When markets don't work

posted on August 20, 12020
topics: economics

It is widely agreed by economists that markets, in the abstract, are a good thing.

Individuals acting in their own interest can be part of a self-improving system. Forcing suppliers to compete with each other on price results in those suppliers constantly brainstorming, researching, experimenting with new methods. The best methods are rewarded and thrive while the less effective methods are discarded.

Many millions of people are better off because we have the ability to produce large quantities of goods efficiently. We have this technology in large part because we have a market system in place which forces competition. If you are not refining your technique while the other teams are, you risk becoming irrelevant.

Roses have thorns, of course. One of the drawbacks of capitalism is that it tends to most reward those who already have the most capital to spend on trying new ideas. You don’t have to be a genius engineer if you have the money to pay somebody else to do the engineering for you.

Nonetheless, an economy for ideas is a good thing, and provides at least some opportunity for talented people to make riches. Clearly, there is better social mobility in modern capitalist America than there is, for example, in feudal Europe.

So market economies, all things considered, have merit.

However, most economists will also acknowledge the existence of market failures, where the hypthetical merits of unregulated markets do not emerge in real-world scenarios.1

A Tale of Two Cities

Residents of Ottawa would like a quick way to travel to Montreal. A savvy businessperson observes this, secures funding from investors, and begins to build a highway connecting them. They start a new company (Adequate Construction Co., or ACC) and are eventually able to recoup the building costs and pay maintainance costs by charging users a toll to use it.

Somebody had an good idea and implemented it. This is a successful business model. They have improved the lives of people using it while making a profit themselves.

Everyone (for the most part) is better off.

But now: a second clever investor sees potential. ACC built their road using outdated mechanical equipment and unnecessarily expensive pavement chemistry. This investor knows that the road could have been built cheaper, and that those savings could be passed on to drivers. They found Pretty Good Construction Co. and pave another road, again going from Ottawa to Montreal.

Because PGCC’s road costs less to build and maintain, they are able to charge drivers a lower toll while still breaking even (at least). Gradually, drivers switch from the first road to this new road, and ACC goes out of business. They had a decent run, but their time is over.

Drivers are happier, because now they have the same service at a lower price. PGCC is profitable. ACC is bankrupt, but hey, what can you do? PGCC was able to deliver the same product more efficiently. That is, after all, the benefit of the free market.

Hold on. PGCC’s road is not optimal yet. Over time, new road-building methods are discovered. Thus inevitably comes Most Excellent Construction Co., which is able to build another road at an even lower price. Just as PGCC did to ACC, MECC undercuts PGCC and takes its place. Driving to Montreal is now cheaper than ever.

Great?

There’s a problem here. Three roads have been built parallel to each other, and two of them now sit unused. Farmland and forests were destroyed and paved to make room for empty stretches of concrete which no longer have any purpose. They are remnants of companies which used to exist, used to profit, but have since died.

And because farmland was wasted this way, the local farming capacity is lessened. More food and other crops will need to be imported from other regions, expensively. The price of travel has gone down, but the system that got us here simultaneously caused the price of bread to go up.2 MECC is profiting, but most people are actually no better off than before.

Drivers barely notice a difference between one road and another. Maybe the new road is a bit smoother, maybe the toll is a half-dollar cheaper, but the differences are marginal. They were fine with the old roads, and would have known no differently if this new road had never been built.

What is obviously, undeniably noticeable is that, when driving on the new road, they look out their window to see another road just like it on their left and another on their right. How did this happen?

Sometimes, markets don’t work

In this example, the individuals involved in building the roads are not to be blamed for building multiple roads. If it had not been them, it would have been others. At fault is the system. Society collectively decided to build three roads parallel to each other by agreeing to a system that encourages (even forces) competition.

This is the result of an unregulated market. Competing with each other also means duplicating effort. We did not need to use the land, time, and resources to build three roads to find out which one would be least expensive. It was not — and never will be — worth that cost. Even if three parallel roads was acceptable, what if it were ten? Or a thousand?

Sometimes, you just don’t need the best or the cheapest road ever built. Sometimes, all you need is one road that is good enough and cheap enough.3


  1. Okay, so not everybody would agree:

    Firstly, there is the Austrian school of economics. These are largely libertarians who believe markets to be very close to perfect and suitable for all use-cases. They argue that markets cannot fail; for as long as profit is being made, somebody must be doing a good job. I hope it is not too revealing of my biases to say that this position, although perhaps internally consistent, is not helpful in efforts to work toward a just society.

    Secondly there are the Marxian economists, who argue that the real purpose of any economy is to improve the well-being of its poorest. They see little or no value in the total pie getting larger if those with the smallest slices of it are not seeing their share grow. This is a pretty fundamental objection to capitalism; from this position, virtually all markets are failing all the time — making “market failure” a redundant term.

    Finally, there is the Milton Friedman school of economics. Devout followers tend to actually concede that market failures do exist, but argue that governments should make no effort to correct them. Basically, their position is that governments are simply too naive (or corrupt) to correctly estimate when a market is failing and the magnitude and scope of that failure. Attempts to regulate will result in overcompensation or wrong action altogether.

    This is probably true sometimes. An example might be the dairy industry in Canada, which is a market that is both failing and also being regulated in entirely the wrong direction.

  2. And not just due to price fixing this time.

  3. For further reading, the phenomenon described in this post is closely related to the concept of natural monopoly.