Sunday, November 04, 2012

Market Failure and the Definition of Terms

In discussing the idea of market failure, in class and in public talks, I usually start by pointing out that technical terms often sound self-explanatory and aren't; the theory of relativity, for instance, is not the theory that everything is relative. I go on to explain that "market failure" is an example of that problem. It does not describe all ways in which markets can fail and it is not limited to markets. 

As I define it, market failure describes a situation where individual rationality does not lead to group rationality. Non-market examples include the game of prisoner's dilemma, where each defendant makes the correct decision for himself (confess and betray his co-defendant) even though both would be better off if both made the alternative decision, situations where an army runs away and is slaughtered because each soldier is better off running although all are better off if they all stand, and traffic congestion at an intersection that keeps jamming because drivers, trying to cross before the light changes and failing to make it, block the intersection. In each of these cases, each actor is making the correct decision for himself but every actor would be better off, at least on average, if they all made a different decision.

I have just been redoing the argument as a chapter for the third edition of my first book, The Machinery of Freedom. In doing so, it occurred to me to wonder in what sense what I have been saying is true. I am describing how I use a technical term in my field. Can I legitimately claim that others, including other economists, who use it differently are wrong?

There is no central authority to determine how technical terms are defined, and if there was I would not be it. I made no attempt, before pontificating on the subject, to research the usage of other economists;  a recent google suggested that what I regard as the incorrect usage is quite common. I should not have been surprised, given that, a year or so back, I emailed the author of a very successful textbook to try to persuade him to change the way in which he used the term. I got back a courteous reply, saying that he would consider the matter. 

I concluded that, in writing the chapter, I should be a little more careful in what I claimed. My definition is not what the term means—meaning is defined by use, and lots of people use it differently. My definition is what the term ought to mean.

Technical terms are tools for thinking and communicating. My definition of market failure makes it a better tool for those purposes than an alternative such as "a situation where the market does not allocate resources efficiently." The latter lumps together similar effects from unrelated causes—the market might produce the wrong allocation because the information to deduce the right allocation did not exist when the relevant decisions were made. It fails to identify situations where the same logic is functioning in the same way in different contexts—rational ignorance in voting as an example of the public good problem, prisoners betraying each other as an example of an inefficiently large output (of confessions) due to a negative externality.

I will continue to argue that my definition is the correct one. I will merely be  a little more careful to explain what that means.


Simon said...

Great post.

I think a problem is that people often are more interested in persuation than in understanding things. So when a word has positive connotations, its definition gets stretched to include more things that the speaker approves of. If it has negative connotations, it is stretched to refer to anything proposed by those with whom the speaker disagrees.

Simon said...

I think the words 'liberal' (in the U.S.) and 'rights' are examples of words that have one definition that is better for thinking and another contrived for persuation.

A narrow definition of 'rights' (i.e., 'negative' rights like freedom of speech) makes more sense to me because its referent is a fairly crisp category. A more expansive definition refers to a more artificial category with fuzzy and changeable boundaries. But the expansive definition is often preferred by those whose first concern is to persuade.

Xerographica said...

The problem with the idea of market failure is that people take it to mean government success. But in the absence of our spending decisions...there is no way to indicate whether the government is truly succeeding where the market is failing. And it's not just a matter of the government's also about the government successfully supplying things we actually value.

That's why I'm a big fan of tax choice.

1. Does the market fail? Sure...fine.
2. Does the government succeed? Yes?
3. Does the government succeed at supplying things that taxpayers would actually choose to spend their taxes on? It would behoove us to find out.

Anonymous said...

I think you covered it pretty well in "Price Theory", under the section about Marshallian/Pareto efficiency. I define market failure thusly:

"The doctrine that, as sometimes rights violations generate enough social welfare to compensate their victims, the State should have the authority to violate rights at any time, without compensation."

Xerographica said...

Haha...did you know that there's no Wikipedia article on government success? So for fun I created one...Government Success. I didn't cite any sources or anything because I'm looking forward to somebody proposing that the article be removed because the topic lacks notability.

Dog of Justice said...

Since the general phenomenon you describe is not limited to markets, I think it's best to borrow or create a different term for it. ("Coordination failure" was the first that came to my mind, but it's doubly crippled by being (i) about as imprecise a fit for the concept as "market failure", and (ii) it also already has a different conventional economic usage.)

Glen Whitman said...

I've been arguing for years that "market failure" is a misnomer, for pretty much the reasons you present. Here's what I said on my blog several years ago:

"One topic that came up with some frequency was the notion of 'market failure.' Economics textbooks almost always use this term as the category heading for such potential sources of inefficiency as positive externalities, negative externalities, and public goods. But the more I think about it, the more I realize this is something of a misnomer. Externality and public good problems are hardly unique to markets; they occur in virtually all institutional settings, particularly legislatures and bureaucracies. Labeling them 'market failures' sends the erroneous message that markets are especially or even exclusively susceptible to these sorts of problems, whereas the truth is almost precisely the opposite. Instead of calling these problems 'market failures,' we ought to simply call them 'failures,' or, if you feel the need for an adjective, 'institutional failures.'"

With regard to what you should say in your book, I think you should try to nudge the definition in a sensible direction. After all, economic terms get defined by a social process involving all economists, and there's no reason you should exclude yourself from that process.

Specifically, I think you should define "market failure" as inefficiencies that arise from certain types of incentive problems (public goods, externalities, etc.) when such inefficiencies happen in a market setting.

Glen Whitman said...

Oops, here's the link to my blog post that I quoted above:

MikeP said...

I for one think your definition of market failure is the correct one: As Simon notes above, it provides the clearest delineation between two very different things. Furthermore, it is an unintuitive but provable result that counters the great majority of what is to some an unintuitive field. As such, the concept carries even more information.

Interestingly, in a comment back in 2004 I cited your Price Theory when clarifying this very topic.

Anonymous said...

I think attempting to define a One True Meaning to a term, outside of very specific domains, is doomed.

Sometimes market failure is about inefficient resource allocation, if that is what a person is talking about. In asserting that it a term is "really" about X, one is generally doing one of two things: attempting to constrain the conversation in a way that leads to a specific outcome (a form of persuasion well known to lawyers and dogmatic peo
Le of many stripes) or abstracting the term. The latter might well be sometimes useful; frequently, it obscures as much as it illustrates.

Rebecca Friedman said...

Not necessarily. If you say "This term means what I mean by it" you've still got the problem that the people you're talking to probably can't read your mind. Therefore, what you mean by it may not be clear to them. The point of a technical term such as market failure is to be able to refer to a set of ideas without laying them all out; if a technical term has multiple meanings, it's much harder to make sure the people you're talking to are thinking of the same meaning you are (especially if not everyone knows all the meanings, or worse, not everyone knows there are multiple meanings). Trying to refer to a set of ideas doesn't do much good if the ideas you think you're referring to and the ideas your listeners think you're referring to aren't the same ones.

I think there's a distinction here between normal words, which are usually clear from context, and technical terms, which aren't. Finding the One True Meaning of "Street" may not be very practical and is in any case unnecessary. On the other hand, Market Failure -without- a clear meaning makes more trouble than it solves.

Anonymous said...

I think the implication of the term ‘market failure’ is a case were the market (freely acting people) can NEVER or with great difficulty reach a state of Pareto optimality. This is a very strong claim and one where there is very little evidence for. Even the prisoner’s dilemma when played multiple times reaches cooperation. It’s funny that people are quick to allocate ‘negative’ externalities but not the ‘positive’ ones…


Anonymous said...

I think you're off base here David. The whole point of technical terms is to take an ordinary word and give it a specific, well-known meaning for specialists. Of course this can lead to some bad results, like confusion among ordinary folk and conflicts between different specialists trying to use the same technical term - but considering how technical economics has become, it seems a little late in the game to suddenly worry about the terminology. For what it's worth I like the term "collective action problem" since what is lacking in these scenarios is coordination among everybody to get the optimal result.

Jim Rose said...

Luke Froeb explains in his textbook that his mba students fell asleep when he lectured on market failure and the standard possible public policy responses. His Dean was thinking of firing him because of poor student evaluations

When Froeb repackaged a market failure as a business opportunity, his MBA students paid close attention. The first to fill these gaps in the market or be the market maker for the missing market stands to profit.

David Friedman said...

Re Jim:

Actually, I quite often, in explaining market failure, make the point that a market failure is also a business opportunity. If there is a change that produces net benefits, a sufficiently clever entrepreneur may be able to figure out how to produce that change and capture an adequate share of the benefits.

Xerographica said...

Speaking of business opportunities...did you folks hear that the Crooked Timber liberal economist John Quiggin is writing the sequel to Henry Hazlitt's popular classic..."Economics in One Lesson"?

You can read all about it on Noah Smith's and here.