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What To Do When Markets Fail?

2013 May 19
by Greg Satell

In the first half of the 20th century, Socialism looked like the way of the future.  When Nikita Khrushchev said in 1956, “We will bury you,” he had good reason to be optimistic.  The Soviet system had seemingly produced an economic miracle.

We now know better.  Socialism failed miserably in just about every way you can think of.  Today, virtually every economy is a market economy and the ones that aren’t are basket cases.   The central debate of the last century was settled long before this one began.

However, even as market systems have proved triumphant, market failures have become increasingly problematic  Crashes have become more frequent and more extreme.  Broad market solutions to social problems such as crime and pollution still elude us.  To solve today’s problems, we need to seek out new solutions and, increasingly, are finding them.

Booms and Busts

They key function of a market is to provide effective pricing.  That, after all, was the point of Adam Smith’s concept of the invisible hand.  We don’t have to count on the good will of the butcher or the baker to provide our dinner, because our hunger creates demand, manifests itself into a pricing signal and incentivizes them to provide what we need.

Unfortunately, sometimes our emotions get the best of us.  We see housing prices going up, so we want to get in on the action too, which increases prices further and encourages others to pay even more.  Soon we are loading ourselves up with debt to pay still higher prices and the cycle continues until the bubble pops and we lose a bundle.

This is nothing new.  John Maynard Keynes called the phenomenon animal spirits. Investor George Soros refers to it as reflexivity and has made a large fortune betting against it.  Any market is only as good as its participants and we’re not as rational as we’d like to think.  Neither are markets.

We have not come close to solving this very basic problem.  In fact, it’s getting worse. Since the 1980’s, when market economics had its greatest triumph, crashes have become more frequent and more severe while productivity and incomes have stalled.

Externalities and Adverse Selection

Another problem with markets has to do with externalities, costs and benefits that are external to a transaction and therefore don’t factor into pricing.  Sometimes, these are very positive, like the knowledge spillovers that a new invention creates or the network effects that occur when more people buy cellphones.

However, externalities also cause some of our thorniest problems.  One is the tragedy of the commons.  People who burn dirty coal have no incentive to increase their costs by switching to a cleaner, more expensive alternatives, but we all pay the price of pollution. In a similar vein, mortgage brokers who profit on sub-prime loans increase systemic risk.

While externalities merely ignore costs or benefits, when adverse selection occurs, markets actually make things worse.  For instance, when health insurance companies choose only the healthiest customers, they leave a toxic pool of unhealthy ones in the system with no viable market to serve them.

Markets and Corruption

In his book, What Money Can’t Buy, political philosopher Michael Sandel argues that there is still another problem with markets – their corrupting influence.  While in some cases, like markets for illicit drugs and human trafficking, the problem is quite obvious, but Sandel points to more subtle and pervasive forms of corruption that degrade community norms.

He calls the phenomenon a “skyboxization” of society where we are creating two classes of people, a privileged class in private boxes and the huddled masses who have to live by different rules.   He further points out that the issue is far more widespread than you would think, people paying to skip line, to have someone to carry their baby and so on.

His central point is one of context.  For example, when the Pentagon wanted to start a futures market for terrorism in order to increase efficiency of prediction, an uproar ensued and the project was quickly killed.

Markets, we all seem to agree, have their limits. To allow people to pay in order to gain special admission (e.g. to a prestigious university) or receive an award alters the meaning of the good in question.  Although markets thrive on valuation, entering money into the equation often degrades moral value.

If you doubt it, try giving your spouse a wad of cash for Valentines Day and see what happens.

Creative Destruction and Brands

One of the problems of classical economics is that, in a perfect market, profits shouldn’t occur.  If supply and demand are truly aligned, then all a firm should be able to charge for a product or service is labor plus the cost of capital.

Joseph Schumpeter ultimately solved the quandary by introducing the concept of creative destruction.  He pointed out that as long as industries continue to innovate, the market will never reach a true equilibrium, profit stays in the system and business can prosper.

However, the initial point remains.  Profit seeking businesses want the market to fail. That, after all, is the point of competitive advantage.  Somebody wins and somebody loses.  In the final analysis, this is a very positive thing, but it does have it’s uglier rent-seeking side, such as patent abuses and big lobbying budgets.

The Rise and Fall of Market Based Solutions

As the shortcomings of markets have become increasingly apparent, economists have taken notice and much of the research done nowadays is goes beyond strictly market-based solutions.  Take a look at the chart below.
 

Percentage of Nobel Prize Winners

 
In the first three decades that the Nobel Prize for Economics was awarded, a large percentage of the laureates focused on financial innovations like Black-Scholes, CAPM and Gary Becker’s work on applying market-based thinking to social problems.  The remaining prizes went to either technical improvements or other areas like game theory.

However, over the past decade none of the prizes were given for explicitly market-based innovations.  In fact, there has been a switch in emphasis to the limits of markets, like the 2001 award for asymmetric information or those given in 2002 for behavioral economics and prospect theory.

In truth, this shouldn’t be all that surprising.  Most of the really interesting work on markets was done in the 60’s and 70’s, when improvements in information technology made research into markets far more productive.  Today, a generation later, the problems markets can solve have largely been solved and the interesting problems lie elsewhere.

The exciting thing is that as we become more aware of how markets fail, we’re also learning a lot more about how to correct for them.

How to Improve Markets

While markets have their problems, the last thing we want to do is reduce their power to do their job.  In the vast majority of cases, there is simply no better way to process large quantities of information.  However, when the market fails, we need to find alternate solutions.  Happily, we seem to be making some progress.

Government Intervention:  The most obvious way to correct for markets is with government intervention.  Unfortunately, government is prone to all sorts of problems such as bureaucracy, inefficiency and corruption.  Not surprisingly, we’ve learned to be skeptical about government involvement.

However, there are signs that government investment can be extremely productive (as I’ve pointed out before, virtually every component in an iPhone has its roots in a government program).  Moreover, performance has been improving.

New initiatives like ARPA-e, which gives grants to early stage technologies in energy, are building on previous successes of DARPA, which created the Internet, radar and artificial intelligence.  Markets are generally not good judges of new technological areas, so this is an area where the public sector can play a positive role.

There is also some evidence that technology is making government more efficient and less wasteful, along the lines of Tim O’Reilly’s Government 2.0 initiative.

NGO’s:  It used to be that when entrepreneurs earned great fortunes, they would leave some to charitable organizations and possibly set up a foundation to spread the wealth when they died.  Today, more high-net-worth individuals are getting actively involved and that seems to be making a difference.

The new breed of NGO’s such as the Gates Foundation are much more accountability focused and data driven.  It’s not enough just to give anymore, but to do so efficiently and effectively.

Innovation Prizes:  Another growing trend is the awarding of large monetary prizes for innovation, such as the X Prize and the US government’s Race to the Top initiative..  These tend to encourage investment many times greater than the value of the prize itself and are proving to be effective in jumpstarting emerging technologies and innovations.

Peer Networks:  In Future Perfect, author Steven Johnson proposes another alternative.  Peer network approaches like the open-source movement, Crowdfunding, Wikipedia and public service apps such as seeclickfix can often outperform traditional market solutions with non-monetary incentives.

The 20th century was, to a great extent, the era in which markets became triumphant. Over the next century, however, we will increasingly learn how to go beyond markets and augment the basic platform with new technologies that improve overall performance.

– Greg

10 Responses
  1. May 19, 2013

    Markets never can produce 100% availability. We know that for a long time. Each market where both ‘use’ and ‘availability’ of the service are important tend to underestimate the value of the service. E.g. health care, public transportation. The reason for this is that a lot of value is not communicated to the market as an information processing mechanism. How you value the hospital or the bus, not actually using it, is information not communicated into the market. So called optional demand is between your ears.

    The result is that the availability of such utility like services are underestimated. This under-estimation has nothing to do with being liberal, capitalist or communist. It’s just about processing information.

    Lot’s of work has been done on this topic. It’s called welfare economics.

    Greg Reply:

    Thank you for sharing your thoughts.

    – Greg

  2. May 19, 2013

    http://www.lectoren.nl/opinies/de-grenzen-van-de-marktwerking.html

    Dutch text on this .

    Perhaps google translate helps:)

    Frans

  3. May 23, 2013

    It is very simple: Markets do not “fail”, in much the same way as the law of gravity never fails.

    It’s just that we do not always like the outcome of a question we have entrusted to “the markets”. The problem is not that “markets fail” (they don’t), the problem is that we expect markets to fix problems we don’t dare to tackle by other means.

    Market means “the strongest wins (and everyone else looses)”. That’s the point.

    There are topics where market dynamics drive things in the right direction. And there are topics where they don’t. Where we want the opportunities to be spread a bit more broadly (e.g. around education, see here: http://www.theatlantic.com/business/archive/2013/05/why-american-colleges-are-becoming-a-force-for-inequality/275923/), a market dynamics are simply not the right solution to the problem.

    Greg Reply:

    Josef,

    You make an interesting point, but I’m not sure it’s accurate. A core function of markets is to act as a pricing mechanism, not to offer equality (although that’s would be nice too). In my examples above (i.e. boob-bust cycles, externalities, etc.), markets fail to deliver that pricing mechanism and so I think it’s appropriate to say that they failed.

    After all, if markets can’t price, what good are they?

    – Greg

    Josef Dietl Reply:

    My first impulse is to say: I’d still hold that markets don’t fail. Of course, markets aren’t meant to offer equality. Markets do provide prices. However, these prices may fluctuate extremely (-> boom-bust-cycles) or may have undesirable side-effects (-> externalities).

    I guess I’m digressing into word-picking about what “effective” pricing is.

    In all my thinking about markets and pricing, I’m using a mental model of a damped harmonic oscillator (I’m a physicist by education, so I’ve learned to rephrase almost every problem in terms of harmonic oscillators…). For example: boom-bust-cycles? are under-damped oscillators – they simply swing back and forth a few times until they reach their equilibrium. Of course, that creates havoc on the people affected etc.

    That said, you’ve inspired me to wonder whether the model of the damped oscillator is always qualitatively correct or whether it couldn’t be a driven oscillator under certain circumstances. If so, the question is where the energy-equivalent comes from. That will require more thinking… Thank you for the inspiration!

    (A lot can be explained with these models, especially when going into multidimensional systems…)

    Greg Reply:

    Glad to hear it. Although I have no academic insight into damped harmonic oscillators, I do have a wife who seems to perform the function quite well!

    – Greg

  4. Kenny permalink
    September 23, 2013

    it is almost impossible to solve a problems with the same thinking we used when we created them and that exactly what you just proposed here.

    Any system’s strength can also be it greatest weakness.

    as was the case with socialist market economist will never be able to fix capitalism because many of these problems that you mentioned are fundamental and point to the limit of the system itself,

    Economy is about resources management, efficiency, and human primary and secondary need, which is contrary to Market Economy of scarcity or artificial scarcity management, Maximizing profit, and need creation through advertising.

    the only way to fix a system is to offer a solution that make the existing one obsolete

    Besides i love reading your Blog

    Greg Reply:

    Thanks Kenny. I appreciate it!

    – Greg

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