Thursday, December 08, 2011

The Failure of Market Failure | The Freeman

People object that there's no such thing as a free market.  (Therefore, I suppose, we need not worry about how unfree a market may become.) 

The proper response to that objection is, "so what?"  What's important is now how close to error-free a system is, but how good its error correcting mechanisms are.

...In the technical literature a market failure refers to any situation in which a market does not produce the "Pareto-optimal, general equilibrium" outcome.  Standard neoclassical theory argues that "perfectly competitive" markets will produce outcomes in which resources are allocated to their highest valued uses and no one person can be made better off without making at least one other person worse off.  In general equilibrium, prices of all goods are exactly equal to the marginal cost of producing them and all households maximize their utility.  In addition, all firms are profit maximizing, but the level of real profits earned is zero, as no reallocation of resources could improve on the current one.

Unreal Conditions

Strictly speaking, any market outcome short of this reflects a "market failure" in that markets have failed to produce the ideal outcome that theory predicts.  However, in the real world the conditions necessary to produce a general-equilibrium outcome are not remotely feasible: perfect knowledge, homogeneous products, and a large number of small firms in every market with none able to influence price.  Given that such a world is not possible, the charge of market failure boils down to the claim that markets don't produce a level of "perfection" that is unattainable under any realistic circumstances.

In this sense of the term, markets "fail" constantly.  It takes an Austrian perspective to understand that these sorts of imperfections (a better term than "failure") are not only part and parcel of real markets; they also are what drive entrepreneurship and competition to find ways to improve outcomes.  In other words, what markets do best is enable people to spot imperfections and attempt to improve on them, even as those attempts at improvement (whether successful or not) lead to new imperfections.  Once we realize that people aren't fully informed, that we don't know what the ideal product should look like, and that we don't know what the optimal firm size is, we understand that these deviations from the ideal are not failures but opportunities.  The effort to improve market outcomes is the entrepreneurship that lies at the heart of the competitive market.

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