The Usefulness of Market Failure in Explaining Government Action

Abstract

This paper contributes to the discourse on the usefulness of market failure as an explanatory and justificatory tool for public policy and government action. Critically examining and evaluating market failure's theoretical robustness, ideological underpinnings, institutional claims and practical application, it argues that while the tool offers some insights into what governments (can) do, it fails to provide a compelling answer to the fundamental question of why governments exist. It is suggested that alternative approaches and theorizations such as institutional political economy and historical inquiry offer more comprehensive explanations for understanding the role and relationship between the state and the market.

Key words: market failure, state invention, neoliberalism, efficiency

1. Preamble

Market failure—the notion that markets fail to allocate resources efficiently to meet societal ideals—is a mainstream logic for interpreting and justifying state action. This reasoning, plus the need to ensure equity, has been described by the World Bank as ‘the economic rationale for state intervention’ (World Bank, 1997 p. 26), and is frequently used by governments, politicians and influential international organizations, including the World Bank and the International Monetary Fund (IMF), in their various policy prescriptions for tackling myriad socio-economic maladies. Market failure is also often cited in the wider debate over what the appropriate size, role and scope or powers of government should be, with each position being constructed on the basis of some form of market failure. However, others flaw the entire argument as presenting a narrow neo-liberalistic view of the market, based on some shaky assumptions, intended to defend and perpetuate the injustices of the market system and therefore advocate alternative theorizations for explaining government action.

This paper makes a contribution to the discourse on the effectiveness of market failure as an explanatory and justificatory tool for state action. In doing so, section 2 examines and analyzes market failure’s central doctrine, including its underlying ideas about the structure and behavior of the ‘normative market’, as well as its purported shortcomings from which the role and scope of government is derived. This is followed by Section 3, which considers the different ways in which market failure is applied in the design of public policy. A critique of market failure is offered in section 4, drawing mainly on existing arguments for and against market failure in the literature. In section 5, I present my judgment on the usefulness of market failure in explaining state action, employing four evaluation criteria: the reasonability of its assumptions; effectiveness in explaining the origins of the state; internal coherency; and applicability. I argue on the basis of what the theory says or is in relation to each of these criteria, that although market failure is a useful tool that provides some insight on what kind of activities can be undertaken by the state, the theory makes unrealistic (and flawed) assumptions about the market, the state and motivations driving public action; is laden with internal contradictions; and suffers from ambiguity regarding the acceptable point of state intervention, thereby rendering it an inadequate public policy manual, even where its capitalist ideology is imbibed. I then propose the use of alternative theorizations, including both inductive and deductive theories, in better explaining public policy and government action (section 6), and offer my concluding comments in section 7.

2. Overview of Market Failure Theory

To understand what market failure is, it is useful first to consider what the mainstream economic model of the market is. The ideal market, in mainstream or neoclassical economic thought, is— or supposed to be—a voluntary and self-regulated exchange system whose defining structure, and ultimate test of efficiency, is perfect competition. Perfect competitive markets are characterized by many buyers and sellers with none having any market power; perfect information; and the determination of prices through free bargain^[1]. Because free competitive markets, through the interplay of the forces of demand and supply, set the price of goods and services and output levels at an equilibrium point where both producer profit and consumer welfare are maximized, market economists argue they are the most rewarding and efficient of all market types, efficiently and allocatively, in the long run. Productive efficiency is where firms are able to produce a good at the lowest average total cost possible. Allocative efficiency on the other hand is where the amount of goods produced in the market is commensurate with total societal demand, such that marginal consumer benefit equates marginal producer cost^[2].

At the same time, however, because this is often not the case (since all the requirements necessary for perfect competition may, after all, not be present), and because private optimum level of production and consumption excludes but affects social optimality, market failure is always said to occur. From a public policy point of view, it is the inability of the markets to deliver all the goods and services desired by society, and or to provide them in ways that do not negatively impact society as a whole (Hughes, 2003).

Market failure, then, is a systemic deficiency of the market system, attributed to the internal structural organization and behavior of actors, which is ubiquitous and bound to persist (Foldvary, 2006) without any outside intervention. In principle, violation of any of the conditions or principles underlying perfect competition amount to market failure; however, four major types of market failure are recognized in the literature. They are:

Monopoly

The incidence of monopoly, the situation whereby a single firm or a small number of them (oligopoly) dominate the market for a particular good or service, is considered a form of market failure. Monopolies emerge when sellers are able to lower the unit cost of an additional good or service provided over a range of output, due to technological superiority or economies of scale from activities with large fixed costs and no viable substitute. Utility providers such as water and electricity suppliers and airline companies are respective examples of firms in monopolistic and oligopolistic markets. These can exploit their cost advantage and market power to engage in anti-consumer welfare and anti-competitive practices, such as reducing output to keep prices and profits high, product tying, lowering product quality, predatory pricing and collusion, if unchecked.

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^[1] The other structural characteristics of a perfect competitive market include: product homogeneity; ease of entry and exist; freedom of choice; long-run factor mobility; zero transaction cost; well defined and transferable property rights; and self-interested, rational actors (i.e., firms and consumers) driven by the motive of profit and utility maximization respectively

^[2] This is also known as ‘Pareto efficiency’, named after the Italian economist Vilfredo Pareto who defined it as the condition whereby it is impossible to make some one better off without making another person at least worse off.