Market Failure Explained

What is market failure?

In the words of David Friedman,

“Market failure sounds self explanatory. It sounds as though it’s about markets and about their failing, but in fact, while it is about a kind of failure, it is not particularly about markets.

A great analogy that Friedman uses is to imagine you are one of many soldiers in a line with spears pointed in one direction. There are a bunch of other solders on horseback, also with spears, charging towards you. If we hold our ground, planting our spears, we stand a chance of breaking their charge. If we all run, most of us will die, since the other army is on horseback. We ought to stand still, since if we break their charge, most of us will live.

The problem with this situation is that you do not control the other soldiers standing with you. If you run and everyone else stays, surely you will be more likely to live. If you stay and they run, you will surely die.

No matter what they do, you are better off running.

Everyone else makes this same calculation, of course, and everyone runs, so most of you die.

This scenario is for illustration only, and it is useful if only to define the term: market failure.

Market failure, therefore, can be defined as:

Those situations in which individual rational behavior doesn’t lead to group rational behavior.

In this example above, rationally speaking, the action that best preserves your life is to run away. The system breaks down because the individual’s rational behavior (I should run) is at conflict with the group’s rational behavior (We should stand our ground).

From wikipedia’s page on market failure:

Market failures can be viewed as scenarios where individuals’ pursuit of pure self-interest leads to results that are not efficient – that can be improved upon from the societal point of view.

How does one improve upon a situation where there is inherent market failure? The answer is incentives. Incentives can be used to bring the individual’s rational behavior in line with the group’s.

To illustrate, consider another of Friedman’s examples: a congested traffic light. Imagine a light where several lanes of oncoming heavy traffic continually jams the intersection. Experiencing this type of traffic at an intersection is proof enough that the individual drivers are acting in their self interests. What do they do? They do the very thing that causes the problem in the first place: each one zooms across the intersection in order to be in the middle while their light is green so they don’t miss their chance. Why don’t the individual drivers just wait at the green light until the intersection is empty enough to go through completely, thus not “blocking the box.”

Waiting at the green light is obviously an unpopular choice among drivers, as any experienced driver can most likely attest. Taking this action does not fit with your own self interests, since likely the rest of the cars will zoom around you, or the light will turn red before you’re able to get a turn to go across, or probably both.

How can incentives help?

The natural incentive is to get into the intersection as quickly as possible, since the chance to make it through are raised. If perhaps the intersection was changed to instantly vaporize any cars stuck blocking the other direction, incentives are naturally altered.

I don’t know about you, but I don’t fancy getting vaporized. The new individual rational self interest is to avoid getting stuck in the intersection, thus solving the problem of aligning the self interest with the group’s interest: Instead of rushing across and getting stuck in the intersection, drivers would tend much more strongly towards waiting at the green light, thus improving the entire group’s behavior as a whole.

In order to explain why government/political systems have a much more serious market failure problem, a new economic term must be introduced: public good.