Markets and Market Failure

There is no question that capitalism and “free” unregulated competitive markets are the most efficient system for the allocation of resources to produce goods and services.  That includes a “capitalist command” economy like China.

The fact is that there is no such thing as a free purely competitive market, despite what libertarians/conservatives may proclaim.  Agriculture is often referenced as such a market.  However, farmers must sell their product to a small number of food processors and buy their supplies from a small number of producers of farm equipment, fertilizer, and other farming necessities.  I will not even begin to bring in the government role of government subsidies/price supports in the U.S. agricultural system, but that certainly is not market driven.

The fact is that “free markets” and unrestricted capitalism exists in the context of market failure.  That is, the efficient allocation of resources to produce goods and services breaks down, it “fails”.  Moreover, while capitalism is the most efficient system, it often results in the least equitable distribution of wealth.  This brings up the next question: What is fair?  What is equitable?

I will start with some examples of market failure, how they come about, and what are the implications for the economy and our society.  These examples include:

  • Market Concentration
  • Public Goods and Free Riders
  • Externalities

Market concentration refers to the fact that competitive markets often result in a few firms or even one firm dominating an industry.  If someone comes up with an innovative good or service, a classical free market assumes that others can produce competing goods and services.  In many cases however, superior product development, marketing, and even luck will eliminate many competitors.  The remaining firms will have acquired “scale”, and the barriers to entry often become prohibitive for new entrants.

For examples, simply look at how various technologies evolved.  Microsoft came to dominate programs for PCs and ultimately many business software functions.  Although there are numerous mobile phones available for a variety of price ranges, Apple continues to set the standard.  Facebook, Google, and Amazon have minimal competition.  When competitive products do appear, the existing corporate powers can either buy them or bury them.

Market concentration and competition, or at least the perception of competition, often co-exist.  After years of consolidation, the airline industry is dominated by a handful of companies.  Airlines may compete on some lucrative routes but have monopoly power in many regions of the country.  It is simple for major airlines to stamp out new entrants.  Cellular phone service and cable/satellite entertainment firms are similar.  Large financial services such as banks and money managers have ever increasing shares of business.  Some asset managers control trillions of dollars in assets.  While there are thousands of asset managers, a relative handful have significant political and regulatory clout.

So what exactly is the problem?  In my opinion there are two major issues.  The first is that economic concentration results in diminished innovation as resources are redirected to things such as lobbying for legislative and regulatory advantages.  A list of all of the registered lobbyists and industry trade associations would be impossible for most people to comprehend.  Unless it is a “slam dunk” product or innovation, it is simply easier to get favorable and profitable changes to the tax code or regulations.  The benefits are clear, the risks are minimal, and the costs are known.

The second problem is that capitalism and competition result in an increasingly unequal distribution of income and wealth.  It is Social Darwinism.  In theory, if you are twice as productive as me, you should receive twice the income that I do.  But this ignores the social side of the equation where only a few would receive the largest share of income and everyone else receives little.  Survival of the fittest.

Income inequality translates directly into the inequality of wealth.  Currently, the distribution of income and wealth approximates that which prevailed prior to the Great Depression era.  Whereas productive and successful people may “deserve” to be well compensated for their achievements (efficiency), this is not sustainable for society as a whole (equity or fairness).  We all do not start out with the same resources and opportunities.  Why is it that gains from investments are taxed at a lower rate than wages?  What is the value of $1000 to someone making $1 million compared to someone earning the minimum wage?

Social Darwinism is market failure in the sense that efficiency determines everything.  The resulting concentration of companies will then have substantial control over social policy.

Public goods refer to goods that are consumed more or less equally by everyone.  The classic example is national defense.  In other words, public goods have the characteristic of “joint consumption.”  You and I both get the same amount of national defense.  If you cannot specifically identify the beneficiaries and make them pay for their “share”, then this is a market failure.  Market pricing cannot allocate such goods.

Now, consider a neighborhood where everyone has a security system with a sign in their yard denoting this.  I do not have a security system, but I just put a sign on my yard.  A potential thief would not know that I did not have the system, and given the prevalence of signs, would probably look elsewhere for victims. I am what is known as a “free rider.”  I get the benefit of my neighbors’ expenditures on security systems without having to pay for the benefits.

Because of the sheer bias in income tax laws, many of the wealthiest individuals and most profitable corporations pay little on a relative and even an absolute basis.  The tax rates on wages versus capital gains is clearly biased to the wealthy.  Because of the complexity of sources of income, the highest income households can hide or shield income from the IRS, who simply does not have the resources to compete with the legal complexities of top earners and the wealthy.  U.S. domiciled corporations can move revenues and costs among subsidiaries to low tax countries and avoid U.S. taxes.

Donald Trump paid $750 in federal income taxes in 2016.  Amazon paid virtually nothing in some recent years.  Trump and Amazon benefit greatly from government expenditures, but they do not pay commensurate federal taxes.

This is market failure.  Trump and Amazon are free riders.

Externalities represent a hybrid between private goods and public consumption.  There is a specific good produced and consumed privately, but there is a public “good” element as well.  Goods consumed privately but whose production causes pollution is a clear example.  Consider a plant on a river that makes a product but discharges its waste into the river.  I buy the product.  It is privately consumed.  The town downriver has to deal with the pollution, and it is jointly consumed by the residents of the downriver town.  In the absence of regulation, the downriver town has to bear the costs of mitigating the pollution.  Neither I nor the producer bear any of the costs.

The government must be involved here.  It can either subsidize the cost of controlling or mitigating the pollution, make the producer pay for these costs, and/or regulate the pollution.  Many “free” market advocates are manifestly opposed to regulation.  However, it is extremely difficult to identify sources of pollution, who is exposed to it and how much, and whether the pollution is from current operations or is “legacy” pollution from old and often abandoned manufacturing plants and natural resource extraction.

What If You Could Do One Thing for Each Market Failure

Market Concentration –> Lobbyists

Eliminate the tax-exempt status for any trade association or lobbying group.  Require full disclosure of all contributors to the individual level.  Eliminate all business entertainment expenses as a tax-deductible cost of doing business.  Require full and public disclosure of interactions between lobbyists and government officials including meetings, seminars, and electronic communications.

Public Goods and Free Riders

Totally revise the tax code to focus strictly on the efficient raising of revenue.  Eliminate personal and corporate tax breaks/loopholes that “encourage” certain “desirable” economic and social activities.  Instead of tax incentives, make direct governmental payments to promote such activities.  For example, if you want to promote homeownership, pay homebuyers directly rather than offer a mortgage tax deductions that benefits primarily the highest income homeowners. This would be substantially more efficient and be subject to direct scrutiny by the public.  Wealthy households and profitable corporations would no longer be able to hide behind an army of tax attorneys and an incredibly complex tax code that no one can fully comprehend.


Institute a carbon tax.  This is a “market” based solution.  One can purchase “rights” to pollute, or conversely, one can earn credits by mitigating pollution.  The government sets the overall levels of allowable pollution and credits.  The market determines the pricing. and it has been enacted in CA.  It should be implemented nation-wide. 

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