The Myth of Market Failure

by
Soham Patil
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A prominent topic that economics students anywhere cannot avoid is market failure. Students everywhere are taught that the free market is inherently unstable and causes problems that can only be fixed through legislation and regulation. As a result, most of those who take an economics class come out of it believing that the state helps counter the shortcomings of the free market.

However, the concept of market failure is fallacious as it is based upon faulty economic reasoning. Belief in market failure is often complementary with seeking to promote politically desirable goals rather than to promote economic growth.

First, a free market operates on freedom of association and property rights. Therefore, for any transaction or exchange to be conducted on a free market, it must be voluntary. Further, if both parties agree on an exchange, then both parties must assume that the exchange is beneficial to themselves.

Whenever consumers buy a product, they value the product more than the money they pay for it. Similarly, the store sells them the product since it values the money earned more than the loss of the product that they sell to consumers. It may be the case that one party is mistaken and ends up not preferring the exchange retroactively, but this is not a determining factor in the choice to transact. Through this process, value is created through free markets. As people are free to interact and exchange, they make mutually beneficial trades that benefit both parties.

However, believers of market failure contend that the free market fails to provide optimal outcomes in some situations. By opposing the outcome of freedom of exchange, they lay the groundwork for coercive economic policy instead. An example of “market failure” pointed to by those skeptical of free markets tends to be market power or the formation of monopolies. They argue that a firm with too much market power can set prices arbitrarily high and force consumers to pay.

Contrary to their contentions, most monopolies form due to statist legislation. Even if a free-market monopoly were to arise, it could not set prices arbitrarily high as it would have to compete against the possibility of a start-up forming if consumer dissatisfaction arose with the monopoly’s pricing policies. The reason for the current prevalence of monopolies in certain industries can be traced back to the fact that there are significant barriers to entry placed upon starting an enterprise in a highly regulated industry. This is hardly a case of free market failure.

Another notable and common example of cited market failure is that of common property. It is often said that the free market does not properly conserve common property. The tragedy of the commons is a well-talked-about example. Situations such as the tragedy of the commons can be fixed through privatization. This is because owners of property have a greater incentive to care about its long-term value than those who do not own it. A lake that is regulated to be publicly owned is more likely to be overfished than a lake that is privately owned. It may still be the case that the private owner of a lake overfishes the lake and causes the demise of the fish population of the lake, but he will do so at great cost. This cost would not exist if he were not the owner of the lake or if he were fishing in a public lake. The moment that private property is established, rational economic calculation through the free market takes place.

While many believe that externalities cause rational economic calculation to be wrong, externalities are not a valid cause for intervention. Some critics charge the free market with underproducing public goods since they are nonrivalrous and nonexcludable. Since public goods have positive externalities that private owners cannot benefit from or charge for, they are not produced to a socially optimal level. An example of a public good is the construction of a dam in a flood-prone region. The dam protects all inhabitants of the region by its nature, and people cannot be charged individually by refusing them protection if they do not fund the dam. However, employing force via taxation to fund public goods is not required. Methods such as crowdfunding provide a free-market method to do so. Even better, these methods do not violate the property rights of people.

Similarly, negative externalities can also be solved by a free-market approach. Taxing goods that lead to negative externalities is improper and a perversion of justice because not everyone is affected similarly by them. Negative externalities can be dealt with through tort law, ensuring that money is paid only to those who are burdened with greater suffering as a result of negative externalities.

Lastly, proponents of market failure assert that information asymmetry can lead to market failure. They assert that one party having more information about a particular service or product can lead to unfair transactions. To some extent, this point has some credence. A party with more knowledge of the particulars of an exchange may stand to have a more-accurate valuation than the other party in the exchange. However, this is nothing other than a fact of reality of the world we live in. We are not omniscient creatures who have perfect knowledge. The free market allows for decentralized knowledge in a society to be used to its greatest capacity, as argued by Friedrich von Hayek long ago. Due to this, people with more correct valuations gain due to their superior knowledge.

Despite the popularity of belief in market failure, there are only a few assertions more ridiculous than the one that states free individuals are less efficient when they are free as opposed to when they have arbitrary regulations imposed upon them.