One important justification of giving government an explicit role in markets (to regulate, to license, to operate)  is that “the market has failed”. that means, essentially, that the benefits of using a free (unregulated) market for allocating scarce resources properly cannot work here for some reason. This post is about why markets can “fail” and justify intervention by society (eg government).

Markets emerge when potential buyers of something come together with sellers and engage in transactions. Markets and the transactions they produce are generally helpful to society because they tend to “self adjust” when prices are too high, or too low, and when excess profits are being made, or too much waste and inefficiency is occurring. The “self adjustment” forces are things like “competition between sellers” which can occur when prices and profits for something are too high, causing  more sellers to enter the market to capitalize on the prospect of high profits. As more suppliers try to get into the business, the difficulty of  attracting enough customers becomes a problem for most sellers— and they start trying to entice consumers via several tactics (have sales, lower prices, increase quality of the product, improve customer service, and other things to entice consumers to buy from them). These kind of  “competitive” tactics lower prices, and lower profits and eventually discouraging more firms from entering. If more customes start buying the product, then prices tend to drift up as sellers run out of inventory too fast, and then sellers try to raise price to capitalize on the increase in demand. This leads to higher prices and profits, and more sellers trying to enter the business to capitalize. These pressures in a market tend to be self correcting — as demand increases prices rise. And higher prices encourage more sellers to enter the business, until price falls. And, over time, markets like this are GOOD for CONSUMERS because prices tend to be as low as costs of the product will permit, high seller profits cannot persist because new sellers will enter and drive profits down. Say again— markets that bring buyers and sellers together tend to be good for consumers. Markets are a good way to organize economic activity in a society because: 

1. the scarce resources in society (human skills, land, manual labor, investment capital) and how they flow to different industries (health care, automobiles, cell phones, grocery stores) are being responsive to what consumers want—- and the allocation of each resource across products gets the “most bang for the buck” in terms of consumer welfare of all possible allocations.

2. prices and profits tend to be low– because if they get high, the new suppliers will                enter the industry and bid them lower–again good for consumers.

3. over time the selfish sellers will try to develop newer and better products and                      better service quality to keep the customer demand high, and restrict the ability of            other sellers to directly compete with them and take their customers away.

These behaviors all operate to the best advantage of customers. Markets that work like this are good for society. Better than doing it an alternate way (Soviet “planned economies, where the state owns all the businesses” —  there a person or a committee decides how much labor, steel, land, and investment capital goes to every firm in every industry. Is it the right level? Is the allocation of resources aiming to provide the optimal distribution to meet the needs of consumers? Not likely. Markets that work well to make adjustments to prices to reflect the intensity of demand and the number of sellers yield hard-to-beat results.

But markets that work well to make these “competitive adjustments” are not always possible. And, particularly in health care, the necessary conditions for markets to work well are not often met. This means the markets may be said to”FAIL”, What that means is that the failed market produces too little or too much product/service, relative to the level that truly competitive market would have produced (and, alternatively, that the market uses too few or too many resources relative to the level that a truly competitive market would have used).

The reasons that markets work well and are competitive are:

a. there are a large numbers of buyers and sellers in the market (no monopoly among sellers, no monopsony in buying either)

b. consumers understand product quality, and quality differences between suppliers

c.  no spillover effects of transactions on 3rd parties (who didnt buy or sell) –eg no                   externalities

If these conditions are not true— then too much or too little output will be produced in a market—too many resources of society will be devoted to this product—- and society would be better off in terms of using its scarce resources if some other allocation had been made instead. eg The market would have FAILED if any or all of the conditions had not been met.

Society (social policy) can, of course intervene and rearrange the activities of these private buyers and sellers when society sees a need to do so. By doing so, society alters the amount produced and sold, and the price in the marketplace, and often the amount of resources going into the industry (eg labor, capital, raw materials). The social philosophers (Adam Smith among them) came to study the role of markets (and private economic interests) in society:  and concluded that society’s best economic interests were being met by private markets and private greed, as if guided by an “invisible hand”.

But sometimes the “people” perceive that the private markets are not serving the collective interest—- these situations are called situations of “market failure”. Markets fail when competition between sellers fails to yield the results that serves the interests of society. These interests generally mean that the market is producing too much of a good, or too little of a good to serve the collective need. It may also be framed in terms of unacceptable symptoms of producing too little or too much: persisting high profits by sellers, survival of many low quality or inefficient sellers. But, remember, failure occurs when markets of buyers and sellers transacting together results in too much or too little goods exchanged in the eyes of society.

A good example of this is prohibition, when public opinion came to believe that too much alcohol was being produced and sold in America, and a law was passed that made it illegal to produce or sell any alcoholic beverage. Or, when the only way to get education for children was to buy the service from a private organization (all the way from k-12 and college). Thats the way it was done. markets determined the price for high school in Boston, NYC, San Francisco, Peoria, Missoula and Austin. But, over time, there developed in society a feeling that way too few people were being educated in the market-based system (eg too many positive externalities for education). And eventually “free, public education (financed by community property taxes) was developed in America for k-12.

Markets generally fail under a number of situations[1]:

• When monopoly power exists (high market shares, price setting power, brand loyalty, patents and licenses)—essentially this arises and persists only when there are barriers to entry (such as when the government grants patients, or when capital requirements are high, or when predatory behavior by incumbents is allowed, or when very high market shares are allowed to persist by regulators).

• When asymmetric information exists (when buyers and sellers do not possess full information about the quality of the product or competitor situations). This is common in health care, where consumers rely on their (self interested) providers for advice.

• When externalities exist (spillover effects on otherwise not involved 3^rd parties[2]), often leading to damages for third parties, or do to depletion of scarce social resources (often public goods).So called “positive” externalities can also occur then private transactions generate “benefits” to third parties (vaccinations, education).

• When poverty exists (lack of spendable income among a segment of the population, resulting in doubt about the strength of the economic buying preferences of this group of persons)

• When insurance exists — people spend according to the point-of-sale price, and over consume because they have “prepaid” and over-consume at the point of service

 

Health Care Market Failure

Buying and selling Health care services if fraught with risks of market failure. That is, selling too much or too little for a variety of reasons for failure. The flaws in health care markets are several:

1. insurance. people that have insurance (eg prepayment, where they end up paying only a fraction of the full price at the point of service) typically buy more services than they would otherwise buy if they were paying the full price. Many studies have confirmed the excessive care seeking.
2. ignorance (asymmetric information)buyers of health care services are often uninformed. As a result, they are often reliant on their provider about what decision to make about testing, surgery, next steps, etc. That is, buyers on not on a level playing field with sellers, and the result is not a fair negotiation between two independent, selfish entities as we assume happens in a free market. The buyer is put in a position where their interests in the transaction is subordinate to the seller–and as a result price is too high, and quantity consumed is often too high as well.
3. Monopoly power. Markets-working-well  assumes that there are many buyers and sellers. If a single seller (a small town single hospital) then buyers looking for a place to deliver the upcoming baby, or the place the employer health plan needs to contract with to provide hospital services— is very restricted. As a result the hospital can demand (and succeed in getting) a higher price, and still get lots of business—– the buyers just cant easily “walk away” because just there isnt anyplace else to go.  Too few suppliers (do few doctors, too few hospitals, too few drug stores, only one supplier of patent-protected drugs, are all examples of restricted number of suppliers in health care markets (eg monopoly power). This always results in  a higher price and lower volume of services that would occur in a well functioning, competitive marketplace.
4. Externalities. Sometimes health care services carry with them spillover costs or benefits to third parties (who were not party to the buyer-seller transaction). Services to treat infections disease (prevention by vaccination, or prompt treatment if already infected) are good examples of positive spillover benefits to society. That is, society would prefer that vaccination rates and prompt treatment of infected persons both be consumed at very high levels—– but, unless some form of social policy to intervene, the level of consumption of these activities will be smaller than society would prefer. The market is said to fail because (in this case) of the underconsumption in the marketplace. Other types of health services also have 3rd parties who suffer from seeing other people (particularly kids and elders) go without needed care. SO, there are many instances like these where markets fail to satisfy the preferred volume of care, and are said to fail because of externalities.
5. poverty. this, like externalities is a situation where society may prefer that everyone be given access to needed care, regardless of income level.

What to do About Failure?

When markets fail, the society in these situations may choose to step in and create a remedy, to expand the quantity of the industry’s output, or to contract it. The options for society are to:

• Do nothing
• Do things that facilitate the market to work better (eg provide information, augment income of the poor, increase demand for education)
• Provide subsidies and taxes to alter market results to change economic incentives
• Regulate the firms (set limits and rules on competitive behaviors, including anti trust enforcement)
• Take over the firms and run the industry as a government enterprise
• Eliminate the firms (eg prohibition)

Natural monopolies are also cause for action. These firms have such pronounced economies of scale, that there really isn’t room for more than one firm of optimal size (lowest achievable average cost). These can be regulated (like the local newspapers, or the local power companies) or taken over and run by government (like the post office).

Where society (government) chooses to see a problem in market failure that needs fixing is a political decision. Sometimes clear market failures do not get acted upon, while in other cases they do. Political activism can motivate action in some instances. At other times, the forces of inaction (usually financed by the firms in question) win out and nothing happens.

In every case, the society must decide whether to take action in response to market failure, and if so, which action to take. Policy generally errs on the side of taking the most measured or conservative response possible. This unwritten rule is in deference to the preference for a “unrestricted market based economy”, preferring to let the market work unless overwhelming public opinion exists and provides cover for politicians who can then safely decide to act.

Market failure can also be addressed by civil legal action. Government provides a legal structure for this to occur. Particularly in the case of “externalities” or “asymmetric information” consumers who are damaged by market transactions can bring individual of class action suits to recover damages. (eg the film A Civil Action showed situations where firms failed to incur costs to protect third parties from being damaged).

Society, acting through legislative bodies of government, also represents one of the major sources of market failure. This happens by “creating” monopoly power at the behest of suppliers. Firms and other suppliers are granted monopoly power in the form of patents and licenses that limit competition, causing prices and profits to rise, and limit supply and consumption. This kind of social action is usually done under the cover of promoting consumer welfare or product safety, but is generally a transparent ruse to limit competition. Examples are (1) requiring all liquor sold to be sold through liquor stores, (2) all taxicab services be delivered by licensed cabs, (3) all medical advice be delivered by MDs, or (4) all cars driven in the state be licensed by the state, all must be inspected each year, and all drivers must have auto insurance policies. While there are always some potential benefits of such requirements for some consumers, there are also very real business benefits to incumbent suppliers in the form of barriers to entry.

Since health care is so vulnerable to market failure, there is a significant involvement in the health industry. We regulate quality by licensing, we control many proposed mergers (to regulate monopoly power), we provide free things (flu shots, other vaccination and public health programs), we provide government insurance for poor people and old people. In all there ways we try to have government step in because, in most cases, we want to supplement higher utilization of services than would be observed if markets were strictly used to determine price and utilization levels.

The Affordable Care Act was the first time society came to believe that markets for insurance were failing to sell enough insurance (again the externalities and spill overs concerning access to needed health services).

Poverty and Non Profits  

Poverty is an especially hard problem to deal with for the market economies. When incomes as well as goods and services are distributed and paid for through market mechanisms (buyers and sellers transacting with each other) it is hard to do two things that need to be done (a) to distribute the goods and services to members of society who can’t afford to pay, as a humanitarian gesture, and as a way of maintaining order, and (b) to do so in a way that protects the role of the marketplace, and the incentives on buyers and sellers, to continue to motivate them to use the market to their own best advantage.

Two things are done to deal with poverty:

1. social programs for the poor (section 8, medicaid, food stamps, school lunches, free public education, others). These are funded by tax money, (tax policy is the battlefield of the need to strike a balance between A and B) above).
2. Encouragement of voluntary contributions to non profit organizations

America has always shown a preference for remedies for poverty that do not involve direct income subsidies. In the case of impoverished small family farmers in the midwest, for example, the Congress has chosen to use artificial price supports for crops (higher corn, wheat and soybean prices) to remedy the situation. This is a very inefficient solution, since it encourages more land to be devoted to these subsidized crops[3], higher prices paid by consumers of these products, diverting consumption patterns throughout the U.S. It would be more direct (and without such diversions) if the government wrote a check for the amount of money they wanted to send to farmers, rather than purchase crops using tax dollars. But, the U.S. didn’t want to give “welfare” to hard working farmers!

In the case of anti poverty programs, the Congress prefers to steer away from direct income supplements (which would also be the efficient way to solve the problem of poverty). Instead, we choose to provide programs that supply the products ‘we’ want the poor families to consume (healthcare, rent, food, schooling, etc.). Here again, like the farmers, the affected group is not allowed to be given the subsidy direct so they can choose for themselves, but are given products that the Congress thinks they should be consuming. This preference of providing products or price supports, tends to create a “balance of A and B” that supports solutions that go through markets, rather than just simple “tax-tranfers”, which would be more efficient, and let the individuals involved make their own choices about what to do with the income supplement.[4]

America is also somewhat unique in the way non profit organizations are allowed and encouraged to flourish. Many countries do not have this form of business organization at all. At core, the idea is that our society thinks of the non profit as a way of propping up the market system in the face of market failure in the form of poverty (eg no income). The way this is done is to “credential” such organizations by the tax authorities as legitimate providers of needed social services for needy populations. The credential allows two tax policies to occur:

1. the organization itself pays no taxes to state or local authorities in exchange for providing needed services to the community.
2. To help finance itself, the organization can accept donations from individuals or corporations, and these donations are made attractive to donors because they are tax deductible.

So, the idea is to encourage the development and growth of non profits as a way of avoiding doing it through a government program—which would require more tax revenues to finance. Again—trying to balance the sharp incentives of the marketplace (and the lowest possible tax rates) with the need to cope with poverty in society[5].

Alternatives to Social Action

Society’s interest is, in theory, best served by acting to remedy market failure, and taking action to better align private market transactions to the interests of society at large. But, “society” is not perfectly implemented in the form of government institutions, whether democratic or not. Indeed, within democracy the selfish interests of elected officials allow specific business (supplier) interests to be influential in two ways in juxtaposition to the interests of consumers and workers: (1) by responding to suppliers pressures to conveniently ‘overlook’ opportunities to eliminate market failures, and (2) by causing market failure by legislating monopoly power. So, imperfect representation on behalf of “society’s interests” occurs when a democratic government responds to business interests in one or both of these ways. The only way around this “failure of democracy” is to educate the public so they can see properly and vote accordingly. A first step might be campaign finance reform, so that elected officials do not have to (or cannot) raise their own funds in elections[6].

Summary of Points

1. Markets (consumers with scarce money and time, and firms competing for their business) are a useful mechanism for allocating society’s resources, channeling the selfish interests of individuals toward the best interests of society at large.

2. Sometimes markets don’t work so effectively, generating results wherein society’s best interest is not served by private interests exchanging assets in a market. This happens when there is Monopoly power, poverty, externalities (third party effects), and asymmetric information between the exchanging parties). These situations arise do to the nature of products/services, and market conditions.

3. Business practices that are not perceived as ethical, or are unduly harsh or selfish are, even if they have important consequences on workers or competitors, are not necessarily market failures. If they tend to prevent competition (promote monopoly power) then this would be a market failure. Abhorrent HR practices like discrimination are not market failures, though there are laws and regulations for protecting workers under guarantees of the constitution and notions of human rights. Child labor may be an exception here, since third party interests are involved when such labor prevents schooling and has health and family stability consequences.

4. When society’s interests are not well met in market exchanges there is a set of tools that can be applied to remedy, or realign the social interests with private actions. The remedy for the most egregious problems is                                                                                            1.  when society decides to produce and distribute products (this is                                        called nationalization); lesser remedies include (in order of                                              severity of the problem)                                                                                                        2.  laws prohibiting certain anti competitive business acts, like                                              merger to monopoly and predatory pricing,                                                                    3.    regulations about max or min levels of emissions (environmental                                   externalities), regulations about some business practices.                                                 Seatbelt requirements, smoking ordinances, zoning restrictions,                              4.     tax and subsidy incentives to change the behavior of consumers                                    and suppliers (like taxing cigarettes to discourage consumption,                                     or providing free vaccinations at public clinics or other locations                                   (government subsidy), or even granting patent (monopoly)                                                privileges to firms to encourage them to do more research and                                        innovation.

5. And, where particular market failures are not able to rise to politically actionable levels for these kinds of governmental (social) remedies (1-4) there is still often opportunity for consumers to act to get civil actions brought against firms who fail to follow more general laws about things like product safety, public health, truth in advertising and labeling, etc. These kinds of statutes generally vary by state and may provide vehicles for private or class actions against companies who disregard or exploit consumer’s or worker’s lack of information or various externalities that are not generally know.
6. To the extent that society (or private action) does not choose to remedy market failure by mechanisms 1-4 (eg society chooses to overlook the market failures), there is still opportunity for sellers to act to create remedies. There are two very important market mechanisms for sellers to create more convergence between private actions and social outcomes as markets fail in the usual situations.

 As social and private interests diverge as seen by science, as reported by the media, and as accepted by growing numbers of people, there is opportunity to pursue “shared value” business strategies. The volume of important market failures is likely increasing these days, and it will continue to grow as population growth continues, and as natural resources do not. Paralysis within and across in democratically elected societal bodies, and general inaction on market failure problems in society will increasingly be good for “shared value” business strategies. So too, the global business environment, the evolution of information interconnectedness, and global population growth all suggest that the volume of meaningful market failures will be increasing, opening business opportunity for connecting with customers who share such concerns because society has failed to act to protect its own interests. Porter discusses this strategy of “doing well, by doing good” in creating social connectedness between the business and those consumer groups that identify with particular social issues (green, sustainability, poverty, gender equity, etc.).

A second action by suppliers to create better alignment between social and private interests when, otherwise, markets would fail is discussed by McKinsey as “long term thinking” by business. The CEO of Unilever discusses this evolution in that firm. The idea is that if firms take a long term strategic view of the interests of the business, they will be led to be more cognizant and more concerned with important “social impacts” of the firms behavior, leading to behavior modification. Using their market power to “exploit workers” or deplete stocks of “key resources” may, in a long term view of the best interests of the firm, lead to concerns about sustainability. This may lead to the firm modifying behavior to bring the firms interests into better alignment with social interests. Like “shared value” this is not about government pressure, nor about ethical or principled leadership— this is about putting the interests of the stockholder first, and doing that by thinking about that stockholder’s best interests over a 10-20 year period, rather than just the next quarter! The author points to the increasing importance of “pension fund” investors in corporate America, and they way this trend is likely to drive more long term thinking among businesses because that is increasingly what these investors want!

It isn’t clear how important either “shared value” or “long term thinking” is to U.S. corporate behavior as an offset to the effects of monopoly power, or other sources of market failure. But, the arguments are interesting.

Principled leadership and CSR are terms that apply to other voluntary actions by suppliers that are the product of ethical behavior by suppliers to develop services and products and brands and workforce policies that are seen as the right thing to do, and may well lead to better (fairer) outcomes for society (because they use sustainable forms of energy, or because they support access to product by the poor, or they are based on less harmful agricultural methods or waste less water). PL and CSR are Supplementary bases for management action to the stockholders-come-first strategies of “shared value” and “long term thinking” described above.

 Principled leadership would also be am appropriate management standard to apply to elected and salaried government officials, who do (or do not) show leadership in taking appropriate social actions (1-4) to remedy or prevent market failure. For government officials who overlook market failure issues in order to curry favor with business interests, or to avoid personal career risks is not very principled leadership, and should be recognized as such.

Closing Points on Market Failure

Market failure occurs when society’s prefers more or less resources be dedicated to a product than do the persons participating in the market. It is caused by externalities, ignorant consumers (asymmetric information) , monopoly power, insurance, and poverty

Several points:

1. this problem in the world is getting worse, due to more people, more demand on resources, and faster pace of technology and innovation (more externalities,more poverty of people left behind by progress,more monopoly as firms compete globally,etc). This probably means that market segmentation in the form of “shared value” will become more an more important as unresolved market failures grow as do the number of consumers who prefer to support businesses that are committed to their type of social action.
2. in the US we try hard to let markets rule —- we have a constitutional committment to free choice and a small federal government. This committment to keep government out of economic affairs creates a reluctance to deal with market failure by imposing taxes, vouchers, subsidies, regulations, and other forms of “interference” to solve the problems of market failure. We are cautious about using anti trust laws (eg ticketmaster case), we dont want to deal with regulations, and taxes and more government programs to deal with any of the failures— except rather tepid actions like the clean air act, the clean water act, zoning regulations, etc. Schools/education and Public health are the extreme examples— local government took over schools from the private sector years ago because the +externalities are so high, and we commit zillions of tax dollars to do research on diseases and other public health programs, again because the private market would never fund that much to fight disease, and the + externalities are so high.
3. The tepid approach to using government to step into solve problems of market failure is likely why we have Non Profits at all— to fight poverty so that government will not have to step into the fight on a direct basis. Or, said another way, if we didnt have non profits doing all the beneficial things they do for needy populations, the unmet needs of these people would be even more acute, and creating more and more pressure for government to do something.
4. Likewise the, strong public promotion (by Exxon and others) for business leaders to step up and take voluntary actions in their businesses (CSR, PL, sustainable policies, etc) may well be politically motivated. That is, promoted by business leaders themselves to delay or prevent problems from getting so acute that the political pressures would rise to the point where government would have to take action to solve the market failures.
5. But, lest we slip into deep cynicism—– it may be that a very limited role of government, and a “social contract” that favors free and unfettered (by government) markets is a really good way to set up the economy. Such a “small and uninvolved and reluctant role of  government” may promote innovation, it may keep taxes on business low and encourage entrepreneurism, and keep growing the economy, etc etc. This is an important issue on which people are deeply divided. But, while unresolved market failures exist, and may even be mounting, this reluctance of government to “step in and make markets work better” might be a consequence of an overall strategy about the role of government, which may be on balance, good (depending on your politics).

 

 

 

footnotes

[1] Failure of the market has nothing to do with failure of firms in the market. Active and fully functioning markets generally involve failing firms, who are forced out because consumers are “voting with their feet” and not buying enough of the firm’s product to keep them viable.

[2] The effect on non participating 3^rd parties creates extra costs (negative externalities) or extra benefits (positive externalities). Consequently, the socially preferred output level for the activity is more than (positive externalities) or less than the private market level (negative externalities).

[3] The subsidy occurs as the government steps in and “buys” these crops. The amount to be purchased depends on how much is required to “support the price” at the desired level.

[4] This seems odd since it avoids a direct ‘tax-transfer’ solution (a diminution of incentives for working/earning), in favor of solutions where society’s preferences are superimposed on those of the subsidized group (the freedom to decide of the group is eliminated in favor of the preferences of the Congress). And, not only this, but the removal of the freedom to decide for the affected group is coming at a higher price for society than would have been possible had we just transferred income.

[5] The non for profit organization is a misnomer. Profit is possible (total revenue-total expenditures) and even desirable (as a source of financing the mission). More properly, they are really “non taxed organizations”.

[6] The Supreme Court, in the recent ‘Citizens United’ case finding, took a step in exactly the opposite direction.