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Market failures, part IV april 25, 2008

Posted by Fredrik Gustafsson in Nationalekonomi, _In English_.
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Nu vet jag inte om det faktum att det inte blivit någon debatt runt senaste inlägget beror på att det jag skriver är så förbaskat övertygande eller att ingen läser det. Hur som helst kommer här nästa del som gör det lite tydligare vad vi egentligen menar när vi säger att ”marknaden” misslyckas.

Can markets really fail?

Before we turn to the important question of what can make the market fail, we have to ask ourselves if we really can say that the market fails. That is, if speaking of market failures makes any sense. In order for there to be failure, there has to be action. If someone or something does not act, it cannot fail. But the market cannot act; only individuals can act. This would in turn mean that the market cannot fail and that it makes no sense to talk about market failures.

The argument is that when we say that the market fails to produce at the lowest cost, to allocate resources in the most efficient manner and to develop new technologies, industries, products and resources, what we really mean to say is that individuals on the free market fail at doing these things. Is it not the owner of the factory that uses too much resources when producing his good, the investor that invests his money in ventures with low returns and the inventor that does not succeed in developing that new technology, even though it is within his capability (or at least physically possible) that fail, and not the free market? And no one would argue against the notion that individuals can fail.

At first glance, this objection seems reasonable. On closer inspection, it turns out that it is pure semantics and of no or little consequence for our discussion. What is meant by the (free) market when market failures are discussed in this article is a set of formal and informal rules that govern and restrain human action. The term does in this case not refer to a place where goods or services and bought or sold. That is, when we say that the market fails, we mean that a certain set of rules fail to produce either maximum static or dynamic efficiency—or, fail at producing higher static or dynamic efficiency than a different set of rules.

To call this set of rules that govern the behavior on a free market for “the free market” is perhaps somewhat sloppy. The more proper way to refer to the thing we mean by market failures is “a situation in our laissez-faire economy where static or dynamic efficiency is lower than an imagined optimum, or, the outcome that would follow from government intervention”. But simply calling these situations market failures is of course a lot easier, even though the term can be somewhat confusing.

Take the way we speak of the “failure of socialism” as an example that proves that this objection is rather silly. Few would argue that we cannot say that socialism has failed to produce static and dynamic efficiency. No sane person would argue that it was not socialism that failed, but instead individuals in socialist countries that failed to produce their products at a low cost, allocate resources to where the returns were highest and develop new technologies, products, industries and resources. In this case, it should be clear that it was the set of rules that governs and restrains human action in socialist countries that failed to produce efficiency, not the individuals that actually produced the expensive products that no one wanted.

Sure, ultimately it was the individuals in the Soviet Union that acted inefficiently (as socialism cannot act). But such a claim misses the point that, while part of the reason for why they acted inefficiently might have been their own incompetence, the main reason for why they acted inefficiently was due to the fact that the rules imposed upon them by the state either prevented them from, or failed to produce sufficient incentives for, acting in an efficient manner. In the same way, this article will study whether the set of rules that govern and restrain behavior in the “perfect” laissez-faire economy too can prevent and fail to provide sufficient incentives for economic growth.

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