Wednesday, April 8, 2020


 And the Ubiquitous Nature of Market Failure

"The huge sums of money being committed by the UK government and others to support companies will inevitably lead to a larger role for the state. This should not become the norm once the virus abates.(Financial Times Editorial 29 March 2020)

"Nonsense. That ship has sailed. The torrent of interlinked challenges facing us, from climate change to oceans to antibiotic resistance, all have at their core some form of fundamental market failure - mainly failures to address externalities. All imply national and international interventions on a substantial scale.

Markets are an important and powerful force, but they need to be the servants of mankind not the masters.

Wake up FT. We are in the 21st century." (A reader’s response.)

This recent exchange neatly summarises a fundamental sea change in political discussion and public attitudes, namely our perceptions of the respective roles of markets and the state. It also highlights the concept of market failure. The Oxford Martin School, to which I have an attachment within one of their most active programmes, has a focus on public policy problems with a global dimension, with several programmes in the field of health, climate change and the global environment.[1] Market failure emerges as the common thread, so it is worth examining the concept a bit more closely, not least because the implications may be too important to be left only to economists.

There are useful formal definitions, but the simplest characterisation of market failure is that individuals (or businesses or governments) have an incentive (or at least no disincentive) to do things which carry significant costs for others or society as a whole. Simple to understand examples in the context of the Martin School programmes might include casual disposal of waste plastic (oceans), individual failure to vaccinate or excessive use of antibiotics (health), and wasteful use of energy (climate). In each case this can be seen in contexts of both individuals’ actions and widespread commercial practices – a single unnecessary antibiotic prescription or widespread use in animal husbandry, or one person throwing an empty bottle in the river against the widespread promotion of single-use plastics. In all these examples there is no or negligible immediate cost of a particular action, but the collective impact over time on society as a whole may be huge.

Economists have sometimes classified market failures in terms of externalities such as those above, or on market failures that stem from unregulated monopolies, or on asymmetries of information. The latter typically occurs where the seller (buyer) has more information than the seller (buyer) and possibly also conceals it. Volkswagen cheating on diesel emissions tests[2] was a prime example. 

But the possibilities for market failure and similar perverse outcomes can arise from a variety of circumstances and some of the most common features are the following:

·         where there are public goods involved, where use by one individual does not reduce availability to others, but there are insufficient individual incentives for the resource to be created or maintained; the creation of knowledge is a prime example, and provides a key justification for patents and intellectual property protection.

·         “the tragedy of the commons”, where a common resource, like fish or grazing land, or indeed the capacity of the atmosphere to absorb additional carbon without adverse consequences, is limited and over–exploited

·         badly designed taxes or regulations which distort the market and create perverse incentives; in the UK energy sector social and environmental policy burdens are placed on the electricity sector, which is the future of carbon-free heating, but not on gas which accounts for significant greenhouse gas emissions.

·         tariffs that are not cost-reflective result in over-use of what is under-priced  and under-use of what is over-priced; the issue is explored for energy tariffs in an earlier posting on this subject

·         short termism, often itself associated with other market imperfections

·         uncertainty and risk, which most people find difficult to address in a consistent way

·         transactions costs, where markets can be established, but the complexity of the transactions results in costs that exceed the notional benefits of a competitive market, and results in distorted choices; the US health sector is a particularly good example

·         “moral hazard”, often stemming from asymmetric information

·         imperfections in capital markets

·         when active coordination, rather than competition, is essential to good outcomes (current competition between US states for medical resources to cope with the coronavirus is a good example)

·         inequality can be regarded both as a source of market failure and a result of it; of this subject deserves far fuller discussion in its own right.  

The above serve to illustrate some of the pitfalls in policy making. They do not apply only to the existential concerns of health and environment, both of which are now very high on policy agendas, but health and environment are both complex subjects and pose unique policy issues. Of course governments are capable of other policy failures too, even in the process of identifying and rectifying market failure, and that is something we should continue to examine on a policy by policy basis.

[1] Current programmes include Collective Responsibility for Infectious Disease, Pandemic Genomics, Planetary Health, Renewable Energy, Post Carbon Transition, and Oceans.
[2] The Volkswagen emissions scandal began in September 2015, when the United States Environmental Protection Agency issued a notice of violation of the Clean Air Act to German automaker Volkswagen Group. Volkswagen had intentionally programmed turbocharged direct injection diesel engines to activate their emissions controls only during laboratory emissions testing. The vehicles' NO x output met US standards during regulatory testing, but emitted up to 40 times more NO x in real-world driving.

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