7 Important Examples of How Markets Can Fail

7 Important Examples of How Markets Can Fail

iStockphoto/The Fiscal Times

Many people on the political right believe that free markets are the solution to most any problem. For example, Senator Pat Roberts (R-KS) introduced yet another attempt to repeal Obamacare with a call to “start over … with true, market based reforms.”

​Free, unregulated markets are not always the answer, however. It’s true that competitive markets have desirable properties, but very special conditions must be present for competitive markets to emerge. When these conditions are not met, as is often the case in the real world, free markets can perform very poorly. In these cases – as illustrated in the following examples – government intervention that eliminates troublesome “market freedoms” can often be used to move these markets closer to the competitive ideal.

1. Retirement Security. The main market failure in retirement insurance markets is called “moral hazard” – people who will not save for retirement because in they know that a compassionate society will give them enough to survive in any case. The solution is to force people to save some of their paychecks each month so that, even if it doesn’t fully cover their retirement expenses, at least they’ll contribute something.

Of course, we already have a system like this, it’s called Social Security, and the main task ahead is to protect this important program from calls to reduce it, eliminate it, or to place it in the hands of the private sector.

2. Health Care Markets. There are two important market failures in the health care market. The first is moral hazard, and it is much like the moral hazard problem in retirement insurance markets. If people know that society will care for them if they break a limb, have a life-threatening disease, and so on – if they can always go to the emergency room at someone else’s expense – many will choose to go without insurance. A solution to this problem, one that is part of Obamacare, is to force everyone to buy insurance and contribute to the care they get.

A second problem, an information problem, is called adverse selection. If people know more about their own health than their insurance companies, as they likely do, they will sort themselves in a way that leaves only the most expensive and unprofitable patients in the market. Forcing people into large pools that do not allow individuals to self-sort according to how likely they are to need expensive care – again a feature of Obamacare – can overcome this problem.

There are many other market failures in health care markets, e.g. patients not knowing enough about treatments to be informed consumers, and all of them can be mostly resolved through government managed health care systems such as those adopted in other developed countries.

3. Carbon Emissions. This “externality problem” is well known, and so is the solution. The environmental costs of production do not appear on the firm’s bottom line, so firm’s do not account for them when deciding how much to produce leading to over production of the good. The solution is to force firms to internalize these costs through mechanisms such as a carbon tax or a cap-and-trade system.

4. Labor Markets. The demise of unions over the last several decades has increased the power of firms relative to workers in negotiations over wages. This appears to be due, at least in part, to government putting the desires of business over those of workers. That needs to stop.

5. Financial Sector. One important market failure in the financial sector is asymmetric information, i.e. the sellers of complex financial assets are often better informed than buyers. The ratings agencies are supposed to provide buyers with the information they need on the quality of these financial assets to solve this problem, but they have failed badly at this job.

There are also information problems that can lead to runs on the shadow banking system. In particular, lack of information about which banks have “bad assets” on their books and which do not can lead to bank runs on healthy institutions based upon rumors and suspicions. Amazingly, even though shadow bank runs were at the heart of the financial crisis, this problem has not yet been resolved.

Finally, many of these banks are systemically important. The actions of a single firm can affect the market, or the nation/world, which violates the assumption that each firm is a very small part of the market. This is the too big to fail problem we’ve heard so much about that was supposedly fixed with the “resolution authority” granted by Dodd-Frank.

6. Government Contracting. A “principal agent problem” is present whenever a person making decisions (the agent) for someone else (the principal) has the incentive to deviate from the best interests of the principal and full oversight of the agent is not possible. For example, managers of large firms may give themselves perks instead of maximizing value for shareholders. The rise in government contracting over the last few decades “from a little more than $200 billion in 2000 to about $440 billion in 2007” brings about principal agent problems, and lack of effective oversight gives ample opportunity for consultants to line their pockets rather than maximize value for taxpayers. In many cases, we’d be better off if the government provided these services itself.

7. Economic and Political Power. As The Economist explained not too long ago, “the world’s biggest firms keep on getting bigger,” and the political power of large firms has grown along with their economic power. There have been some attempts by regulators to rein in companies like Google, but much more is needed, particularly for large firms in the financial industry.

When there are substantial departures from the conditions needed to approximate pure competition, markets usually perform poorly and government intervention can often help. In some cases, e.g. with a carbon tax or cap-and-trade, government intervention will reduce output and employment growth in the industry and many misguided market fundamentalists, or those with other agendas, will object to these “growth killing” policies. In other cases, e.g. in health insurance markets, government intervention will cause the industry to expand rather than contract. Here, the objection is generally about the growing size and power of government.

But in both cases what’s important is that government intervention is moving us closer to the competitive ideal, and true believers in the power of markets would endorse rather than object to these policies.