There are many people who were, and continued to be, negatively impacted by the Great Recession of 2008. Though there is never a single cause for an economic downturn, a significant contributor (and, perhaps, trigger) to the near economic collapse of 2008 was the meltdown of the global financial sector. See figure 1.
Figure 1
Many believe that an oversupply of credit and incredibly complex financial instruments sowed the seeds of America's near-economic collapse. One practice has been singled out for blame—the bundling of loans into assets that could be sold on to investors. The charge is that by breaking the link between those who screen borrowers and those who bear the cost when they default*, securitization led to the lax lending that both expanded and crushed America's housing market.
Securitization is not new, and decades of refinement and standardization in areas such as mortgage finance, car loans and credit cards have removed many deficiencies. The development of this financial product is no different from the development the other financial products like certificates of deposit or futures contracts. Innovation is what we expect from a free and profit-seeking market.
But in this case innovation combined with greed, lax oversight, and shortsighted decision making led to market failure. And market failure is the focus of this module.
* Traditionally, those who originated the loan, held that loan until the term expired. The bank both screened the borrower and bore the risk if the borrower defaulted on the loan.
Vacuums and Markets
Question: How do you know when a market fails? Before we answer this question let’s examine an example using familiar household object: A vacuum.
It is not difficult to know when a vacuum fails. It fails when it does not perform it primary function: sucking up dirt. There are few stores who would refuse to give a refund for a product that failed to work as advertised. But failure to perform is not the only reason a customer may want to return a vacuum. What if was too loud? Or what if you did not like the color? In other words, the vacuum could be working fine and yet still fail (in this case it failed aesthetically).
Like a vacuum, the free market economic system has a single primary function. The free market is supposed to be relatively efficient (relative to other economic systems) with scarce resources. If the free-market system fails to achieve a higher level of efficiency than other economic systems, then it is the equivalent of a vacuum cleaner that does not suck.
Can the free market fail, like a vacuum, even if it is working fine? Yes. Even if the free market yields efficient outcomes, the market participants may not like them. It may be efficient for a firm to down-size and lay off workers during a recession but that does not mean the unemployed workers are happy about it. The free market can fail if market participants are simply unhappy with market outcomes.
So, in broad terms, a free market can fail in two ways:
- inefficiency (performance related)
- unsatisfactory market outcomes (non-performance related)
Efficiency Review
You will recall from the Supply and Demand lesson that the free market is able to achieve higher levels of efficiency with the 2-C’s
Communication: Communication between market participants
Competition: Competition between suppliers
Communication and competition are the tools with which the free-market system achieves high levels of efficiency.
Anything that interferes with communication between market participants or competition between suppliers leads to a drop in inefficiency and, ultimately, to market failure.
This is important to remember because when we examine specific performance related to market failure, it can be attributed to either a breakdown in communication or competition.
Types of Market Failure
There are four specific types of market failure:
Table 1
Market Power
Market power is the type of market failure that is the subject of this lesson. Market power is the ability of a firm to influence the price of a good or service. When a firm controls a significant amount of market supply it can shift the market supply curve by supplying at all price levels. See figure 2.
Figure 2
The more of the market a firm controls the more market power it acquires. As market power increases the level of competition decreases. Since competition is one of the two features that enables the free market to achieve a relatively high level of efficiency it is not surprising that a rise in market power leads to a drop in efficiency. A significant fall in efficiency can lead to market failure.
Externalities
Externalities are costs or benefits borne by someone not involved in a market transaction. To understand why an externality can cause market failure you must first understand the role communication plays in the free market.
Market participants use prices to communicate. Consumer desires and production costs are examples of information that is transmitted through the price mechanism.
Communication between market participants is essential for efficient market outcomes. If buyers do not know the cost of a good, then how would they know if they overpaid? Conversely, if suppliers do not know what their consumers want then how can firms prevent their warehouses from overflowing with unwanted goods? Without communication you will end up wasting money and resources.
The existence of externalities means that there is a breakdown in communication. If a third party (remember it takes two to make a deal) incurs a cost or receives a benefit from a market transaction they have nothing to do with then some vital information must be missing from the market price. This means buyers and sellers will be making choices based on incomplete information – and poor choices lead to inefficient outcomes. We will analyze externalities in the next lesson.
Public Goods
Goods on the free market can be divided into two groups: private and public. Private goods are typically traded in markets. Thus, private goods have prices and tend to be excludable. They have clearly identified owners; and they tend to be rival in nature. For example, others cannot enjoy a piece of cake once consumed.
Public goods have just the opposite qualities. They are non-excludable and non-rival in consumption. An example is a street sign. It will not wear out, even if large numbers of people are looking at it; and it would be extremely difficult, costly and highly inefficient to limit its use to only one or a few people and try to prevent others from looking at it, too.
The problem with public goods in a free market is related to production. After all, who would produce a good that can be consumed by people who do not have to pay for it? Once the public good is consumed by one it is there for all to enjoy. So, it is often the most rational strategy for private actors to let others go first and seek to enjoy the good without contributing to its production. This is why free markets under produce public goods.
Equity
Market power, externalities, and public goods are sources of market failure that result in a breakdown in either communication or competition. These shortcomings lead to inefficient outcomes. And remember, if the free market cannot achieve relatively efficient outcomes, then it is broken (like a vacuum not sucking up dirt).
What if these three sources of market failure were eliminated? One would think that if there were no interference with communication or reduction in competition there would be no market failure. But this is not always the case. Even though efficiency is important to every economy it is not always a top priority. Sometimes things like equity or environmental preservation are given top priority and they are achieved at the expense of efficiency. It may be efficient to fire a senior employee and hire a younger worker for less pay, but some would say that is a bit heartless. What about loyalty? What about fairness? Many are willing to accept a little inefficiency if it means getting something of higher value in return.
If the free market is producing efficient outcomes that market participants do not find appealing, then one can say that the market has failed.
A current example of the free market producing suboptimal outcomes can be found on the information superhighway. The issue of security has been with us since the internet’s inception. Hacking, phishing, spamming are threatening to undermine confidence in using the internet as a mode of communication and commerce. Can the market participants, without any governmental direction, find a way of dealing with these problems? The New York Times recently ran an article on this question.
Just as the government eventually stepped in to mandate seat belts in cars and safety standards for aircraft, says James A. Lewis, a computer security expert at the Center for Strategic and International Studies, the time has come for software.
Mr. Lewis, who advised the Obama administration about online security last spring, recalled that he served on a White House advisory group on secure public networks in 1996. At the time, he recommended a hands-off approach, assuming that market incentives for the participants would deliver Internet security.
Today, Mr. Lewis says he was mistaken. “It’s a classic market failure — the market hasn’t delivered security,” he said. “Our economy has become so dependent on this fabulous technology — the Internet — but it’s not safe. And that’s an issue we’ll have to wrestle with.”
January 18, 2010, NYTs, “Companies Fight Endless War Against Computer Attacks”
