Market Failure

February 3, 2008

[Response to Thomas, Part 1 of 3]

The reason the field of economics exists, its fundamental purpose, if you will, is to answer this question: how should we allocate the world’s scarce resources in order to best satisfy people’s unlimited wants? All of economics is geared toward answering that question.

In order to analyze different possible systems of economic organization, economists need some criterion on which to say that one system is better than another. Thus, the idea of economic efficiency is used to give a sort of “grade” to different systems or principles of economic organization. When economists say some system or rule X is more efficient than another system or rule Y, this means that using the same set of resources, X does a better job of satisfying people than Y.

So far all of these concepts have been pretty murky, but eventually economics does hit upon a quantifiable concept by which to compare systems: total surplus. Total surplus is made up of two components: producer surplus and consumer surplus. Consumer surplus is the difference between how much a consumer values a product and how much they actually have to pay for it. If I can get something for less than I would be willing to pay, I’m getting consumer surplus from the transaction. Producer surplus is analogous. In summary, the most efficient system is the system that maximizes total surplus.

Most of economic theory is based around the concept that a system of property rights and free exchange is the most efficient possible system for allocating resources, as measured by the total surplus produced by such a system. Economists like to point out that even some imagined “benevolent dictator” could not possibly come up with a better allocation of resources than the exchanges generated in a free, perfectly competitive market. The free market, in other words, maximizes total surplus.

Market failure is a tricky concept, because it doesn’t mean that the standard economic analysis as described above doesn’t hold. Well-defined property rights and free exchange are always the ideal in terms of efficiency. Instead, the problem in a market failure situation is that one of the assumptions of the model isn’t true, namely that property rights are well-defined. It is this insight that is fundamental to understanding why climate change is considered a market failure.

If someone comes into my house and steals my television, I can demand compensation from them and get it, because my right to that TV is defined. Pollution is different. If someone pollutes the air, neither I nor anyone else have the legal right to compensation from that person for harming my air. No one owns the air, yet everyone is made slightly worse off by an individual producer’s air pollution. Thus when the producer makes a deal to buy coal or oil or some other carbon-dioxide producing fuel, the price of this pollution is not factored into the cost; the cost paid by the producer is lower than the true total cost, including pollution effects, of the fossil fuel. There is a market failure here. Still, the market failure, in this case, results not from some flaw in the economists’ reasoning that free markets work, but rather from the fact that there property rights are non-existent in this case. The free market would still be the best system, if those rights were in place.

“Market failure” is somewhat misleading as a label. The problem is not with the market itself, but rather the fact that markets can’t function as they should because the foundations are not in place.

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