When Markets Fail—Part I
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“The only function of economic forecasting is to make astrology look respectable.” J. K. Galbraith
The reputation of financial economics as a “dismal science” (a phrase that Thomas Carlyle coined in relation to economics) was richly deserved during the 2008–2009 financial crisis and its aftermath. Although many scholars, including Robert Shiller, Paul Krugman, and Raghuram Rajan, rightly viewed the impending situation as a crisis (see also Lerner 2008), the perceived failure of economic scientists and high-level Wall Street practitioners to predict the meltdown reinforced this low reputation.
Several well-educated and skilled financial regulators were corrupt, as the documentary Inside Job points out. Yet I must remind readers that the handling of the crisis as it unfolded was highly competent, thanks mostly to Ben Bernanke, chairman of the Federal Reserve, and Tim Geithner, then president of the Federal Reserve Bank of New York. Economic knowledge, then, still stands for something. Below I discuss what contemporary economics has learned about cases in which markets fail and the state has to intervene.
The Role of Regulation
My statement about the deft management of the crisis might have sounded like heresy even a few years ago, and many people still deny government’s considerable role in maintaining a sound economy. Indeed, beginning with the (grotesquely named) first fundamental theorem of welfare economics, which mathematically proves that market allocation of resources is the most efficient method (Varian 2009), there is no lack of arguments that governments are unnecessary impediments in economic life. Yet, organized societies throughout history have always attempted economic regulation, a fact that should give market worshippers a pause. Could it be that a perfectly rational “economic human” has never seen his or her direct interest in abolishing regulatory functions of government?
In her novel Atlas Shrugged, Ayn Rand, the patron saint of the modern antigovernment radicals, even sentenced to death a character who bought a train ticket and assumed his right to ride a train despite not being its owner. It never occurred to Rand that a train ticket is a binding contract between the railroad company and the passenger.
If she wanted capitalism without binding contracts, I do not know what form it could have taken. Enforcement of contracts is expensive and time consuming and requires the kind of controlling authority—a government—that historically has been supported by taxation. Furthermore, the collapse of the organized state and its regulatory functions does not usher in a state of economic perfection, but rather leads to armed conflict, tyranny, and the descent into feudalism (see Lerner 2011). Why is this so?
Economists have been asking this question for a long time, particularly in its more philosophical form: why do organizations exist? The first coherent answer came from Ronald Coase (1937, 1991) in the 1930s. Coase pointed out that the costs of negotiating contracts—“transaction costs”—are not negligible and cannot be regarded as simple add-ons to the cost of production. Another important insight came in the 1970s, when George Akerlof (1970, 2003) and Joseph Stiglitz (2002) discussed the institutional framework as a way to partially alleviate information asymmetry. Finally, there has been a renewal of interest in the work of English economist Arthur Cecil Pigou (1932), one of John Maynard Keynes’ teachers at Cambridge. Pigou emphasized the existence of some markets as detrimental to social welfare, and proposed “sin taxes” as a means to regulate them. Similar ideas have existed throughout history: the Bible hints at the regulation of prostitution, and ancient Greek and Chinese treatises contain condemnations of gambling.
There are additional questions that pertain to public-private relations. For instance, in developed nations, why are defense and law enforcement almost always functions of the government? Why are infrastructure, healthcare, and education typically a mix of public and private efforts? Yet consumer goods are produced by private entities almost everywhere, North Korea being an exception.
- In the end, one can formulate five principal reasons for market dysfunction:
- Transaction costs and market frictions;
- Information asymmetry and adverse selection;
- Market externalities;
- Existence of public goods (bads), nonexclusivity of consumption, and Pigovian markets (activities that reduce society’s welfare, or marketing bads); and
- Problems of collective action (e.g., arms races).
Transaction Costs and Market Frictions
Coase tried to answer a narrower question: why do corporations exist? In principle, production might rely entirely on contractual labor, without a formal institutional framework. In fact, for millennia, most labor was organized this way. The film industry as it exists today is a prime example of this type of labor: many movies are produced by ad hoc production companies, which are often owned by actors or directors and which hire production crews only for a specific movie.
In contrast, under the Hollywood studio system that existed from the 1920s to the 1960s, work was organized in an industrial fashion. Stars were practically the property of the big film companies, which dictated many aspects of their lives, including their attire and their public persona (the film Mommie Dearest paints a clear picture of this). Why was it arranged this way?
To find out why the studio system predominated in the past and why it declined, we can first look to the reason Coase (1937, 1991) gives for the existence of corporations. The costs and delays inherent in negotiating transactions are far from trivial. The corporation benefits both the consumer and the producer by reducing these costs and delays. Instead of searching for the combination of lowest price and highest quality among producers of cereal, for instance, the consumer can rely on supermarkets that offer comparable brands and non-negotiable prices. Similarly, modern societies organize labor by prescribed roles within organizations; management does not have to negotiate prices for each operation, but simply directs the work.
Obviously, it is hard to attribute a complex social development such as the demise of the Hollywood studio system to one factor, but the Coasian argument seems to run along the following lines: when celebrities became independent contractors and their salaries became the major driver of production costs, the economy of scale through the retention of large permanent crews at the company’s expense disappeared.
In the early and the golden years, when movie production relied on self-trained manual labor for many tasks—for example, setting up props, ordering and developing large quantities of film, procuring expensive equipment, and hiring extras—transaction costs were mitigated by the economies of scale. The emergence of college programs dedicated to teaching all the technical and nontechnical skills (such as the course in celebrity journalism—i.e., paparazzi training—offered by my alma mater, Syracuse University), and the progress of technology, which obviated the need for staff such as typists and secretaries, made contract labor much more attractive. Thus the movie industry returned to the preindustrial production pattern.
Yet, in the trading of incomparable objects such as fine art, an old order persists in the form of relatively long-term relationships among artists, gallery owners, and art collectors. Here is a seeming paradox: the comparison of cereal brands is relatively cheap but standardized, while the comparison of art pieces is expensive but nonstandarized. One would assume that a more expensive and time-consuming search and comparison process would favor standardization, but this is not the case. This brings us to the second impediment to market efficiency: information asymmetry.
Information Asymmetry and Adverse Selection
In 1993–1994 in Vienna, I observed an extreme form of liquidity risk with respect to the Yugoslav dinar (in the midst of Yugoslavian civil war) and later the Russian ruble. Austrian retail banks sold these currencies at a fixed price, but did not buy them at any price. Similarly, during a brief, worldwide episode in 1998, some investment banks sold Russian bonds (at about 20% of the face value), but refused to take them back. In the second case, they simply chickened out, being scared of the media (which was not always materially uninvolved). The holders who enlarged their portfolios of long-term Russian bonds at the time received full payment of the face value and most of coupons—nearly a 500% profit (Lerner and Wu 2009).
The insights of Akerlof (1970, 2003) and Stiglitz (2002) (see also Varian 2009) provide a uniform explanation of a number of diverse phenomena. Akerlof uses the example of the used-car market: unaware of the reasons that sellers put their cars on the market, buyers suspect the worst. Sometimes, the discounts they require for their lack of trust in the buyers completely prevent the transaction and shut down the market. A host of related phenomena are classified under the term “adverse selection.” Think of it this way: the existing members of the Politburo of the Communist Party of China do not select new members who are smarter or more energetic than they are, for fear of being unseated by them. As a result of this practice, octogenarians and nonagenarians dominated the party by the end of the 1980s. Because of adverse selection, the cooptation principle for the formation of organizations is generally bad, unless the purpose of the organization is to prevent members from harming each other (as with medieval knighthood).
Research by Akerlof, Stiglitz, and others reveals that the reduction of information asymmetry results in more efficient markets. We can see their ideas at work in the calls for more transparency around securities transactions.
The healthcare industry in the US is a particularly pertinent illustration of information asymmetry. Because patients are generally much less informed than service providers about the availability and efficacy of treatment, and much more emotionally involved in the decision making, the rational pricing of healthcare services is highly problematic. Private insurance companies directly benefit from as much information asymmetry as possible because, in the end, this is their bottom line. The net result is that highly specialized care for the terminally ill is emphasized, relatively little is spent on preventive healthcare, and the healthcare of the young and uninsured is almost universally subsidized and cross-subsidized.
Moreover, information about healthcare outcomes is intrinsically ambiguous (it deals with average populations and not with the given patient), and there could also be the influence of the distinction between true uncertainty and ambiguity. The Ellsberg paradox asserts that human perception is markedly different between cases of covert but certain information and statistically uncertain outcomes. Loosely speaking, the whole phenomenon of plea bargaining relies on this behavioral paradox.
The distinction between stochastic uncertainty and ambiguity contradicts the existence of a (unique) risk-neutral measure, which is the foundation of most asset-pricing models (Epstein and Schneider 2008; see also Lerner 2013). It also excludes the possibility of rational healthcare pricing even if each patient could be educated up to the level of the most proficient doctors.
The practical result of information asymmetry and adverse selection is that some markets are intrinsically inefficient, and almost all markets require the public disclosure of certain information in order to function efficiently. The latter necessitates coercive authority, which in modern societies usually comes from the state, but this is not universal.
In medieval times, the source of this authority was often the Catholic Church, which administered oaths. As these oaths were also used to bind peace treaties, one can make one’s own judgment about their efficacy: medieval rulers did not take the security of their souls lightly, but they could be released from their oaths by high-ranking clerics on various pretexts.
In Part II, I will discuss the other limitations on the functioning of free markets: market externalities; the existence of public goods (bads), nonexclusivity of consumption, and Pigovian markets; and problems of collective action.
–Peter Lerner, MBA, PhD, is a semi-retired financial researcher who lives in Ithaca, NY.
Akerlof, George A. August 1970. “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism.” The Quarterly Journal of Economics 84, no. 3: 488–500.
November 14, 2003. “Writing the ‘The Market for “Lemons”’: A Personal and Interpretive Essay.” The Nobel Foundation.
Coase, Ronald H. November 1937. “The Nature of the Firm.” Economica 4, no. 16: 386-405.
December 9, 1991. “The Institutional Structure of Production.” Prize lecture given at the Nobel Prize Award Ceremony. Stockholm, Sweden: The Nobel Foundation.
Epstein, Larry G., and Martin Schneider. February 2008. “Ambiguity, Information Quality, and Asset Pricing.” The Journal of Finance 63, no. 1: 197–228.
Lerner, Peter. June 23, 2008. “Alternative View of the Current (2008) Crisis in the US Financial System.” Working paper.
September 21, 2011. “The Real Road to Serfdom.” The Finance Professional’s Post. The New York Society of Security Analysts.
2013. “Asset Pricing Theory in Light of Ellsberg Paradox.” The Journal of Behavioral Finance and Economics 3, no 2: 25–42.
Lerner, Peter, and Chunchi Wu. 2009. “Microstructure of the Bid-Ask Spreads of Russian Sovereign Bonds (1996–2000): Spreads as Indicators of Liquidity.” In Emerging Markets: Performance, Analysis and Innovation, edited by Greg N. Gregoriou, 555–576. Boca Raton, FL: CRC Press.
Pigou, Arthur Cecil. 1932. The Economics of Welfare, 4th ed. London: Macmillan. First published 1920.
Stiglitz, Joseph E. 2001. “Joseph E. Stiglitz—Biographical.” The Nobel Foundation.
Varian, Hal H. 2009. Intermediate Microeconomics: A Modern Approach, 8th ed. New York, NY: WW Norton.