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Market Failure 1: Ideal Markets (Why you should care about spherical cows)

To the naive mind that can conceive of order only as the product of deliberate arrangement, it may seem absurd that in complex conditions order, and adaptation to the unknown, can be achieved more effectively by decentralizing decisions and that a division of authority will actually extend the possibility of overall order. Yet that decentralization actually leads to more information being taken into account.

Friedrich Hayek, The Fatal Conceit: The Errors of Socialism

To understand how markets fail it is important to understand how markets work. Without that, any discussion of market failure will degenerate into subjective arguments about what the market should or shouldn’t be doing. Before we get into market failure we need to have a concrete definition of market success.

To get an understanding of what properly-functioning markets do, read I, Pencil. If you discuss politics on the Internet you have probably been pointed at this before (it’s a favourite of libertarians), but even though its writing style might best be described as “overwrought” I’d like you to read it, not as a weapon in the rhetorical war between markets and government (although that is clearly what the author intended it as) but rather as a description of what the market for a relatively simple good has to account for when establishing a price:

  • How many pencils people want, and how much they are willing to pay for them.
  • The availability of each of the natural resources that go into pencils, and the time and effort required to extract them.
  • The time and effort taken to turn these resources into pencils.
  • The time, effort and resources required to transport the pencils and pencil-precursors from extraction, to manufacture to retail.

Note that markets have to solve this problem simultaneously across all goods since wood and aluminium and graphite all have alternative uses they may be put to, so you can’t just solve for pencil production and go home. For that matter, it needs to be able to solve for goods that don’t exist, but could.

Also note that markets have to solve this problem without any central direction. Nobody on Earth knows all of the things listed above. Somehow we are getting a suitable number of pencils being produced without anyone having the requisite knowledge to make an informed decision.

So how is the trick performed? How do you make a system that is smarter than its constituent parts? The key is to take global problems and turn them into local ones. Termites manage to make complex nests and yet no one termite has the cognitive capacity to understand the architecture of what it is creating. They do it by applying a set of very simple rules and signals that ensure each termite only needs to worry about the part of the nest it is working on – the global problem of designing a nest is reduced to a set of simple, local problems by using a signal to coordinate the disparate actors. This is also how markets work and the signals markets use markets are prices.

Prices are important because talk is cheap. If you just ask everyone how much they want something, basically everyone will say “a lot” and that gets you nowhere. First off, how do you weigh one person’s statement of desire against another’s? Secondly, how do you determine if they are inflating their statement of desire? To be useful as a resource allocator, a statement of desire must be credible (it can be expected to reflect the person’s actual preferences) and commensurable (you can meaningfully compare them). Prices fulfil both of these requirements very well.

If you are a rubber producer you don’t need to balance the global desire for pencils against tyres or other rubber products, you just sell your rubber to whoever will pay the most for it. In turn, pencil makers balance the prices of their inputs for the price they can sell their pencils. And the pencil retailers determine how much they can pay for pencils, based on how many pencils they can expect to sell, and for how much.

In addition, since the market participants are trying to make a profit, the “do what makes you the most money” rule is incentive-compatible. It’s a rule the market participants are inclined to follow anyway, so there’s no need to try and enforce compliance. This is what Adam Smith meant by the Invisible Hand – the market takes self-interest, a problem in most social systems, and co-opts it to improve the operation of the market.

OK, that may sound good in theory, but how do we evaluate it in practice? If the output of the market is so complex that we can’t independently check what it does are we stuck with just shrugging off every anomalous result by saying “the market moves in mysterious ways”? For economics to be more than ideology (or that matter theology), we need to be able to evaluate market performance in practice.

The key is to evaluate the process instead of the output, if the process is working fine then we can most likely rely on the outputs. If the process is flawed, then identifying those flaws is the key to working out what the problem is and fixing it.

The tool used to do this is the First Welfare Theorem, a mathematical description of the circumstances under which markets would deliver perfectly Kaldor-Hicks efficient outcomes. Kaldor-Hicks efficiency is what economists normally mean by efficiency (except when we’re talking about the Efficient Market Hypothesis). For a situation to be Kaldor-Hicks efficient there has to be no possible action that could make anyone in the society better off without making others sufficiently worse off that the winners couldn’t compensate the losers. This makes Kaldor-Hicks a utilitarian criterion for evaluating a social system, and while it isn’t necessarily the only thing you should care about, it is very important as it reflects the preferences of the people in your society.

The conditions required by the First Welfare Theorem area little technical, but in broad terms for markets to be perfectly efficient the following things need to be true:

  • The costs and benefits of a transaction accrue to those who are engaged in the transaction – that anyone who is gaining or losing from another’s activity has a chance to bargain with them.
  • No one player in the market, be they buyer or seller, may have enough influence to materially affect prices through their own decisions.
  • People need to have some baseline level of information and decision-making ability.

Having read that list, you may be ready to object that the real world doesn’t look much like that. And you’d be right. The point of the First Welfare Theorem is to give us a model of a perfect market, so we can identify the flaws in real-world markets. We call these flaws Market Failures, and they are going to be the topic of discussion for most of the remainder of this series.

Next week, we’ll get into the first of these Market Failures – externalities.


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James is a government policy analyst, and lives in Wellington, New Zealand. His interests including wargaming, computer gaming (especially RPGs and strategy games), Dungeons & Dragons and scepticism. No part of any of his posts or comments should be construed as the position of any part of the New Zealand government, or indeed any agency he may be associated with.

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87 thoughts on “Market Failure 1: Ideal Markets (Why you should care about spherical cows)

  1. No one player in the market, be they buyer or seller, may have enough influence to materially affect prices through their own decisions

    you say. But then how is the market to reflect their preferences? Do you mean that no one player may impose these changes on others, as though they were an external force to a market consisting of the original minus the imposer? (I think this is what you mean, but I also think it’s worth rephrasing it this way)

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  2. I do think this

    Also note that markets have to solve this problem without any central direction.

    is perhaps a bit overstated. There’s some central direction. The manager of the pencil factory directs the flow of certain processes, for example, as do the owner/operators of the zinc mines. Now, this direction probably hews very closely to the incentives the market provides and a lot of the “direction” probably comes from below, with, say, ground-level workers setting the pace or innovating (or resisting) repeatedly as they encounter challenges to production. But my point is there’s some central direction.

    I’m being nitpicky here, because I really like this post and look forward to the others. And even if I’m right, that doesn’t by itself mean the state ought to intervene, just that the hand, even if a non-governmental hand, is in some cases more visible than others.

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  3. Are there any markets, you think, that actually work the way the theoretical pencil market does, including the real-world pencil market? If so, is there anything that makes that market intrinsically superior to the others. If not, does it matter?

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    • I mean,, if the 30s taught us anything, it’s that you run out of turtles eventually. (So far as I can see, at least) There’s a certain resolution at which this market model/device is super useful. You can zoom in below the level where it’s descriptive, and you’ll find that the system at that level isn’t especially market-y, in that the characteristic assumptions James laid out are wrong, and so the theory can’t make predictions accurately, but there is a level on which the pencil market works as such, and it’s a useful one to consider, even if only to get a feel for this “market” thingy before we start breaking it.

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      • Guy
        ‘You can zoom in below the level where it’s descriptive, and you’ll find that the system at that level isn’t especially market-y,’

        Could you unpack that a little bit?

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        • Well, in ‘s example above with the pencil factory, the factory workers and owners and managers aren’t (with respect to the pencil market) behaving quite in the way that linked article claims, because we’ve gone in too close. The pencil company is the entity that interacts directly with the market (of pencils), where no decisions are made from on high. When you look at the literal people, you get to a place where the market isn’t quite descriptive. On that level, ‘s first two assumptions are both violated – many people who stand to gain or lose in a given transaction have no chance to bargain with the participants, and several players have the power to set prices very broadly (for that matter, some of the players don’t really fit the categories of “buyer” or “seller”).

          I’m thinking of it like classical versus quantum mechanics, where in this metaphor the microeconomics that James is explaining is the classical mechanics, and some complicated thing I suspect I’ve never encountered (but which might be some kind of game theory?) is the quantum mechanics. In the classical limit (when you zoom out to companies and aggregated groups of consumers), quantum mechanics gives the classical result (a market in the sense that James is talking about is what occurs).

          I’m also having trouble explaining this.

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    • Please do not confuse an economy with a market. There are many ways to have an economy, but markets are like gravity–you will always have a market, whether you want one or not.

      And yes, there’s all sorts of ways that gravity gets complicated, but “ways that the standard model does not describe reality” is kind of the whole point of this blog post series.

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  4. On the availability of resources, are there any examples of markets or business people not rapidly depleting naturally depleting resources because buyers were available? During most of the 18th and 19th centuries, lobsters and oysters were very cheap and popular food. Than over-fishing turned them into luxurious goods. Nobody ever seemed to think that they should not aggressively harvest either to make sure supplies remain large enough for future eating. Fishing seems to have this problem in general but oysters and lobsters have it worse. The timber industry also seemed to be really big on just cutting down as many trees as possible to make money during the 19th century. For both fishing and timber, it took the advocacy of environmentalists and government regulation to stop business people from going wild with the resources.

    How do you deal with the incentive to rapidly deplete resources for short term gain with purely or mainly market mechanisms? My reading suggests that business people are really bad at this. Resources will be milked until they become rare rather.

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    • How do you deal with the incentive to rapidly deplete resources for short term gain with purely or mainly market mechanisms?

      You’re describing the tragedy of the commons, and the solution is to make the resource not a free-for-all commons. Ideally the solution involves property rights. When a resource is available for anyone to take, you have an incentive to grab as much as you can before someone else does. But if you own a stock of the resource, and no one else can take it from you, you want to maximize the net present value of the revenue stream you derive from selling the resource. If you think it’s going to be scarce (and thus more valuable) later, then it makes sense to keep it into later instead of exploiting it now.

      When private property is either logistically or politically difficult, quotas are a second-best solution. Unfortunately, these are often determined more by political considerations than by economic ones.

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    • During most of the 18th and 19th centuries, lobsters and oysters were very cheap and popular food. Than over-fishing turned them into luxurious goods.

      I could make a tasteless joke/pun based on how we use certain words here at OT. But I refuse to do it and I won’t. I WON’T, I say!

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  5. “If you are a rubber producer you don’t need to balance the global desire for pencils against tyres or other rubber products, you just sell your rubber to whoever will pay the most for it.”

    Is this always the case? What do we make of people who have non-financial incentives?

    For instance, if I were a producer of whatever metal is used to make bullets (Is it still lead? Let’s say lead for now…), I might opt not to sell my lead to companies that make bullets even if they pay a higher price because I might have moral qualms with that. And I certainly wouldn’t sell my lead to bullet companies based in, say, Syria. Regardless of the price they offered. What impact does that have on the market? Probably minimal because there are probably plenty of people more than happy to sell to bullet companies or whomever else is the highest bidder. The effect may be localized to my bottom line… but maybe not?

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    • This is where fungibility comes into play. If there are a lot of market players, your principled stance doesn’t really tip any scales. (Look at the oil market.)

      However: in the US, the prisons that use capital punishment are running into problems with buying the cocktail of drugs for lethal injection. The people who make it will not sell it to prisons and, more than that, enough of them are refusing to sell it that prisons are trying to figure out what to do.

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        • From what I understand (and I am *FAR* from an expert on this), the chemical companies who make this cocktail have come to the conclusion that they will lose more money in bad press from those opposed to the death penalty than they will gain from selling the cocktail.

          So, if this is true, they looked at the bottom line and concluded “nah, we won’t sell this because it’s too expensive to sell it.”

          I don’t know what would happen if a prison said “okay, we’ll pay double! Triple! We’ll give you an exclusive contract!” but one of the options is that a company would say “okay, it’s no longer too expensive for us to sell it” and then start selling it again.

          Is this the market failing or the market working?

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          • “Cocktail” may give people the wrong idea. The drugs are not mixed pre-injection; three drugs are administered in a particular sequence. The first renders the recipient deeply unconscious. The second paralyzes most muscles. The third stops the heart. IIRC, the real problem is with the first drug. It’s no longer manufactured in the US, the EU bans export, and the Indian suppliers have not been approved for human use in the US. As an anesthesia, it’s been largely replaced in the developed world by safer more-expensive drugs that do not put the patient as far under.

            There’s a lot of economic and political discussion points here.

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          • So if the companies are still looking at a financial bottom line, then my very amateur eyes make me think that is the market working. But if a company willingly takes a worse financial arrangement in exchange for some other benefit — let’s call it a boatload of the “feel goods” — how does an economic analysis of a market correct for that?

            The feel goods have value undoubtedly. But how do we account for their ‘price’?

            This seems to permeate through the system. When consumers buy at the Mom-and-Pop instead of Walmazon — paying a premium — because the former gives them the warm fuzzies and the latter gives them the heebie jeebies, that indicates that these transactions are more than just financial exchanges of items of tangible value. So how do we account for this?

            None of this should be construed as an argument against anything Mr. K is saying here. I have fewer legs than a snake to stand on in arguing with a true expert on the matter. Rather, I’m curious if/how any of this gums up the works because of the elusive nature of valuing something both intangible and highly variable.

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            • The feel goods have value undoubtedly. But how do we account for their ‘price’?

              I imagine that their price is worth somewhere around where they say “okay, we’ll change our minds” and start accepting cold, hard cash instead of intangible fuzzies.

              (And, much like anything else, fuzzies might be worth a hell of a lot today and not even half that much tomorrow.)

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            • “When consumers buy at the Mom-and-Pop instead of Walmazon…that indicates that these transactions are more than just financial exchanges of items of tangible value. So how do we account for this?”

              um

              is there some reason we can’t just use “price at Momanpop minus price at Walmazon”?

              If you say “well, but that means we can’t determine subjective value until after a transaction has occurred!” you’re right, but see above re: markets being like gravity. It took a long period–like, centuries–of observations before someone figured out how to express gravitational attraction as an equation. And even then it was a curve fit rather than something derived from first principles–and, as time goes on, it’s proven increasingly unable to explain what we actually see happening in the universe.

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            • So if the companies are still looking at a financial bottom line, then my very amateur eyes make me think that is the market working. But if a company willingly takes a worse financial arrangement in exchange for some other benefit — let’s call it a boatload of the “feel goods” — how does an economic analysis of a market correct for that?

              I probably don’t know what I’m talking about, , but here’s my stab at it.

              The market is about choice and price points. And economic analysis is about how people make choices according to their own preferences, what they believe to be in their best interest at the time. “Best interest” could be the very “boatload of the ‘feel goods'” or it could be “I’d lose a lot of money.”

              If I’m right, then the economic analysis doesn’t need to “correct” for that so much as take note of it.

              However, maybe someone else can chime in to explain where I’m off base.

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              • I think what I’m struggling with is the idea that we can ever really understand the value of something.

                I’ll use myself as an example. Near my work, there are two grocers I frequent. They carry a pretty similar array of products but one is generally more expensive than the other. Such that I couldn’t do my regular shopping at the more expensive one. But the more expensive one is closer to my work. It’s two blocks away where the other is about six blocks. Today, I needed to go grab one item and my initial thought was, “I’ll go to Westside. It’s only $3.99 there. It’s probably like $4.99 at Gourmet Garage.” Because, as a general rule, paying a 25% markup just doesn’t make sense for me. But today my time was limited and I said, “Paying an extra buck to save myself 10 minutes is easily worth it. I’ll go to Gourmet Garage.”

                But on other days, I’m likely to think, “I got time to kill. It’s nice out. I’ll make the walk and save a buck. Or maybe even by myself a little snack with the dough I save.”

                So, how much is that item worth? Is it worth $3.99 or $4.99? It not only depends on the person, but it depends on the day and the context and so many other factors.

                Now, maybe I’m misunderstanding how this whole thing works. Like, I might be ENTIRELY misunderstanding IT ALL. But when I think about just my pursuit of a clamshell of baby spinach, it makes me wonder how any of this works…

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                • “[H]ow much is that item worth? ”

                  One of the fun features of a market is that things are worth different amounts at different times, depending on the cost of production and acquisition.

                  As you so ably demonstrate here, where sometimes ten minutes is worth a dollar and sometimes it isn’t.

                  ***********

                  One of the many assumptions that go into modeling markets is that everything is constant–costs are always constant, resources are always constant, utility of an item is always constant. Once these assumptions are no longer valid, simple models (of the sort that are easily conveyed to Econ 101 students) have trouble keeping up.

                  Sort of like how one of the many assumptions that go into our model of gravitational attraction is “mass is constant”. When mass isn’t constant anymore, simple models of gravity don’t work anymore.

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            • Those warm fuzzies are all part of the price mechanism. If enough people prefer shopping at an independent store over a corporate chain, that will allow the independent to charge more for equivalent goods than the chain can. This could allow an independent with higher costs to survive in the face of superficially superior competition. I say “superficially superior” because the local store does have a competitive advantage – people like shopping there.

              In fact, were I tasked with answering the question “how much do people prefer shopping at independent stores over chains?” I would probably look at price differentials between equivalent products in independent and chains stores near each other.

              None of this is market failure, it is the market working as intended. People care about more than just money, so allocative efficiency has to care about more than just money too.

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          • I don’t know what would happen if a prison said “okay, we’ll pay double! Triple! We’ll give you an exclusive contract!” but one of the options is that a company would say “okay, it’s no longer too expensive for us to sell it” and then start selling it again.

            Nothing would happen, because those drugs are used about 30 times a year, and probably were not profitable *in the first place*. 30 doses a year for the entire planet(1) is an insanely small market. I’m not sure what it costs to make a dose, but seriously.

            I suspect that the companies that *were* making it already had it set up from when it was used medically, and just kept doing it.

            It’s also why no clever company has stepped into the void left by the market. I mean, making an unpopular product is exactly why little niche companies exist. Set up one that *just* makes that, and rake in the profits, and who cares what anyone thinks about it, if it doesn’t make anything else no one can ‘boycott’ it…except that, like I said, the market is so tiny it’s not actually a market. *Lemonade stands* sell more product. So no one has done that.

            1) The US is one of the few nations that still does the death penalty, and is pretty much the only nation that tries to do it ‘humanely’.(2)

            2) By which we mean ‘does not look painful’. The actual most *humane* method of execution remains, as it has since its invention, the guillotine. But it *looks* horrible.

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            • Of course, incredibly tiny markets do exist. I mean, *someone* is making 100 million dollar yachts and diamond encrusted Rolexes and whatnot.

              But we’re not talking ‘triple’ the price, we’re talking a lot more than that.

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      • “in the US, the prisons that use capital punishment are running into problems with buying the cocktail of drugs for lethal injection.”

        Of course, the market-orthodoxist would point out that this is due to government interference with the market for those drugs, and that market-orthodoxist would be correct. Amusingly, drugs intended to kill humans must follow the same requirements for testing and FDA certification as any other drug intended for use in humans.

        That’s right–the same thing that lets Turing Pharmaceuticals charge thousands of dollars for Daraprim is keeping states from buying lethal-injection drugs.

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          • I guess you’re right. We certainly wouldn’t want to use lethal-injection drugs that had an increased risk cancer or long-term cardiac damage. Although the notion of a double-blind clinical trial for lethal-injection drugs is rather droll. “Did you experience cramps, vomiting, nausea, headache, blurred vision, dry mouth, or engage in other activities without remembering it the next day?” “Uh, he died five minutes ago.

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  6. To me, the interesting thing about ideal markets is just how few there are in the ordinary life of most people.

    Most people in the US are not self-employed. So the single most important economic relationship in most people’s lives is hierarchical, not market based. (And the market for labor is very different from the market for pencils.)

    Relationships among family and friends are rarely market driven.

    Many of the goods and services that are most important to an ordinary household are provided by government: potable water, sewer, police and fire protection, schools, parks, roads, etc.

    One of the most important services that many Americans do not get from their government is chock-full of market imperfections — health care and health care financing.

    Yes, it’s absolutely true that global markets in commodities and finished goods have created extraordinary consumer wealth compared to the past. But it’s also worth remembering how much more there is to daily life.

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    • Well definitely.

      Heck, at its base economics are something we like to fight over so much in modern times because they are something that we can feasibly measure. In liberal modernity we don’t fight over the intangibles like we used to and that inclination has served us well.

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    • Most people in the US are not self-employed. So the single most important economic relationship in most people’s lives is hierarchical, not market based. (And the market for labor is very different from the market for pencils.)

      There is absolutely a labor market and a whole field of economics dedicated to studying its interactions, labor economics.

      The idea of a market ought to be non-ideological, because the idea of a market is simply the space in which market participants make exchanges. In that sense, there is definitely a market for any and all things, because all of human interaction is based on some form of mutual exchange.

      It’s in the rules of the market, the aims of the actors, and the extent to which some external authority intervenes that ideology works in its way.

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      • Maybe a better way to put the argument would be that it’s a question of how well the abstract economic model of a market, with its sloping demand and supply curves, describes the behavior of the actual, imperfect, market that exists in the world.

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  7. A lot of people talk about market failures and whatnot, including here, but in reality, I’ve always thought that ‘market failure’ is a bit of a null term.

    Markets don’t fail, at least not at being markets. They just get distorted by (And this is apparently next week) by externalities. Should be fun.

    What I hope we eventually get into is ‘How to recognize that a market, even an ideal market, will not produce the outcome you want’, which is something free market fans often seems to miss. I.e., they think the problem is the market is distorted, but the problem is actually you wish for an outcome that ‘markets’ cannot provide. (So we should probably stop trying to *use one* there.)

    I could come up with serious examples of this (Our justice system for one, and I’ve argued health care before.), but instead I will list a very odd one I’ve noticed in Fallout.

    Namely, those little tiny circular nuclear shelters. Not the Vaults, I mean the blue circulate things above ground, where you apparently put in a quarter and are ‘shielded’ from a nuclear blast.

    I…can’t quite figure out how those things exist in any market. So, *after* the total destruction of society by nuclear war, someone was going to go around and collect *one quarter* from each of them? How…what? Why?! What exactly is the expected profits from this endeavor?

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    • What I hope we eventually get into is ‘How to recognize that a market, even an ideal market, will not produce the outcome you want’, which is something free market fans often seems to miss. I.e., they think the problem is the market is distorted, but the problem is actually you wish for an outcome that ‘markets’ cannot provide. (So we should probably stop trying to *use one* there.)

      I think I agree, and Burt Likko made a similar point in Tod’s workers comp insurance post:

      The very purpose of regulation and legislation into economic matters is to inject non-economic values into the way economic matters are handled.

      *******[snip]*******

      The right response to someone resisting a proposal to regulate economic activity who says, “But that creates economic inefficiency!” is “So what? We pay that price in other contexts, why not this one?” The real political question is whether we value the non-economic good that the regulation will enhance more than the degree of economic good that the absence of regulation would permit, and we make that sort of bargain all the time and there is no point in human history that one can look at and find a society wherein such bargains are absent.

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      • The very purpose of regulation and legislation into economic matters is to inject non-economic values into the way economic matters are handled.

        Well, yes, and no.

        That is the point of regulation, obviously.

        But I’m talking about the fact that to get *some* outcomes, we have to distort the market to such an absurd extent than we should probably stop trying to involve a market at all.

        There’s a reason we don’t operate competing law enforcement agencies and let the market decide…because while I’m sure we could *hypothetically* come up with some sort of horribly distorted regulated ‘law enforcement’ market that would get us outcomes like we want, it’s easier to, uh, just have the government do it.

        And as I’ve said before, we sure are spending a *lot* of time and effort trying to make the health insurance industry (an industry that literally produces nothing) act like we want it to, but it’s actually a bit worse than that…we’re pretty heavily regulating health *care*, also, because the unregulated health care market is completely insane. And it’s hard to figure out how that’s better than just…the government hires people to produce health care. Instead we have one highly distorted market managing another highly distorted market.

        And then we get into the imaginary invented line of ‘socialism’ if the government provides *one* set of services, vs. not socialism, etc.

        But, like I said, I’m hoping the discussion will cover these.

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    • Putting in a quarter is unrealistic, but one way to fund it would be for people to pay for a membership as a sort of insurance. This gives you a key that allows you to get in in the event that you need it. You could also make some money on them even without a disaster, just renting them out as a sort of miniature hotel room.

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    • What I hope we eventually get into is ‘How to recognize that a market, even an ideal market, will not produce the outcome you want’

      There are two possible scenarios that fit what you described.

      1) A Public Good, where the market will not produce the good (or will under-produce it severely) due to a mismatch between the benefits of the good and paying for it. These will be covered in Part 4. These are market failures.

      2) A policy goal which is unrelated to allocative efficiency, which is something the market isn’t able to optimise for. These will be covered in part 8.

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      • Okay, let me see if I’m getting these.

        With #2, you mean something like, for example, lowering gasoline usage in cars, right?

        And I know what a public good is in #1, but did you restrict it to ‘will underproduce the good’ for a reason? Because sometimes things can be produced in a fine amount, but just get extremely misallocated by the market. (Again, health care springs to mind.)

        I.e., if society really needs everyone to get at least 3 X a day, and companies produce enough for everyone to get 4 X a day, but we’ve got a bunch of wealthy people, for no real reason, buying 1000 X every day and screwing up the supply so the poor can only afford 1 X, that’s misallocation…and could be solved by higher production.

        …I just answered my own question, nevermind.

        Okay, good.

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        • By underproduce the good, I mean incentive problems will result in the market producing less of the good than would be allocatively efficient. In the case of many public goods it will actually produce none. I explain more in Part 4.

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    • Markets don’t fail, at least not at being markets. They just get distorted by (And this is apparently next week) by externalities. Should be fun.

      This is a bit like saying that objects don’t fall to earth; they just get distorted by the earth’s gravitational pull. It’s kind of true, but meaningless.

      What I hope we eventually get into is ‘How to recognize that a market, even an ideal market, will not produce the outcome you want’, which is something free market fans often seems to miss. I.e., they think the problem is the market is distorted, but the problem is actually you wish for an outcome that ‘markets’ cannot provide. (So we should probably stop trying to *use one* there.)

      It’s not that we miss it. It’s that we believe in most cases there is no mechanism that better informs us as to what we want than a properly functioning market. Just because you have decided that people should get X amount of good A and Y amount of service B, doesn’t make it so.

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      • This is a bit like saying that objects don’t fall to earth; they just get distorted by the earth’s gravitational pull. It’s kind of true, but meaningless.

        The second we start talking about ‘market failure’, we get entangled with debating if a market ‘failed’ or not, which means different things to different people.

        For example, people will claim the market didn’t ‘fail’, and instead it ‘correctly’ stopped producing something we all would like it to produce, because such a thing was not profitable. They are correct, that is indeed how the market is ‘supposed’ to behave.

        That phrase ‘market failure’ turns everything into a semantic debate about what ‘failure’ means, with some people thinking it’s the failure *of* the market to do something, and other people thinking it’s the market failing *at being a market*. Those two things are not the same thing.

        Instead of using the term ‘market failure’, I think it makes more sense to just talk about what we (As society) wanted the outcome to be vs. what outcomes the market is producing, and try to figure out why it’s doing that.

        It’s not a ‘failure’ if we, a society, can’t get what we want from the market. It just means we either need to distort the market more (Or less!) with regulation, or do something in addition to, or instead of, the market.

        It’s not that we miss it. It’s that we believe in most cases there is no mechanism that better informs us as to what we want than a properly functioning market. Just because you have decided that people should get X amount of good A and Y amount of service B, doesn’t make it so.

        Well, no, just because *I* decide it clearly doesn’t make it so.

        When *society*, however, has spent absurd amounts of time and effort trying to distort something to make it barely somewhat producing outcomes we would like…

        …at that point, we should at least *consider* if a different method besides the market might be something we want to try.

        Especially since, in a free society where people can do things *even if* the government is doing them, the government deciding wrong is just going to lead to *waste*, and not shortages.

        I.e., if the government, for some reason, decided to produce toilet paper for everyone (Although there’s no possible problem with the market in that.), we can’t end up with shortages like in the Soviet Union…*someone* would step in and sell toilet paper.

        The big scary monster of ‘shortages’ and ‘famines’ hiding inside communism doesn’t actually happen in a free society where random markets are allowed to exist, and so what the government does is in *addition* to the market…in fact, it’s the *regulations* trying to *distort* the markets that seem much more likely to cause shortages. The government *underproviding* toilet paper would be quickly remedied by the market…the government *price controlling* toilet paper can’t be.

        For a notable example, just replace everything I just said about toilet paper with ‘housing in Manhattan’. Price controls are stupid and causing more problems than they solve. If we as society *actually wanted* apartment with cheap rent in Manhattan, the solution for the government is to…buy some land, build some apartments on it, and rent them out cheaply. Um, duh. (We do *not* actually want that, and in fact that’s a really really stupid ‘goal’ of dumbasses who don’t understand how housing works, but the point is, we could solve that ‘problem’ if the government would do it itself instead of trying to manipulate the market.)

        Of course, this leads to the obvious rebuttal that often that the outcomes we *think* we want are not the outcomes we actually want…but, as I pointed out, right now that just leads to insane laws and regulations that attempt to bend the market semi-randomly, to the point we have no idea how it would operate naturally. Frankly, us turning to the government and saying ‘We really would like this outcome…why don’t we just *produce* it, instead of trying to manipulate things to where it happens?’ makes sense, and, hell, at least we could see what it was doing.

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        • The second we start talking about ‘market failure’, we get entangled with debating if a market ‘failed’ or not, which means different things to different people.

          That is just wrong. Market Failure means something specific with the context of economics. You are, of course, free to name things as you please, but that makes it very difficult to have conversations about things.

          Right now you’re arguing about something that it appears you don’t understand. I don’t mean that as an insult. I literally mean that your description of what a market failure could be is quite at odds with what it means in the context of economics. I suggest that you shelve your objections until James K has had a chance to flush this series out.

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        • In the context of economics, a Market Failure is a situation where a market violates one of the conditions of the First Welfare Theorem (see the main post). This framework takes the purpose of markets to be efficiently allocating resources (using Kaldor-Hicks efficiency as the benchmark). If they don’t do that properly,they have failed. If they are doing that properly, they have not failed, even if society wants something other than allocative efficiency.

          This is the context in which I will be discussing Market Failure in this series.

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        • Guys, I know what market failure actually is in economic terms. The reason it’s called market failure is because it’s really ‘market theory failure’…it’s the point that market theory sorta starts breaking down, where the assumptions are no longer true.

          It’s science, it’s like talking about (Because j.r. mentioned gravity.) how relativity breaks down at singularities and you can’t use it anymore. (Although you’ll notice they don’t refer to that with the dumbass name of ‘relativity failure’.)

          This was, I feel I should point out, *in the frickin post*, and something I already knew.

          My point was, that *every time* people start talking about market failures, some people will attempt to include things under that umbrella that are *not* failures of the market to be a market, but are instead failures of the market to do what we want it to.

          For an example, *the comments on this very post*.

          And the thing is, even though market failure is a specific technical term in economics, there is *nothing* wrong with the English sentences ‘The market failed to provide affordable health care’, or even ‘There has been a market failure to provide gold plated watches at $5 apiece.’. (It’s a bit of reification, but it’s fine.)

          If you actually wish to have conversations with human beings instead of economists, you probably should stop using the term ‘market failure’, or you have to *constantly* explain what you mean, and why what looks like a failure to them is actually correct market behavior. (And you also have to explain why things are technically ‘market failures’ that do not look very much like ‘failure’.)

          Again, I point to *comments on this very post, in which you actually defined what a market failure and success is*. And yet it didn’t stick!

          Thus I was suggesting that people stop using the term ‘market failure’ to refer to markets that have been distorted by externalities and just *say* that they’ve been distorted. There. Done. Economists know you’re talking about a market failure, and everyone else understands it. (And the same with various other methods of what is wrong with a market, but I think most of them can be simplified to ‘something is distorting things’. But I could be wrong.)

          Meanwhile, people who want the markets to *do something* that it won’t do in its natural state should also not use the term ‘market failure’, because it’s actually wrong there, and it’s even more confusing.

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          • This sounds like the argument that we should redefine “inflation” from how economists use it the, “I feel in my tummy like the price of gas is higher” definition that most non-economists use because that’s what most people mean when they say it.

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          • Also, what’s with the word “octave”? It sounds like you’re talking about part of an octopus. It’s confusing, it leads to conversations that don’t have anything at all to do with music. We should say “eight-notes” instead. Musicians understand that you’re talking about an octave; everyone else avoids getting into conversations about sea creatures.

            And that’s doubleplusgood.

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            • Firstly, if you think octave means ‘eight notes’, it is *you* who is, in fact, mistaken. Octave is the range between one tone and another that’s double the frequency. On a piano, in fact, there are *12* notes in each octave, and pianos are missing some flats and sharps that are possible on other instruments. So, inadvertently, you just proved my point: If someone was trying to explain musical theory and kept talking about the number of notes in an octave and everyone kept assuming that was eight and that had to be constantly corrected in the comments…

              If I write a primer blog post for understanding theatre direction, and write that ‘An important principle of blocking actors is that actors without focus should cross above the action.’, what *exactly* do I mean?

              Let’s say that I then explain that ‘above’ means ‘on the upstage side’….and that’s not any clearer, so I then explain that ‘upstage’ is the direction away from the audience. Fair enough, *most people* at that point could figure that sentence out…except in the comments, a few would still confused, because reading comprehension is for SATs, not blogs.

              And then I keep using the word ‘above’, and ‘below’ through the series, and every time, in the comments, someone wonders how the hell people on stage can be *above* or *below* each other. Are there platforms? Are we flying performers?

              They wonder this because ‘above’ and ‘below’ have common meanings that theatre is ignoring, and thus I either end up having to define every time I use them (and even then, it’s a blog, someone is going to fail to read the entire article), or, alternately, I could just say ‘behind’ and ‘in front of’ when *speaking to a non-theatrical audience*, and, hey, problem solved.

              James K. specifically said above, ‘One of the tricky parts of writing a series like this, is figuring out what I can safely simplify.’.

              I am attempting to inform him that not only can he not assume people know what ‘market failure’ means, which he clearly knows, as he wrote *this* post about it, but it might be best to stay away from that term at all (Instead of fricking titling his entire series with it.), because even *in the post* where he explains what ‘market failure’ means…he’s got people not sure of what it means, and it’s just going to get worse in later posts where he probably intending to assume people *already* know what it means.

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              • I appreciate the advice, but the problem is that when I think about economics concepts, I think in economics jargon. It’s really important for any technical field to develop its own language, otherwise you get caught in semantics and misunderstanding.

                I’m hoping as this series is released, people will come to understand why economists use some of the language they do – I think more people having an understanding of economic terminology will help a lot of debate.

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  8. I, Pencil seems badly misdirected. It’s a feature of any large human enterprise than no one knows all the details; they’re known best by the people who need them to accomplish their goals, and a bit less well by the people closest to them, and so on. That remains true in a highly centralized organization like a refinery, where the operators know a hell of a lot about which plants need which sort of babying, their direct management knows a bit less, and top management is in general fine with delegating that. There’s nothing about knowledge being distributed that’s unique to markets.

    On the other hand, the fact that a pencil, whose creation requires so many inputs and so many connections, costs about a dime? That’s amazing, and shows the value of letting motivated, self-interested people optimize each step. But Mr. Pencil doesn’t talk about that.

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  9. James,

    Just wanted to let you know I read this post (so I’m ready for the next installment!), but I did have a nagging worry that I thought I’d ask you about:

    Kaldor-Hicks efficiency is the state in which markets no longer admit K-H improvement, which is in turn defined as a transaction in which those made worse off could theoretically be compensated by the winners to achieve a situation in which everyone is actually made better off. (Is that right?) If so, does K-H requires an objective theory of value upon which this calculus is based? And if so, how does that reasoning go (eg., is the compensation made in the form of cash, or other values, or is it just a theoretical principle which doesn’t need further clarification, etc.) and is it even relevant in any event?

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    • It does not require objective value, which is one of the signal virtues of Kaldor-Hicks. The compensation required is whatever it would take for the party who suffered a loss to feel compensated. Naturally, this would be very difficult to figure out in practice, which is why economists evaluate it by checking for violation of the First Welfare Theorem, rather than tryign to observe it directly.

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