All Commentary
Thursday, December 8, 2011

The Failure of Market Failure

How about government failure?

One of the most commonly deployed arguments against free markets is that they are plagued by “market failure.”  Critics point to particular cases where some problematic outcome has occurred and then argue that markets either did not or cannot possibly address those situations.

The market-failure criticism has two problems, both related to the fact that the critics rarely understand the meaning of term has in economics.  First, the meaning itself is problematic from a Austrian understanding of the market process.  Second, saying that markets have failed does not mean that government intervention can improve on the outcome.

In the technical literature a market failure refers to any situation in which a market does not produce the “Pareto-optimal, general equilibrium” outcome.  Standard neoclassical theory argues that “perfectly competitive” markets will produce outcomes in which resources are allocated to their highest valued uses and no one person can be made better off without making at least one other person worse off.  In general equilibrium, prices of all goods are exactly equal to the marginal cost of producing them and all households maximize their utility.  In addition, all firms are profit maximizing, but the level of real profits earned is zero, as no reallocation of resources could improve on the current one.

Unreal Conditions

Strictly speaking, any market outcome short of this reflects a “market failure” in that markets have failed to produce the ideal outcome that theory predicts.  However, in the real world the conditions necessary to produce a general-equilibrium outcome are not remotely feasible: perfect knowledge, homogeneous products, and a large number of small firms in every market with none able to influence price.  Given that such a world is not possible, the charge of market failure boils down to the claim that markets don’t produce a level of “perfection” that is unattainable under any realistic circumstances.

In this sense of the term, markets “fail” constantly.  It takes an Austrian perspective to understand that these sorts of imperfections (a better term than “failure”) are not only part and parcel of real markets; they also are what drive entrepreneurship and competition to find ways to improve outcomes.  In other words, what markets do best is enable people to spot imperfections and attempt to improve on them, even as those attempts at improvement (whether successful or not) lead to new imperfections.  Once we realize that people aren’t fully informed, that we don’t know what the ideal product should look like, and that we don’t know what the optimal firm size is, we understand that these deviations from the ideal are not failures but opportunities.  The effort to improve market outcomes is the entrepreneurship that lies at the heart of the competitive market.

Thus the value of markets is not that they will achieve perfection, but that they have endogenous processes of discovery that enable people to correct the market’s imperfections.  Just as it’s the very friction of the soles of our shoes on the floor that enable us to walk, it is the imperfections of the market that encourage us to find the new and better ways to do things.

Government Failure

However, even if all of the above weren’t true, or if critics don’t believe it, there’s a second half of the argument that must be dealt with.  To say that markets fail does not, in and of itself, mean that government intervention will improve things.

Note that the market-failure critics fail to apply the same logic to government that they do to the market: Just as markets lack the impossible features that would enable them to achieve perfection, so do governments.  In fact, government failure is at least as common as market failure.

So why then do we think markets are better?  To answer that question, we must ask: Which process has better built-in mechanisms to provide the knowledge and incentives necessary to notice imperfections and improve on them? It is here that the Austrian argument for markets comes to the fore.  Markets are desirable not because they don’t fail, but because they are better able than government to respond when they do fail.  Thus the charge of “market failure” itself fails to address the main issue.  Rather than worrying about when and why markets supposedly fail, we should be concerned with how well they, and the political process, respond to imperfections.

Read a Portuguese version of this article here

  • Steven Horwitz was the Distinguished Professor of Free Enterprise in the Department of Economics at Ball State University, where he was also Director of the Institute for the Study of Political Economy. He is the author of Austrian Economics: An Introduction.