Market failure, which I define here as a market that does not reach a state of equilibrium where the quantity supplied equals the quantity demanded, is ubiquitous.
Every time we go into a store, we see a market failure: shelves and shelves of goods are sitting, waiting for buyers. This is an oversupply (surplus), a market failure. If the market was in equilibrium and perfectly clear, then when you (marginal buyer) walk into the store, you should only see the good(s) in the exact amount you want to buy at a price exactly equal to your willingness to pay for the marginal unit. Nothing else should be left. You can make your purchase and the store closes, having sold everything it was willing to sell at a price determined by the interaction between buyers and sellers. Obviously, such an effect does not exist. Some of the items we are looking for are available for sale. Others are missing. And, as a result, the market failed.
But this failure is essential to the functioning of the market, which is widely called “the market process.” As Hayek reminds us in his famous article, “Use of Information in Society,” the factors necessary for the market to be perfectly clear (complete knowledge of preferences, complete knowledge of available resources, complete knowledge of relevant information) are not known in advance. If they were known, goods would simply be provided; the market becomes less of an optimization problem. Instead, they are expressed by the functioning of the market itself.
There are two ways of thinking about how the market process creates prices and transmits this relevant information. The first, as developed by Leon Walras, is to treat the economy like a grand auction (which he calls “tâonnement,” or “trial and error”). People make bids, and those bids are accepted or rejected by sellers. When the demand is high, the price goes up. When there is more money, the price falls until the market reaches equilibrium.
There is some truth to the Walrasian auction story, but it falls short of explaining reality. Some markets have an auction process and the price goes up/down until the market is cleared. Even if we treat the Walrasian auction as a metaphor instead of anticipating actual auctions, it collapses. So to speak, we have something for a silent auction. A consumer walks into a store and sees a price. It is more than they are willing to pay for good, so they leave. That is a seller’s “offer” that the buyer rejects. The seller then adjusts his offer until it matches the bid. The goods are then sold at those prices. But, as I noted above, this is not the case with most markets. We have a chronic deficit/fund.
A second way of thinking about how prices evolve and adjust is through the thinking of John Hicks. Rather than being set by people coming together to bid on goods, Hicks argues that prices are fixed (at least in the short term). When the store owner opens the door each day, he has set prices. People come in. Some buy at that price, some don’t. And, at the end of the day, you close the store with some unsold goods, and the rest is in short supply. But changing prices is an expensive process, especially for supermarkets. Shelf tags need to be replaced, electronic price checks need to be updated, and so on. In addition, consumers face real problems as well: fixed incomes are too high. Given the expensive process of adjusting and adhering to consumer behavior, a store owner can easily adjust the price he offers, rather than his price. He must look at inventory, actual spending trends, etc., when making changes. As a result, the market can be in a perpetual state of surplus and deficit.
There are other reasons why the market is always in disequilibrium, of course. Given how difficult it is to make forecasts, it would make sense for a company to want to keep plenty of inventory on hand. It can help smooth the cycle of use and avoid bullwhip effect where small changes in consumer behavior lead to large and incremental changes in asset management. In addition, consumers tend to punish firms more for shortages than for surpluses, so holding excess inventory can be a way to avoid consumer resentment.
However, the key takeaway here is that market failure is ubiquitous. But, more than that, it is what is needed by market activity. If a shopkeeper ends the day with more inventory than he wants to hold, that sends an important signal to him: your value is too high. If you can’t fix the price, find something else to fix. When a customer goes to a store and sees a price higher than what they are willing to pay, that sends an important signal to them: their expectations are over. Find a replacement or revise your will. These signs only until the market failed.
But now let’s look at a more rigorous definition of market failure. A strong definition of market failure is not simply that the market is in a state of disequilibrium, but that there are obstacles preventing it from reaching an equilibrium where goods are allocated to their highest and best use. Factors such as externalities, high barriers to entry, cluster integration problems, high procurement costs, etc., can prevent the market from reaching a higher level of price and value. It is under these circumstances that interventionists often oppose government intervention to solve market failures. But even under these circumstances, the failure of the market itself is essential to the success of the market process.
A market failure can also be called a profit opportunity. There are tradeoffs that haven’t been completed and anyone who can do those jobs will benefit. Anyone who can break down barriers or give someone a better position can make a profit. In other words, market failure creates the stimulus needed for correction. Smart entrepreneurs find ways to overcome these obstacles, solve market failures and turn a profit. Government intervention is almost unnecessary.
Does this mean that there is no government role in market failures? I don’t think so, no. But it raises limitations on government. Rather than being an active player, governments can be more of a referee. If there are artificial barriers that make the market fail, the most useful thing you can do is to remove those barriers. Or create solutions that allow private markets to emerge (eg, changing laws to allow class action suits in foreign cases). Governments are just like other economic actors. They are limited by constraints and have limited knowledge. There is no reason to think that the government can intervene in the market better than the real participants. For purposes of market failure, the best thing the government can do is remove artificial barriers and get out of the way.
All of this is a long way of saying that market failure is something of a misnomer (yes, another one). The market has not yet succeeded to the point that it does not work. Instead, it behaves as needed to generate the necessary information. It’s best to think of a market failure as a “failure situation,” in which some goal is not met. In this case, it’s like failing a class test. Yes, the test had a “fail status,” in that the objective (to pass) was not achieved. But knowledge was really gained: this is my strength, this is my weakness, and this is how I can improve. And that knowledge (for the honest reader) is how one gets better. Similarly, market failures create information about how the market can improve.
The market failed; live in the market!
