Economic Q&A on Linked-In: Market Failure

For a week or so, I decided to field questions on LinkedIn’s Answers board. This question in particular elicited answers that I felt I must address indirectly:

Q The failure of the free market? Or not?
Many people have over the last few months suggested that the current global recession is an indication of the failure of the free market.
Personally I’m not convinced by this view.
However there seem to be just about as many interpretations of what a free market is as there are people commenting on the subject.
In today’s highly connected marketplace, where almost anyone can take their goods or services to a global market more easily than at any time in history, what exactly do we mean by “the free market”?
Possibly more importantly, is the current version of the free market the one we should be taking forward into the next couple of decades?
If not, what should the global free market look like in the future?

This is my answer, partially in response to the no-such-thing-as-a-market-failure crowd:

These questions are sure to raise ideological hackles, particularly in the United States, where there is a strong tradition of free market advocacy from early industrialists to Ayn Rand to Robert Nozick and Milton Friedman and beyond.
In the case of the current global recession, there are many, many factors involved, both from governments and markets. Honestly, to really disentangle them would require more knowledge than I have. Personally, I believe that government failures in deregulation of some financial institutions (particularly in regard to honestly reporting operational risk), an inability to regulate new financial instruments, poor policy by the Federal Reserve, and others; and market failures in the form of perverse incentives (commission systems all pointed towards inflating the real estate market), information failures (triple-A ratings for junk mortgage-backed securities) and the typical boom-bust market dynamics driven by market imperfections all contributed. There are plenty of reasons for this mess and markets only get some of the blame.
As for what we mean by “free markets”, the use of the phrase is varied and often hopelessly rhetorical. In the strictest sense they do not and cannot exist in the same way a Carnot engine does not exist—it is a theoretical notion approximated by real systems. The Walrasian market whereby we derive the fundamental welfare theorems that provide a normative justification for free markets is a mathematical fiction.
Unfortunately the unattainability of free markets encourages a kind of no true Scotsman fallacy for some free market advocates. If the market looks to be misbehaving, we can always point out how it is not a true free market, and is therefore insulated from criticism. For a person of this persuasion, there may be no such thing as a market failure by definition. Ironically enough this is very close to the form of reasoning used by communists to dismiss the failures of communist countries (i.e. the USSR doesn’t count because it was not real communism).
In any case we are left with real world, mixed and imperfect markets and have to make do with them as they are and whether freer is better, or what mix of markets and governments are best, must be checked the hard way: empirically and with the guidance of our best economic models.
For those that assume less market distortion always equals more efficiency, check out the Theory of the Second-Best. Simply stated:
“The Theory of the Second Best states that if there are two or more market
imperfections (distortions), correcting one of them may either increase or decrease welfare. For example, if there are two tariffs, eliminating one may not increase welfare. A pessimistic interpretation of this theory is that it implies that economic theory allows us to reach no conclusion about real world markets, since we know that these are subject to many imperfections/distortions. A more moderate interpretation is that we cannot uncritically use economic theory to conclude that a particular reform, such as trade liberalization, necessarily improves efficiency.”

Leave a comment

Your email address will not be published. Required fields are marked *