may be overly exclusionary. Economists consider club goods to be a partial market failure, depending on the social importance of the product. The goods are excludable, which makes it possible for private producers to charge a price to consumers. But, the product is non-rival. This means that a wide consumer base is essential to the delivery of the product.

Producers of club goods typically have high fixed costs (buildings, land, equipment). To cover the cost, and high risk, of the important capital investments needed to set up production, such as a golf course, producers ask consumers to pay membership fees, subscriptions, or a variation on this theme. The high risk capital-heavy investment also encourages producers to collude, reduce competition, and sometimes overcharge consumers. This situation creates a natural oligopoly or monopoly. Examples include ski hills, golf clubs, newspapers, internet services, and telephone services.

An important market failure, and a key insight from this analysis framework, is the over-exploitation of resources available in a common pool. This applies mostly to natural resources, but also to physical capital such as public infrastructure that are rival, yet non-excludable. As the name implies, the resources are available to everyone, with no control or property rights. Ironically, common pool rights were developed to ensure a democratic access to resources. A famous example of this were the Boston Commons, a grazing ground for cattle. The land became overused quite quickly and therefore no longer usable as pasture. This situation represents market failure because the resource will be over-exploited, due to lack of control over who gets access to it.  Examples include forests, fisheries, mining, and non-toll congested roads.

Total market failure is characterized by a situation where private enterprise will not, ever, provide a particular good or service. This is because there is not a way for business to generate sufficient income when the product is non-rival, and non-excludable. Samuelson argues that this is the case with pure public goods: total market failure. Since the product is non-rival, you usually cannot produce individual units for consumption. These are usually a shared service, like a hospital, a highway, or a school. These products require large investments in physical capital to produce even one unit. You need some scale to be able to make these services available in an affordable way. If you could charge admission for the service, it would be a club good. However, the universal offering of the service makes it non-excludable, so you can you can ask for a voluntary contribution, but cannot force clients to pay. This is the Free Rider problem. The private sector will never produce these goods and services. Examples include public health care, public education and national defense.

A political issue often rises with public goods because the provision of services is paid for with tax revenue, and the unit-cost structure is usually impossible to measure. We know how much tax we pay to the government. But do we know how much each unit of production costs? No.

How much does police protection cost per murder threat? How much does a single hip surgery cost? How much does it cost to teach one student an hour of trigonometry? These costs are not measurable at the margin, for each unit of production. The services are offered to groups at a time, and costs are known on average, overall. Discussing the value of public services is thus a little bit more complicated than discussing the value of a two dollar cup of coffee.

The following table shows the four categories of industrial structure, according to the rivalry and excludability criteria.

Table - Market Failure Categories

	Rival	Not Rival
Excludable	Pure Private Good   Restaurant Meal Automobile Clothes	Club Good Golf Club membership Private Health Clinic Private School Private Security
Not Excludable	Common-Pool Resource   Unrestricted Forestry Unrestricted Fishery Unrestricted Mining	Pure Public Good Public Hospital Public School Police

• Government Intervention

These Market failures are proof that markets are not always perfect. This theory is therefore a very strong argument in favour of government intervention in the economy, albeit in certain very particular circumstances. The government now has an economic argument to regulate the private enterprises, or produce itself, to ensure fair prices, sustainable exploitation of resources, or universal supply of public goods such as health care, education and national defense.

In common-pool resources, governments must regulate the exploitation of natural resources. For example, the first-come, first-serve nature of fish stocks creates an incentive for fishermen to deplete the ocean before their competition does so first. Because no one can exclude others from fishing, the fish disappear as quickly as we develop better fishing technology such as mega-fishing-nets. The solution is simple: local groups or the government must intervene to draw out ownership rules of the resource and manage its exploitation and protection. In this case, a Common-Pool Resource is transformed into a Private Good.

In the case of club goods, government intervention depends on the social, cultural, and political nature of the product. Is it acceptable for private golf courses to exclude low-income citizens from the country club? Maybe. However, many cities have set up public golf clubs to increase its affordability for middle-class and lower-class income earners. The public golf club is not quite universal of access, but it is considered in some communities to be enough of a socially important product to be organized as a public good. The same argument holds for public transit. It would be much more simple to not have fares on public buses and trains. However, taxpayers who don't use transit would not appreciate having to pay for a service they don't use. Hence, an affordable fare makes transit accessible almost universally, without being considered a pure public good.

- Green Policy

Pollution can be attributable to any type of market. However, the Common-Pool Resource category is the worse-case scenario. This is basically a “free-for-all” situation with no regulations at all. Any company can come in and fish, cut trees, or extract oil, without any limitations from the community, or the State. Unregulated extraction leads to resource extinction, such as the disappearance of the famous Cod Banks in eastern Canada. Forty years after the imposition of a strict moratorium on Cod fishing, this incredibly abundant species of fish has still not recovered from over-fishing in the 20^th century.

As you regulate the extraction activity, you move that industry out of the Common-Pool category, and into the Private Good category. Access to the resource is limited to those you have a permit, so that you exclude producers from the industry to limit the production. Each company’s production can also be limited by annual quotas.

A totally “free-for-all” situation is harder to find nowadays. Most resource industries are more often regulated than naught. For example, one cannot operate a gold mine without government permits, which include environmental regulations. At least, we should strive for this model to be predominant. In many poor countries, mining operations are left unregulated which leads to social and environmental catastrophes.

The scale of production is also a huge issue. Property rights can limit over-extraction, but this mostly applies to renewable resources. If you own a plot of farm land, or forestry land, and you know you can't expand that land base, you probably will manage the land with a long-term view. You will harvest a share of the annual growth that is sustainable over hundreds of years.

The problem with property rights is that many resources are non-renewable. This is the case with mining, where geologists know that a resource can be extracted, and will not be replenished naturally. A copper mine might have a life expectancy of 20 years. Once the rock is gone, there is no more copper in this location. In this case, property rights are not sufficient because the mining company knows it is going to leave a hole, and leave. Mining needs to be strictly regulated so that environmental degradation due to its activities are repaired. Governments need to impose mining companies in advance for environmental costs, holding millions in trust so that the money is available decades later, when the mining company leaves and mineral revenues are gone.

- Climate Change Solution

In the case of climate change, the over-production of CO2 is associated to the “free-for-all” situation similar to the Common Pool situation. CO2 is not extracted freely, it’s actually a by-product of many other productions. However, the fact that it can be produced with impunity is a major issue.

One solution is to issue emission permits that will create a market for CO2, which allows the industry to use the Private Good market mechanism to self-regulate. The permits are a finite resource, which makes the production of CO2 excludable.

- Democracy Booster

Industry would pocket more profits if there were fewer regulations, both social and environmental. It is important to know that industry will lobby governments to further their agenda. Citizens who care about the environment must make sure to convince elected officials of their intention to support politicians who can stand up to industry.

A further step you can take is to support environmental organizations that lobby the government in your place. Many organizations hire specialists such as biologists, ecologists, and economists who the study the issues in great detail to inform their members, and to help politicians take better decisions.

- Wrap-Up

Markets often function very well. But in some very specific cases, they do not. This depends on rivalry, and excludability. When these criterions are not met, there is market failure. Non-excludability creates the Free Rider problem, where some clients get away Scot free.

For Pure Public Goods, there is no private supply of essential goods and services such as national defense, education and health care. For Common-Pool Resources, there is no management of natural resources, so they are over-exploited. And for Club Goods, the non-rival nature of the good needs a wide consumer base, which is a natural incentive for oligopolies and monopolies.

When market failures arise, the government has an argument to intervene through regulation or public supply.

- Cheat Sheet

Market Failure:
A theory that argues some types of industries will never be competitive, and some types of products will never be produced by the private sector.

Club Goods:
Non-rival and excludable products involving large and risky capital investments: a recipe for a natural monopoly.

Pure Public Goods:
Non-rival and non-excludable goods and services, usually needing important sums of capital investment. Most private companies cannot profit from this unless they exclude the poor. An argument for government intervention.

Common-Pool Res.:
Rival yet non-excludable products. Because they are first-come, first-serve, these resources tend to be over-exploited and depleted.

- References and Further Reading

Samuelson, P. A. (1954). The Pure Theory of Public Expenditure. Review of Economics and Statistics. 36 (4): 387–389.