This article will describe my own notion of market failure, called Vandivierian Market Failure (VMF).
There are several classic definitions of market failure, but three seem to stand out:
- A market failure is a situation where individual rationality does not lead to group rationality.
- A market fails when it is not pareto-efficient. Pareto-efficiency is a state of allocation of resources in which it is impossible to make any one individual better off without making at least one individual worse off.
- A market fails when it is not socially efficient. The key difference here is a distributional concern which is often related to wealth or income, but can be anything the analyst chooses such as ethnicity or other criteria. There may be a number of pareto-efficient outcomes, but they do not all have a socially optimal distribution, the theory goes.
I will now lay out my definition, show some important differences, and defend those differences:
VMF occurs when essentially free individual rationality does not lead to the group optimal result, and there is an available public policy which improves total surplus by more than the cost of policy implementation.
- “Essentially free individual rationality” vs “individual rationality.”
- We start from the Friedmanian definition of rationality, not the Austrian nor the Neoclassical definitions, although I think the Austrian and Friedmanian definitions can be harmonized.
- The ‘essentially free’ additive ensures that we are discussing an actor who is in a market which has not been significantly distorted by public policy.
- This was Friedman’s intent from the beginning, but it’s not clear in his formalization, leaving the door open to a trap in which public action creates a market failure in order to justify public action.
- “Group optimal result” vs “group rationality.”
- I’m not sure what group rationality means, and it might mean the same thing that I mean by group optimal result, but rationality is generally thought to be a set of behavioral assumptions.
- My point is consequentialist rather than assumptive.
- The intended point is that failure to achieve pareto-efficiency does not constitute market failure.
- If the market solution results in larger total utility than the alternative public solutions, then the market didn’t really fail at all because it is the utility maximizing option.
- This is perhaps the key notion behind VMF. I think a market is not correctly called a failure if there is no better alternative. This is largely a semantic difference, but I think it is important to have semantic clarity in order to communicate effectively. I think there is a sort of semantic battle in culture and I don’t want to seed the high ground by allowing them to use the term market failure even in a technical sense.
- “…and there is an available public policy which improves total surplus by more than the cost of policy implementation.”
- This snippet has 3 functions. First, it reiterates that there must be an available public policy alternative. The market didn’t fail if there is no public alternative. Not a theoretical alternative, but an actual, implementable policy alternative.
- Secondly, this snippet requires that the policy alternative improve total surplus. If it isn’t clear enough, I mean unweighted total surplus. This is to prevent the manipulation of calculations on concerns of equity, distribution, or social efficiency. I believe markets internalize social considerations. If the poor prefer income more strongly than the rich, the market will show it. It does not need to be imputed by an analyst.
The third and most important point is that the cost of implementation of the public policy solution must be less than the degree to which the policy solution improves total surplus. If the public solution would benefit the economy to the tune of $1B, but it costs $2B to implement, it is a bad idea.
Given this definition of market failure, I don’t think any exist. I also think monopolistic government action will only benefit the economy when a VFM exists. It follows that I don’t expect monopolistic government action to ever benefit the economy.
The next time some one tells you that carbon pollution represents a market failure, ask them which available policy solution would improve total surplus by more than it costs to implement.