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When Markets Fail: Part Two

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There are five main 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).

In Part I of this article, I discussed the first two reasons. Below I cover the remaining three.

Market Externalities

In January 2013, David Goldhill, president and CEO of the Game Show Network, published Catastrophic Care: How American Health Care Killed My Father—and How We Can Fix It. He soon appeared on Fareed Zakaria GPS on CNN and The Colbert Report on Comedy Central. My son, a mechanical engineer by education, watched the episode of Colbert with me. I was surprised when he shrugged his shoulders and asked, “Has this guy ever heard about market externalities? About public goods ?” I  asked him how he knew about such things. It turns out that he learned basic economics at Ithaca High School. (Ithaca High School produced an architect of the American “victory” in Iraq, Paul Wolfowitz.)

Market externalities are probably the most intuitive violations of perfect market equilibrium. They come in several forms, but many are related to barriers that make switching or substituting a product or a service too costly or time consuming or otherwise impractical.

In the late nineteenth and early twentieth centuries, trusts monopolized particular railway routes in the US and could extract all monetary surpluses from manufacturers who needed the railroads to transport their goods or receive raw materials. Only through action by Congress and presidents Theodore Roosevelt and Woodrow Wilson could the trusts’ grip on the US economy be weakened.

A modern example of a monopoly is Microsoft Office, which I am using to write this article. I use it not because it is cost competitive (OpenOffice is free), user friendly, or attractive in other ways, but because everyone else uses it. It is expensive, its various applications are circuitously bundled, and Microsoft’s customer service is (mostly) a horror. Since I need Office to make presentations, communicate with students, and collaborate with colleagues, any time and resources spent on learning and applying alternatives would be a pure waste. Thus, market externalities frequently result in monopolistic usurpation of entire markets.

Warren Buffett once said that his friend (and poker pal) Bill Gates convinced him that Microsoft is not an illegal monopoly. Indeed, in most other industries, an entity that distributes faulty products and then extorts payments to fix the damage done by these products would be called not an “illegal monopoly” but rather a “criminal racket.” This is how pervasive the squeezing of market competition by market externalities can be.  

Another important source of externalities is the unpaid use of public resources for private gain. If a meatpacking business dumped waste into a nearby creek—a practice that was typical in the not-so-distant past—most people would consider this to be criminal behavior; in contrast, coal-fired utilities that pollute air and water on a much larger scale, and thus provide cheap electricity, have many supporters. Obviously, there is a behavioral benefit in harming many people a little rather than a few people a lot. Here we turn to the next problem: public goods (bads).

Public Goods (Bads)

Right-wing bloggers frequently compare the requirement to have health insurance to a requirement to have a car, citing a supposed similarity between government-subsidized healthcare and government-subsidized cars. Before I argue that this reasoning is not a bad example of the difference between public and private goods, I want to mention the factual incorrectness of it.

In fact, the government provides many of its employees (e.g., the postal service) with cars, and some with expensive armored vehicles and even combat aircraft that cost hundreds of millions of dollars. I would remind people who object to this analogy that in medieval times, knights supplied their own weapons and armor, but their militias proved no match for the armies that were raised by the nation-states and paid for by taxpayers. The origin of European feudalism was intimately related to the need to support armored cavalry in the practical absence of state taxation (see Lerner 2011).

Typically, the economic notion of “public good” refers to a situation in which it is difficult to exclude a citizen from consuming goods or services (e.g., air defense) or to estimate a particular benefit for these goods or services. For instance, a new highway benefits the owner of a nearby diner even if he or she does not use the highway often.

The acquisition of a Lamborghini by someone in New York does not benefit me at all and negatively influences air quality for everyone. In contrast, I directly benefit not only from my neighbor’s flu shots, but also from immunizations in other countries, since they slow the progress of epidemics and lower health premiums. That’s why it makes economic sense to subsidize preventive medicine but not personal cars. Apart from the fight against infections and epidemics, collective benefits accrue from prenatal care, regular health exams, and catastrophic coverage, to name a few items.

Public goods often entail the problem of nonexclusivity of consumption, or “freeloaders.” Most current vaccines are pretty safe, but it was not always that way. People who did not want to risk adverse effects from immunization could forego their shots with relatively little penalty (chance of contagion), as long as most of their neighbors got vaccinated. However, if everyone decided to abandon immunization in the hope that others made the opposite decision, the purpose of an immunization campaign would be easily defeated (see the section on “Problems of Collective Action” below).  

In theory, a government could issue multiple bills for things like air and space defense, international aid, and school lunches instead of requiring a consolidated tax payment. This could be made no more complicated than an average phone bill. However, punishing nonpayers would be a problem: a utility customer could be denied service, but it is not clear how a recalcitrant nonpayer into NORAD, NOAA, or NASA could be effectively penalized.

The question of public goods has been well analyzed within the discipline of public economics. The problem of public “bads”—activities that reduce the aggregate well-being—has not been examined as thoroughly; the markets for bads have been even less well studied. Some of the markets are well known—e.g., trafficking in narcotics, arms, and human beings—but probably the largest of all is the market for political patronage. As long as organized governments have existed, there have been people willing to convert their positions of power and influence into wealth, and people willing to pay for favorable political decisions and publicity.

I call these markets “Pigovian” in honor of Arthur Cecil Pigou, a British economist who proposed “sin taxes” to control the negative consequences of human activity. While their existence is an inevitable consequence of the human condition, successes in past decades to limit smoking and alcohol consumption suggest that there is significant room for improvement.

Digression: Cost of Regulation

Of course, market regulation does not come for free. Therefore, regulatory efforts must always be assessed against potential benefits. However, pricing regulatory costs can be a non-trivial mathematical problem (see Lerner 2010 for a simple exercise). One of the bigger problems is that regulatory benefits may come as an opportunity cost of avoiding a disastrous failure.

The more relevant issue for the financial community is the effect of regulation on stock returns. A study by Harrison Hong and Leonard Kostovetsky (2010) confirms a very intuitive fact: companies in red states spend less on socially responsible causes than do companies in blue states. Of course, there are outliers such as Utah, which has a history of environmental consciousness and social cohesion. However, as expected, a higher level of social responsibility comes at the price of reduced stock returns. According to the law of diminishing returns, companies are likely first to mitigate the less costly sources of environmental pollution, and only later address the more costly and difficult cases.

Yet, if we take market efficiency seriously, it is not necessarily the case that reduced returns cannot be mitigated on the portfolio level. If consumers require environmentally conscious investing, portfolio managers could, for instance, consider the companies that have realized easy pickings in environmental cleanup as benchmarks. This would be similar to considering seasoned mortgages as benchmarks in real estate investment.

Problems of Collective Action

The term “arms race” for collective-action phenomena came from attempts in the 1960s to model the Cold War along the lines of the prisoner’s dilemma and other concepts in game theory (Brito and Intriligator 1995). Yet, arms races predate humanity in evolutionary terms (see Frank 2011). For instance, the gigantic antlers of male ungulates demonstrate virility and foster the romantic success of individuals. This phenomenon is neatly explained by the game-theoretic notion of “costly signaling”: animals that can afford practical encumbrances and still survive are preferable mates. If the encumbrances were not real and did not involve costs in the forms of extra nutrition and extra strength, imitators—e.g., birds with more attractive plumage and deer with larger antlers—could easily be found among weaker competitors, and the evolutionary significance of these encumbrances would vanish. Yet, in terms of the whole species, arms races among competing males reduce foraging opportunities and prevent escape from predators.

Collective-action phenomena are not restricted to evolution. When movie theaters had flat floors, a person could see the screen better if he or she stood up. Yet, if everybody stood up, seeing the screen would be at least as difficult, and there would be a “free” unwanted effect: standing through an entire movie is much less comfortable than sitting. We see this principle at work in periods of hyperinflation—e.g., the hyperinflation that existed in South American countries in the 1970s and 1980s. Because changing all prices in a store takes time, during hyperinflation it makes sense to visit multiple stores in search of bargains. Moreover, some time into hyperinflation, this practice becomes unavoidable if one is to survive. It also makes sense to obtain bargains for neighbors and barter with them for their catch.

Yet this behavior does not benefit consumers as a group and causes further economic decline, as the time that would have been used for work or leisure is spent in futile shopping expeditions and barter transactions. As the joke of the time went, “Why is it better to travel by taxi than by bus? Because in a bus one pays on entry, and in a taxi on exit.”

Problems of collective action frequently manifest themselves in “races to the bottom.” In the current economic situation, many US states cut taxes and reduce protections for workers in the hope of attracting more business to the state. Obviously, these actions do not come for free: they lead to reduced government services (i.e., employment), worsening infrastructure, and diminished buying power of state workers. Yet, in the view of state legislators, a better business climate might compensate for these negatives.

However, if neighboring states commit to the same policies, the advantages of low taxes and reduced job security can quickly disappear, leaving the initiator of these policies in a worse shape than before these measures were adopted. Furthermore, in a globalized economy, states compete not only among each other but also with other countries. Can the states compete (and do they really want to compete?) with Indonesian infrastructure or Cambodian salaries?

Collective-action phenomena do not contradict classical economics, but fit poorly into it. Indeed, classical economics deals mostly with small fluctuations around stable equilibrium points. When a change in a problem’s parameters destabilizes the equilibrium, it is usually assumed that the economic system can find another stable equilibrium. The idea that common action can lead to a persistent state of maximum inconvenience is inimical to classical economics.

There is no coherent mathematical description of collective-action phenomena in quantitative finance. One is needed if we are to successfully model market crashes, underpricing and underperformance of IPOs (much theoretical and empirical work on this subject has been done with little certainty), and alternative investments. I predict points of growth in the development of this mathematical description.

–Peter Lerner, MBA, PhD, (@PeterLerner18) is a semi-retired financial researcher who lives in Ithaca, NY.


Brito, Dagobert L., and Michael D. Intriligator. 2005. “Arms Races and Proliferation.” In Handbook of Defense Economics, vol. 1, edited by Keith Hartley and Todd Sandler, 109–164. Amsterdam, The Netherlands: North-Holland.

Frank, Robert H. 2011. The Darwin Economy: Liberty, Competition, and the Common Good.  Princeton, NJ: Princeton University Press.

Goldhill, David. 2013. Catastrophic Care: How American Health Care Killed My Father—and How We Can Fix It. New York: Alfred A. Knopf.

———. February 20, 2013. Interview by Stephen Colbert. The Colbert Report. Comedy Central.

———. April 13, 2013. Interview by Fareed Zakaria. Fareed Zakaria GPS. CNN.

Hong, Harrison G., and Leonard Kostovetsky. 2010. “Red and Blue Investing: Values and Finance.” Simon School Working Paper no. FR 09-06. papers.ssrn.com/sol3/papers.cfm?abstract_id=1214382

Lerner, Peter. 2010. “Attempts at Pricing the Regulatory Commodity: EU Emission Credits.” Environmental Economics 1, issue 1: 144–156.  

Lerner, Peter. September 21, 2011. “The Real Road to Serfdom.The Finance Professional’s Post. The New York Society of Security Analysts. 


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