A Closer Look at the Definitions
of Market Failure

Harry Pollard

[A detailed response to ecnomist Arthur Cordell by Harry Pollard.
Reprnted from a Land-Theory online discussion, 28 February 2006]

Economist Arthur [Cordell] answered my "what is market failure" with a list of descriptions of market failure. So I went through his cites and answered them. I was surprised at how many were of the type "Market failure is when the market fails. Anyway, it gave me an opportunity to provide my view of the failure of the land market.

Many academics are less interested in improving their discipline than in finding some tiny niche that they can use to publish a definitive if somewhat arcane paper.

Thus, economics overflows with esoterica causing its basic principles and intentions to be overwhelmed by a flood of useless argument and sophisticated trivialities.

Perhaps the change came at the beginning of the 20th century when it was thought that for economics to achieve stature as a real science it had to become mathematical. Then it was argued it could take its place beside physics, chemistry, and the other natural sciences.

But mathematics is only a tool. It suffers, as does the computer, from GIGO -- garbage in, garbage out. You cannot make something true with mathematics. You can only connect between things. If the premise is not very good you cannot improve it by moving it through a train of mathematical logic.

At the very center of the science of economics is the market. This is where people exchange goods, where human cooperation reaches its optimum. Unfortunately for mathematical theorists, the market can only be described as 'quick and dirty'. The billions of market transactions that occur every day are likely to be anything but perfect. People pay a bit too much for something they want. A supplier gets less than he could get because he has misjudged the demand for his goods.

All in all, the market is imperfect because people are imperfect and the market is about people. Such a circumstance does not lend itself to the perfection of mathematics. For this a perfect market was needed -- even though it doesn't exist.

Once an economic scientist has established in his mind the concept of market perfection he can then return to reality where he finds nothing but imperfection! So, barrels of papers can be written, not about the market, but about how the market fails in practice -- that is, how it differs from the fantasy of market perfection.

First we should establish something. The engine of the market is price mechanism control. Demand raises prices, which effect stimulates supply. Production and movement of goods to market satisfies the demand and brings prices back to equilibrium.

To the engineer, this is a simple negative feedback mechanism such as is found in the thermostat found every home. It operates simply and efficiently to maintain a desired temperature. If one were to place a lighted candle under the thermostat, before long the house would be freezing. Would it then be sensible to claim that the thermostat was faulty -- was imperfect?

I would suggest that this is an analogous to claiming the market is imperfect. However, let's look at your cites.

The first is www.fiscallygreen.ca/efr5.html which deals with environmental externalities. If the producer is harming the air or water in the course of production but it costs him nothing, then obviously he can sell cheaper in the marketplace. As you know, Georgists regard the air and water as part of the common stock to which all of us have an equal right. If Cordell Inc. messes up our air and water, it must either stop it or compensate the rest of us for the damage it's causing to our air and water.

If the community doesn't put a price on this external damage how can it be reflected in the market? This might be a failure of political action but it is hardly a failure of the market.

The next cite is at www- personal.umich.edu/~alandear/glossary/m.html.

Here we find that market failure is: "Any market imperfection, but especially the complete absence of a market due to incomplete or asymmetric information."

"Incomplete or asymmetric information" is part of every real-life market, though obviously not part of the perfect market of economic fantasy. Mrs. Smith meets Mrs. Jones in Safeway. Mrs. Jones says "Don't buy tomatoes here -- Loblaw's has better tomatoes for one dollar less a pound."

This is the market operating, though I doubt that it will appear in any economic mathematical modeling. Supply, demand, and information, are changing all the time. The result of this market process is to improve quality and reduce costs.

If Mrs Smith did not meet Mrs Jones, she would not be getting the best tomatoes at the lowest price.

Ha ha!

The market is imperfect! At least when compared to the mythical concept of the perfect market in the economist's mind.

The next cite: www.econ100.com/eu5e/open/glossary.html is hilarious.

"Market failure: The failure of an unregulated market to achieve an efficient allocation of resources."

What a wonderful example of begging the question, or if I were a modern economist I should probably call it petitio principii or circulus in probando. Fortunately, I don't bear the burden of neo-Classicism so begging the question is good enough. The implication is that a regulated market does achieve "an efficient allocation of resources. That would be true if efficient allocation meant umpteen tons of butter stored in caves, or mountains of cheese blocking out the sun.

The 'efficient' regulated market spawns shiploads of excess food being dumped on unsuspecting countries, thereby ruining their markets (and no doubt proving again that markets are inefficient).

Implicit in this statement is that the regulated market would achieve efficient allocation of resources. By whose criteria? Why, the regulators of course, people who presumably know far better than ordinary people in the marketplace what they want or desire. Douglas Jay achieved a peculiar notoriety as a member of the postwar British Labour government when he outspokenly claimed that the government is far better able to decide what is good for the British housewife - than the British housewife. His popular phrase was "The man in Whitehall knows best".

The free market assumes by virtue of its name that there is no interference with exchanges. So a regulated market is not a free market. At this point, a red herring is usually introduced. "You want an unregulated market in which kids can buy plutonium."

Normal health and safety laws apply quite properly in our society. Yet, how sensible safety restrictions can be related to fixing the price of milk, or to preventing the importation of ladies' bras is grist for the PhD mill.

The next cite is:

www.adb.org/Documents/Guidelines/Eco_Analysis/glossary.asp

It begins "Market failure. The inability . . . because of imperfections in the market mechanism." Have these blokes never heard of circular reasoning?

It then uses a lot of words to say that market failure is when the market produces too many goods or too few. But then we are back to those about caves filled to the top with butter while mountains of cheese despoil the horizon -- not to mention the grain filled ships getting rid of an over- abundant production.

Oops! But that isn't the free market, is it? That's the controlled economy -- you know, the regulated replacement for the market. We all know that in the free market, should there be over-production of goods -- or under-production -- then prices quickly change to get rid of the excess or to spur production. And this will be done while the government is finding members for the committee that will report on the problem.

This cite ends with: "The existence of market failure provides a case for collective or government action directed at improving efficiency."

Now we know why young economists are told about market failure. It provides an excuse for the Douglas Jays of our generation to make our decisions for us.

The next cite is:

www.rri.wvu.edu/WebBook/Schreiner/glossary.htm.

This says that market failure is: "Failure of the market system to attain hypothetically ideal allocative efficiency. This means that potential gain exists that (for some reason) has not been captured.

I just love "hypothetically ideal allocative efficiency". It is said that to the economist reality is a special case. Here, once again, they discuss a market as being "hypothetically ideal". It would be a lot more fun if they discuss the market as it really is the rather than as an economic mindset.

Then we get to: www.tutor2u.net/economics/gcse/revision_notes/key_terms.htm.

This says of market failure: "These are the problems that result from the economy being left solely to the free market. There would be an absence of Government involvement in the economy."

Of course, no mention of what the problems would be if there was "an absence of Government involvement in the economy." By now, it must be pretty evident that the official line includes the assumption that the government must control the economy. This assumption colors every interpretation of 'market failure'.

We continue to the next cite on market failure:

www.oceansatlas.com/unatlas/uses/uneptextsph/infoph/ gsglossary.html

"The concept that markets do not reflect the societal costs of all economic activity and, in particular, the economic costs imposed on third parties."

This is just a notion, an idea -- at least he's honest. Again, let me repeat, external costs are nothing to do with the market. If anything, they are a fault of the government which should be taking care of things far from the marketplace -- that is establishing the rules of behavior that should be worth adopting in our society.

Your next cite is: www.crfonline.org/orc/glossary/m.html.

This says simply that market failure is "A condition that arises when unrestrained operation of markets yields socially undesirable results."

I have no idea what are these "socially undesirable results". Usually, they are supposed to be, for example, imported tainted meat. Yet, why should anybody import tainted meat. Our ordinary health laws would forbid its sale. So an importer would waste his money on meat he can't sell.

However, if government is derelict in its duties, there is a further check and balance. A retailer, or fast food supplier, who sells tainted meat is asking for bankruptcy. They have every reason to the world to make sure their customers go away happy.

The next cite is from:

www.booksites.net/download/mcaleese/student_files/glossary .html.

Here, market failure is the inability of an unregulated market to achieve allocative efficiency in all circumstances. The main types of market failure not mentioned earlier are monopoly and public goods.

Public goods are not usually part of the market process. We build one road to somewhere, we don't build a half-dozen roads to compete with each other. The market doesn't apply so how can it fail? (There are ways to bring the efficiency of the market into the public sector, but we'll discuss them another time.)

I suppose there are two kinds of monopoly -- natural and legislative.

Legislative monopolies have nothing to do with market failure. They simply remove the market from the scene. A private law (privilege) conveys special benefits to one -- or to a group - at the expense of another. This has nothing to do with the market. Perhaps it could be called political failure -- or the success of corruption in our political system.

Natural monopoly is a problem. If the price of a location increases with demand, there is no apparent way to bring it back to equilibrium. One cannot produce more locations nor can locations be moved from elsewhere to bring down a local price. The price rises and rises, uncontrolled by the price mechanism.

Land is not controlled by the market price mechanism, so something needs to be done. When the something is government intervention we run into all kinds of problems. They range from restrictions on production that raise prices and prevent consumers from getting what they want, to encouragement of production that produces the mountains of food earlier described.

In the case of land, we find mixed signals as governments seek to restrict this or stimulate that. The result of their endeavors seemed to be that land that should be used isn't, while land that shouldn't be used, is.

Henry George's method of dealing with this problem was simply to put land back in the free market where the efficiency of price mechanism control would handle allocation of available resources.

His proposal was to tax 100% of the economic rent of land. This value is produced by the local community anyway so it is quite ethical to recapture it for community purposes. The economic effect of this would be to end land speculation -- the holding of land from the market, perhaps for decades.

Land holders who would normally hold their land from the market for many years would still have to pay the heavy land value tax. Their choices are to put the land to use, or turn it over to someone who would. Land would be pried loose from its monopoly power and freely enter the market.

It would be a buyers market. As land came into the market, prices would fall ushering in a new era of really affordable housing. At the moment, land cost is between 50 and 70% of the price of a home. As land prices fell, the cost of housing would be likely to drop dramatically.

Developers who now must search for land wherever they can find it -- even if it's in the middle of a natural habitat - - would find a plethora of opportunities within present cities. Whether by improving vacant lots or razing slums to put up new and better buildings, builders would enjoy a boom as they produce inexpensive housing.

In practice, the policy of increasing taxes on land values has been accompanied by decreasing taxes on buildings. Such taxes, which oppressively add to the cost of housing, by their removal would make a home even less expensive.

However, without Henry George's remedy, present land cost is horrendous. It's hidden under the somewhat euphemistic "housing prices" -- but it's really heavy and rising land values.

It's remarkable that in all these cites of market failure, no economist has noticed the obvious "market failure" -- rising land values from the lack of a free land market.