Market Failure: Who is to Blame?

Big Corporations, Big Government, Big Problems

In my economics class today we got into a conversation about "Market Failure." Basically, there are certain ailments which can not be alleviated by virtue of the market system itself. The most common examples are pollution and environmental damage, poor working conditions, faulty products, and fraud or misrepresentation. The free market system is set up in such a way that there are incentives to doing these morally wrong acts, and without outside intervention they will become more and more prevalent.

$2000 worth of Econ in 2 Minutes (Cash and Credit only)

It makes no sense to talk about market failure without talking about market success. In a correctly functioning market, prices are low innovation is high, and product quality is always improving. I the Smithian ideal, consumers only buy the best product, which, if they want to compete, forces companies to produce the best product. If one company shortcuts by making an inferior product it will lose money. Companies must innovate to get ahead, striving to get that new idea that makes them loads of money. Once they start making large profits, however, other companies will imitate the new innovation, thus reducing the origional innovator's profit. A perfect market system keeps all firms, in the long run, from making some of the obscene profits that companies in reality make.

The ideal free market system has several assumptions. First, it assumes that consumers have perfect information about every product and that they make rational decisions It also assumes that consumers always buy the product which benifits them the most. Classically this means they buy the product which is the highest quality and lowest price, but I like to update it to include products with emotional value (which explains splurges, sweat-shop free goods, and brand identification). Lastly, the ideal market system assumes that markets are easy to enter and exit. While there are almost no markets which are fully ideal, the ideas work for almost every market. They can even be applied to non-free markets, as long as you are careful to know where your assumptions limit you.

The Setup

Let's imagine a situation of a market failure, which I will use to demonstrate market failure. Say there is a company, Flintstone, which makes tires. This is a large company, so it sells 10,000 tires per year. After 5 years, Flintstone starts to hear reports that its tires have a small probability to catastrophically fail, causing massive injury to drivers and passengers, and sometimes even death. These failures were not noticed in their quality tests, so they are not yet at fault. What should Flintstone do?

Options and Outcomes

Flintstone has three options: (A) recall all tires, (B) keep current tires on the road but make all new tires better, or (C) keep producing the faulty tires. Option A would be a properly functioning market. In a perfect system, all firms do the "right" thing, because if they don't consumers will not want to buy their product. Option B and C both classify as market failures, because the company continues to make an inferior good. B is "less" of a market failure, but is nonetheless a sign that something is not working the way it should be in an ideal situation. Given this situation, almost every company will choose option B or C. Option A costs thousands of dollars (50,000 faulty tires have been sold), and very likely loses many customers. In a competitive system, this option would likely close the company. It is very likely that, given the low chance of injury, the company calculates that it is cheaper to keep producing faulty tires and endure lawsuits than it is to spend money researching better tires.

Johnny Market's Report Card: F

How did the market fail? First of all, consumers do not truely have perfect information about all the tires on the market. Besides being able to recognize the StayPuff Marshmallow Man or the Goodbeer Blimp, most consumers know very little about tire brands. Also sometimes consumers do not make the choice (when buying a car, for example) or they make the choice hastily (when your only spare blows). It has been a while since I bought a tire, but as far as I remember the brand names are used for the most part to give names to prices. In this sort of market it is easy to get by with somewhat inferior products, as long as they are cheaper.

Another failure, which is often not deemed a "market" failure, involves government influence on business. The government is involved in two ways: laws which ensure consumer saftey, and the criminal justice system which prosecutes companies for fraud and criminal negligence. The former, which is intended to force companies produce safe products, often lulls consumers into thinking products are safe. When a safety scandal comes out in the news the offending company loses business for a short while, but in the long run people assume that the government is doing its job, keeping consumers safe. The government's other remedy, criminal prosecution, is basically a joke. Companies are often fined increadibly small amounts, and many companies just plain don't pay! It is a very rare occasion indeed that corporate leaders spend time in jail.

Part of the problem with government solutions is that politicians and upper management of large corporations tend to get along very well. Campaign financing and lobbying are very important to politicians and they play close attention to anyone who can greatly help their campaign. (Note that this also happens with "neutral" politicians such as judges. It was recently found that, in Ohio, judges were significantly more likely to vote in favor of a company who gave them campaign contributions.) Politicians and corporate leaders are no more to blame; both have strong incentives to do what they do, and few disincentives.

The third sector in which the "market" has failed is that of civil suits. Civil litigation, ideally, should be the second largest deterrent (after losing customers) to intentional fraud and negligence. Realistically, however, most cases are settled out of court, with very small fines aginst the company (and little compensation for the victim).

Abanden Ye All Hope?

Now that we know what the problems are, can we fix them? I do not think, at least in the case of Flintstone Tire Co, consumers will ever overcome the imperfect information problem. Consumers have shown that they just don't care about tires, and there's nothing you can do to change that.

The issue of civil litigation is very hard to solve. You have to have a system which deters frivolous lawsuits (which are harmful to the consumer), while keeping compensation high for real cases, all while ensuring the system is equally accessible. This is a whole topic in itself (I may delve into it some day) so for now let us say that the civil litigation system also can not or will not change.

This leaves us with government failure. Interestingly, if government were treated as a company (and why can't we?) its failure to protect consumers would be considered a market failure. If the food and drug inspection were done in an ideal market system, we would never see e-coli outbreaks in lettuce or deadly prescription drugs. Ideal market mechanisms should eliminate companies which let these sorts of things pass, but the market fails in that the government has a monopoly. What are the alternatives? We obviously can not let these companies go unregulated, for, as we saw before, they will harm people. But who says the government has to be the one to regulate? The government is made up of people, just like UL, Consumer Reports, and the Insurance Institute for Highway Safety. If an entity has a vested interest in safety (UL loses money when it fails, the FDA gets exactly the same amount of taxes) it will promote those interests.

In addition to private oversite companies, insurance companies could be allowed to take over interest in the area of safety. If Flintstone Tire Co buys lawsuit insurance from Allgate Insurance, Allgate wants to do everything it can to never have to pay out a claim. How does it do this? It sends inspectors to the plant, it runs tests on the tires, and it hires engineers to review the design. If Allgate believes the tires are unsafe they will raise Flintstone's insurance rates. Flintstone wants to make the largest profit they can, and they do this by making quality products and lowering their insurance costs.

Conclusion

Many people like to believe that large corporations do everything they can to harm the consumer, and the government does everything it can to help the consumer. I hope that I have shown that this is a much more complicated issue, but one which can be rationally and logically discussed. Often times seemingly irrational or immoral decisions are the only ones practical or available (possibly yet another topic for another article). I also hope that I have shown that there is no need to rely on government as the sole providor of safety; people were safe for a long time before there was government. Please let me know of anything you disagree with or are unsure of. I love to discuss this stuff!







		Market Failure: Who is to Blame? Big Corporations, Big Government, Big Problems In my economics class today we got into a conversation about "Market Failure." Basically, there are certain ailments which can not be alleviated by virtue of the market system itself. The most common examples are pollution and environmental damage, poor working conditions, faulty products, and fraud or misrepresentation. The free market system is set up in such a way that there are incentives to doing these morally wrong acts, and without outside intervention they will become more and more prevalent. $2000 worth of Econ in 2 Minutes (Cash and Credit only) It makes no sense to talk about market failure without talking about market success. In a correctly functioning market, prices are low innovation is high, and product quality is always improving. I the Smithian ideal, consumers only buy the best product, which, if they want to compete, forces companies to produce the best product. If one company shortcuts by making an inferior product it will lose money. Companies must innovate to get ahead, striving to get that new idea that makes them loads of money. Once they start making large profits, however, other companies will imitate the new innovation, thus reducing the origional innovator's profit. A perfect market system keeps all firms, in the long run, from making some of the obscene profits that companies in reality make. The ideal free market system has several assumptions. First, it assumes that consumers have perfect information about every product and that they make rational decisions It also assumes that consumers always buy the product which benifits them the most. Classically this means they buy the product which is the highest quality and lowest price, but I like to update it to include products with emotional value (which explains splurges, sweat-shop free goods, and brand identification). Lastly, the ideal market system assumes that markets are easy to enter and exit. While there are almost no markets which are fully ideal, the ideas work for almost every market. They can even be applied to non-free markets, as long as you are careful to know where your assumptions limit you. The Setup Let's imagine a situation of a market failure, which I will use to demonstrate market failure. Say there is a company, Flintstone, which makes tires. This is a large company, so it sells 10,000 tires per year. After 5 years, Flintstone starts to hear reports that its tires have a small probability to catastrophically fail, causing massive injury to drivers and passengers, and sometimes even death. These failures were not noticed in their quality tests, so they are not yet at fault. What should Flintstone do? Options and Outcomes Flintstone has three options: (A) recall all tires, (B) keep current tires on the road but make all new tires better, or (C) keep producing the faulty tires. Option A would be a properly functioning market. In a perfect system, all firms do the "right" thing, because if they don't consumers will not want to buy their product. Option B and C both classify as market failures, because the company continues to make an inferior good. B is "less" of a market failure, but is nonetheless a sign that something is not working the way it should be in an ideal situation. Given this situation, almost every company will choose option B or C. Option A costs thousands of dollars (50,000 faulty tires have been sold), and very likely loses many customers. In a competitive system, this option would likely close the company. It is very likely that, given the low chance of injury, the company calculates that it is cheaper to keep producing faulty tires and endure lawsuits than it is to spend money researching better tires. Johnny Market's Report Card: F How did the market fail? First of all, consumers do not truely have perfect information about all the tires on the market. Besides being able to recognize the StayPuff Marshmallow Man or the Goodbeer Blimp, most consumers know very little about tire brands. Also sometimes consumers do not make the choice (when buying a car, for example) or they make the choice hastily (when your only spare blows). It has been a while since I bought a tire, but as far as I remember the brand names are used for the most part to give names to prices. In this sort of market it is easy to get by with somewhat inferior products, as long as they are cheaper. Another failure, which is often not deemed a "market" failure, involves government influence on business. The government is involved in two ways: laws which ensure consumer saftey, and the criminal justice system which prosecutes companies for fraud and criminal negligence. The former, which is intended to force companies produce safe products, often lulls consumers into thinking products are safe. When a safety scandal comes out in the news the offending company loses business for a short while, but in the long run people assume that the government is doing its job, keeping consumers safe. The government's other remedy, criminal prosecution, is basically a joke. Companies are often fined increadibly small amounts, and many companies just plain don't pay! It is a very rare occasion indeed that corporate leaders spend time in jail. Part of the problem with government solutions is that politicians and upper management of large corporations tend to get along very well. Campaign financing and lobbying are very important to politicians and they play close attention to anyone who can greatly help their campaign. (Note that this also happens with "neutral" politicians such as judges. It was recently found that, in Ohio, judges were significantly more likely to vote in favor of a company who gave them campaign contributions.) Politicians and corporate leaders are no more to blame; both have strong incentives to do what they do, and few disincentives. The third sector in which the "market" has failed is that of civil suits. Civil litigation, ideally, should be the second largest deterrent (after losing customers) to intentional fraud and negligence. Realistically, however, most cases are settled out of court, with very small fines aginst the company (and little compensation for the victim). Abanden Ye All Hope? Now that we know what the problems are, can we fix them? I do not think, at least in the case of Flintstone Tire Co, consumers will ever overcome the imperfect information problem. Consumers have shown that they just don't care about tires, and there's nothing you can do to change that. The issue of civil litigation is very hard to solve. You have to have a system which deters frivolous lawsuits (which are harmful to the consumer), while keeping compensation high for real cases, all while ensuring the system is equally accessible. This is a whole topic in itself (I may delve into it some day) so for now let us say that the civil litigation system also can not or will not change. This leaves us with government failure. Interestingly, if government were treated as a company (and why can't we?) its failure to protect consumers would be considered a market failure. If the food and drug inspection were done in an ideal market system, we would never see e-coli outbreaks in lettuce or deadly prescription drugs. Ideal market mechanisms should eliminate companies which let these sorts of things pass, but the market fails in that the government has a monopoly. What are the alternatives? We obviously can not let these companies go unregulated, for, as we saw before, they will harm people. But who says the government has to be the one to regulate? The government is made up of people, just like UL, Consumer Reports, and the Insurance Institute for Highway Safety. If an entity has a vested interest in safety (UL loses money when it fails, the FDA gets exactly the same amount of taxes) it will promote those interests. In addition to private oversite companies, insurance companies could be allowed to take over interest in the area of safety. If Flintstone Tire Co buys lawsuit insurance from Allgate Insurance, Allgate wants to do everything it can to never have to pay out a claim. How does it do this? It sends inspectors to the plant, it runs tests on the tires, and it hires engineers to review the design. If Allgate believes the tires are unsafe they will raise Flintstone's insurance rates. Flintstone wants to make the largest profit they can, and they do this by making quality products and lowering their insurance costs. Conclusion Many people like to believe that large corporations do everything they can to harm the consumer, and the government does everything it can to help the consumer. I hope that I have shown that this is a much more complicated issue, but one which can be rationally and logically discussed. Often times seemingly irrational or immoral decisions are the only ones practical or available (possibly yet another topic for another article). I also hope that I have shown that there is no need to rely on government as the sole providor of safety; people were safe for a long time before there was government. Please let me know of anything you disagree with or are unsure of. I love to discuss this stuff! Further Reading Walter Williams, "Protecting the Environment" John Stossel, "Dismantle The FDA?" Mary Ruwart, "What is the libertarian solution to corporate power abuses?" The Cato Institute, "Turning to Government"



		© 2001 - 2007 Bryan Metz Published October 20 , 2006 \| Updated October 20, 2006 bmetz (at) bucknell (dot) edu