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Market Failures After reading about Smith, Marx and Keynes, you may get the idea that we economist don’t agree on much. However, we do agree on a lot of things, including the idea that the markets are not always perfect. Market outcomes are supposed to be efficient, both allocatively and productively. When they (market outcomes) are not efficient, we consider them failures. So if a free market gives us too many of some type of good, or too few of another type of good, we are either over-allocating or under-allocating our resources. In the case of market failures we are productively inefficient and/or allocatively inefficient. The market system has failed to deliver on what its advocates claim it does best. Recall your math versus econ project. If you devoted too much time to math and not enough time to econ, you didn’t meet your goal of maximizing the total points earned on an exam (allocatively inefficient). When your math teacher dropped the lowest test score and you decided to only study econ for eight hours and take the rest of the time off, you didn’t use all of the study time available (productively inefficient). We have five general categories of market failures.
Market Power and Competition Market power is the ability to influence the market price. Adam Smith recognized early on in his analysis of the market system that his conclusion that markets yield a harmony of interest rested on the existence of competition. (Recall that the definition of harmony of interest is when someone pursues their self-interest and in doing that they serve the interest of society.) What do we mean by competition? Once again, it is a bit different from what you might mean when you say it. To an economist, competition has three characteristics. 1. There must be a very large number of buyers and sellers, each consuming and producing a small fraction of the goods in the market. The producers and consumers are such a small fraction of the market that whether they buy or sell, it has no influence over supply and demand. 2. All the items in the market must be identical. 3. There can be no substantial barriers (obstacles) to entry into, or exit from, the market. I suggest you look in your text starting on page 158 for a more complete discussion of the nature of competition. The closest thing our economy might have to purely competitive markets are those for agricultural goods like wheat. There are lots of wheat farmers, so that satisfies criteria 1. One can’t tell the difference between one grain of wheat and another, satisfying criteria 2. Criteria 3? It’s relatively easy to start a wheat farm (although this is changing). In this market no single wheat farmer can alter his output and change the market price. Sometimes we call the participants in competitive markets price takers because they can only "take it or leave it" when it comes to the market price. As you found out in one of your projects, we’ve seen the price of gas skyrocket. This has been in part due to an oil refinery fire, which reduced the amount of gas in the Northwest. It was also due to the concurrent decision on the part of other members of the oil industry to cut back production. Clearly, this is not a competitive market. The market participants have been able to influence price. In fact, the oil industry is called an oligopoly, or an industry where there are only a few firms in the market. What are the results if markets are competitive? Without going into too much detail, the results are good for the consumer. We get a lot of goods at a very low price. In fact, the price is so low that the business will barely make a profit. If you want to see how we can assert this, read chapter six in your text. But let’s look at a short analysis of competitive markets. If I open a factory that produces widgets (something that just about anybody could make) and find myself making a handsome profit, what do you think other people would do? That’s right. They would enter into the market and start making widgets too. What would that do to the price of a widget? That’s right, the price would go down. What would happen to the number of widgets in the market? Right again-- there would be more of them. More simply put, the supply curve would shift to the right. When would it stop shifting? When there was such a small profit that no one else would be tempted to enter into the market. What does this do to the way that the firm owner operates his/her business? It forces him/her to always be looking for ways to cut costs. When he is successful, he can earn a higher profit, but soon his competitors will lower their costs in the same manner and he’ll have to look for other ways to cut costs. This results in more goods being produced causing the market price to go down. Those firms that don’t cut costs won’t be able to make a profit at this lower price and will go out of business. It’s a fairly relentless process, just ask any farmer. Who wins? The consumer, by getting a lower price and more goods. One of the reasons that Americans enjoy some of the lowest food bills in the world is because of our competitive farming sector. It’s also why farmers have trouble making a living. In fact, can you see something of Karl Marx’s prediction in our agricultural sector? But what if markets are not competitive? In fact, very few fit our definition of competitive. Look at exhibit 8.1 on page 228 to see the other forms of market classification. Monopolistic competition and oligopoly are much more common than pure competition and pure monopoly.
Monopolistic Competition Most firms attempt to get away from the relentless downward pressure on prices and profit in competitive markets. There a two ways that a firm can accomplish this. First, it can make its product somehow different from other products. In this way it makes consumers perceive an extra value when they purchase the product and thus be willing to pay extra for it. You should note that this differentiation doesn’t have to be real. It can be solely in the mind of the consumer. American beer is a good example. There is very little difference between the taste of Bud, Coors or Miller. This has been proven in test after test. But, these firms spend millions of dollars trying to make people (mostly men) think that these products have some extra value. Because of the nature of these consumers, the industry quite often resorts to things like sex to sell the product. No matter how hard I try to convince some of my young male students, they still think that a gorgeous young half-clad woman will run towards them in slow motion if they drink such and such beer. Nor, to be fair, am I very successful in convincing some of my young female students that wearing a certain perfume will result in a "studly" young fellow in an incredibly small swimsuit swimming across the pool towards them. Sometimes the differentiation can be quite real. For example, the difference between fast-food tacos and hamburgers. If product differentiation is the only thing that firms use to get away from pure competition they are called monopolistic competition. Most people who haven’t studied economics would call this kind of market competitive. It is characterized by many firms with relatively low barriers to entry, making it competitive. But since the products are somewhat unique (only McDonald’s has a Big Mac) it has an element of monopoly. That’s why we call it monopolistic competition. The biggest problem economists have with monopolistic competition is that this kind of market tends to create a situation where the economy over-produces these goods. In every town or city there is a main road that has a bunch of fast-food restaurants, too many used car lots and a zillion motels. All of them serve the same basic function, none of them running close to their capacity. Essentially there ends up being too many of these firms. This is as inefficient as too few. Our economy is inefficient because we are over-allocating resources to these kinds of markets. On the other hand, (Harry Truman once asked for a one armed economist so he’d never have to hear this phrase again) this kind of market does serve a function: consumers value differentiation. We don’t all want to eat the same kind of food, wear the same kind of clothes, or live in the same kind of dwelling. So we face a trade-off between the costs associated with over-production and the benefits we perceive from product differentiation.
Oligopoly and Monopoly Another way that firms try to avoid competition is by controlling supply. If a firm can control supply, it can hold back production causing prices and profits to go up. This is good for the firm, but bad for the society. First, we end up under-allocating resources to industries with market power. Second, those firms that have market power use their power to artificially keep their profits up to the point where there is over-allocation of income to the owners of these firms. The key difference between oligopoly and monopoly is the number of firms in the market. In oligopoly markets there are a few firms, like the automobile market. In monopoly markets there is just one firm like your local telephone company or electricity provider.
There are many ways that firms try to control supply, so I’ll just cover some of the major ones.
Economies of Scale Economies of scale are when a firm gets large enough that it ends up with certain cost advantages over its potential rivals. These cost advantages tend to come from being able to spread the costs of very productive capital over a lot of production. For example, you could make a car in your garage at home. Just go to the local parts store and start buying everything you need, from tires to engine to frame and so on. When it came to some task like putting the fender on, you could weld it on faster with a large commercial spot welder. But, that would cost several thousands of dollars and you would use it only a few times. This would drive the cost of your backyard car way up. GM can afford a very productive and expensive robot to do this because it can spread the costs of this machine over thousands of cars. If you use a less expensive small electric welder you would have to go much slower, again driving the cost of making your car up. So, no matter what you do, your car is going to cost more that GM’s because they have economics of scale and you don’t. A second advantage that GM has is that it can ask for a much lower price from its suppliers than you can. After all, your just going to buy one engine while GM will buy thousands. Because there are only a few firms in oligopoly markets, they can influence the price of the good. That means that they have market power and can take advantage of the system to raise prices and profits. This means that we are under-allocating resources to this area and over-allocating them in some other, more competitive area. On the other hand : ), even if the firms use their market power, the consumer may not be better off if these firms didn’t exist. Standard Oil, the firm put together by John D. Rockefeller, had tremendous market power and was found guilty of abusing that power in 1911. But, when we look at real prices before Standard Oil consolidated its power and after, the prices were lower. So, even though Standard Oil had market power and used it, prices went down because the economies of scale were so large.
Agreements that Restrict Trade Firms can also avoid the downward pressure on price and profits by entering into some kind of agreement that allows them to cut back production to raise prices. These agreements can take many forms from informal "gentlemen’s agreement" to not compete, to cartels, to mergers and hostile take-overs. Microsoft tried to buy a software rival called Intuit (they produce Quicken, a personal money management program) because they didn’t want to compete with them. Steel makers in Pittsburgh attended a yearly dinner party where they agreed to production quotas. The Organization of Petroleum Exporting Countries (OPEC) agreed to cut back oil production in the 1970’s, forever changing the relationship between the Middle East and the West. There are countless ways that firms try to avoid what they call "ruinous competition."
Controlling Resources Firms can try to "corner" the world market for essential inputs. For years Anaconda Copper controlled most of the copper producing mines. In the 1930’s and 1940’s Alcoa Aluminum controlled the only bauxite (aluminum ore) mine the world. Today De Beers controls the worlds diamond market by controlling the wholesale market for diamonds.
Government Grants Governments often grant monopoly rights as a reward for certain behavior. The reason we grant patents (a monopoly right) is as a reward for research. We grant the medical industry monopoly rights over who can become a doctor in order to increase the quality of medical services. The government grants itself monopoly rights over the ability to print money.
Success Sometimes a firm becomes a monopoly because it produces the best good and that is what people will buy. At one time IBM produced a typewriter (The Selectric) that was so innovative that it dominated (90% market share) the business typewriter market.
Conclusion What are the consequences of market power? Well, they are not as clear as we would always like. The U.S. has spent a lot of time and resources trying to make sure our markets remain somewhat competitive. We are seeing another one of these attempts in the Microsoft case going on right now. Your text does a very good job of covering this on pages 245 to 256. Government and Market Failure What we now call government came into existence in a form that we would recognize about the same time as capitalism did. (Generally speaking, we’re talking about 1500 to 1750 in Europe.) It is not a coincidence that the nation-state system of government and capitalism relied on one another for their success. Capitalism, as with other market systems, relies on governments to write and enforce the rules of exchange in order for it function effectively. It also relies on governments to provide other public services such as, road building, money standardization and so on, that combine to facilitate exchange. Nation-states need successful economies in order to carry out their interests, such as protecting sovereignty (the ability for a nation to do as it sees fit). The primary way that nation-states assert their sovereignty is by fielding an army. The ability to field an army depends on the size of a nations economy. One of the main reasons the U.S. can act the way it does towards other nation-states is that it has the most productive economy in the world. For those of you who are interested in the evolution of such relationships, I recommend that you read Robert Heilbroner’s The Making of Economic Society. Despite the fact that these two institutions need one another to exist, there is also a certain level of tension between market forces and political forces. This can be seen in the relatively unsuccessful attempts that our government has made to stop the market forces in the drug trade, or in the failed attempt our government made to stop the market for alcohol. Markets are, as you have discovered, individuals following their own self-interest as they engage in exchange. For example, individuals who want to drink alcoholic beverages with individuals who want to sell it. Political forces are, in essence, groups of individuals trying to force other individuals to behave in certain ways, that further the interests of those groups. For example, a group of people who believed drinking alcoholic beverages was inappropriate passed a law forbidding its consumption by all people. The struggle between political forces and market forces are at the center of many of our most intractable social problems. We tend to turn to governments when market forces are not functioning the way the some of us think they ought to. If a monopoly is charging to much for its product (your cable bill), some of us expect government to intervene to correct the problem. If we are downstream from that polluting widget factory, we may expect government to stop that factory’s widget waste from getting into our drinking water. Not all of us agree when government should intervene, or even if its interventions are successful. Indeed, your text speaks of government failures, when its action makes matters worse rather than better. Be that as it may, when governments intervene in the market system they have four basic tools to change economic outcomes.
Taxation and Subsidies. Governments have the power to tax (take money or other assets from individuals) and subsidize (give money or other assets to individuals). If government taxes certain behavior, like smoking, in discourages it. If it subsidizes other behaviors, like financing community college operations, it encourages it. In each of the market failures, taxing and subsidizing is an effective tool to change market outcomes. There is an interesting tax reform movement that is gaining strength here and in the Europe. It wants to change the current system based on these concepts of encouragement and discouragement. It would eliminate our current tax structure, which taxes income and wealth (thereby discouraging work and wealth creation), and replace it with tax system which taxes certain other behaviors like burning fossil fuels (thereby, reducing air pollution, global warming, and traffic congestion).
Public sector production. Governments can also choose to produce an item independently of the market. As I said, one of the main interests of any government is to protect its sovereignty (the ability to act as it sees fit). That protection often takes the form of an army. Most armies are "owned and operated" by the government. Other public goods such as law enforcement, road building, port construction, and public education can also be the result of public sector production.
Antitrust Legislation. In the late nineteenth century U.S. businesses came up with a rather unique way to gain market power. By using trust laws (a trust is when someone manages someone else’s assets for them) industries set up "Trusts" where a stockholder in an individual firm could exchange their stock for trust certificates in an industry-wide Trust. When the Trust obtained controlling interest in most of the firms in an industry, it could effectively manage that market like a monopoly. Essentially, it would cut back supply to raise prices. Any firm that was tempted to engage in "ruinous competition" (lower prices) was ordered to stop by the Trust. Stockholders (now trust-holders) were happy because this made for higher profits. This practice became so widespread in the U.S. that there was a reform movement that resulted in the Sherman Antitrust Act which made this practice illegal, as well as any other attempts at monopolization. Your book does a very good job of summarizing the antitrust laws of the U.S.. However, you should note that not all governments have antitrust acts. Germany is a famous example of a country which doesn’t have antitrust legislation.
Regulation. Governments can also pass laws and regulations that require businesses and individuals to behave in certain ways. Phone companies might have to provide the poor with low cost telephone services. Businesses may not hire people below a certain age. All cars must have catalytic converters installed. Economics divides regulations into two types, social and economic. Economic regulations are those laws which are directed towards trying to maintain relatively competitive markets. When large firms merge (two independent firms become one firm) they must get permission from the justice department, which bases its decision on how that merger will influence the level of competition in the market place. Many of the economic regulations in the U.S. were passed during the nineteen thirties. Social regulations are those laws that regulate other behaviors of individuals and firms, such as safety standards, non-discrimination laws, and laws requiring accommodations for people with disabilities.
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