Understanding Market Failure: Do We Need More or Less Regulation?
ERIC MOLINO
Professor of Microeconomics
Quality Leadership University
Is water a solid, a liquid or a gas? I usually start my
semester with this apparently evident question.
Half of my students are confused thinking they
enrolled in the wrong class, and the other half is
suspicious as to why I am asking such a simple
question. Eventually someone will just look at me
and say: “it is a liquid (obviously)”. Nevertheless, if
I wait long enough, someone will give me the
answer I’m looking for: “well, it depends.” Exactly,
water can be a liquid, but only at 1 atmosphere of
pressure and between 0 and 100 degrees Celsius.
Changing either its pressure or its temperature
would make water become either ice or steam.
This very simple question, although seemingly
unrelated to economic theory, has profound
implications in policy making. You see, it is key for
economic analysis to understand that nothing is
an absolute in practice, and that everything
depends on the premises we use to frame our
questions. In this article we will briefly review
how understanding which factors cause market
failure will help us determine the appropriate
policy response and why more regulation or less
regulation are not panaceas.
First, we need to define what we mean by market
failure. In microeconomic theory, market failure
occurs under any deviation from a perfectly competitive
market. This unpretentious premise is not trivial.
Perfectly competitive markets have some desirable
characteristics for consumers: 1) firms are price
takers and they are unable to affect price as
demand is perfectly elastic; 2) firms can enter and
exit the market easily without high transaction
costs enabling constant innovation and inefficient
firms to drop out; and 3) lastly, there is no deadweight
loss to society and welfare is Pareto Efficient.
In order to have such outcome, the market should
possess the following characteristics: rational
agents, enough buyers, enough sellers and none
with the capacity to influence price, low entry and
exit barriers, low transaction costs, product
homogeneity, and no information asymmetry. It
is imperative to understand that if any of these
premises do not hold, market failure exists. If, for
instance, products are not homogeneous or they
are difficult to compare, each firm can behave as
a monopolist, become price seekers and set price
at their profit maximizing output and not the
Pareto Efficient quantity, there would be market
failure. Consequently, one might ponder: should
something be done about this? Would government
intervention achieve market efficiency?
Jeffrey Sachs, who has done extensive research on
economic development and poverty, suggests
that economists should be more like doctors.
Consider for a moment, how a doctor evaluates a
patient. A responsible doctor would ask a patient
questions such as: what are his/her symptoms?
Has he/she changed his/her diet recently? Does
he/she have any allergies or history of illness in
his/her family? What the doctor is trying to do
with these questions is to determine what is the
most appropriate treatment for the patient.
Prescribing acetaminophen would certainly help
alleviate a headache, yet it is dangerous for people
with liver disease. Thus, not asking all the necessary questions can be potentially fatal to the
patient. Hence, even though a policy maker could
have the best of intentions, prescribing the incorrect
policy or an unnecessary intervention could
potentially exacerbate the market failure or create
new ones. That is, it would be unfitting and irresponsible
to determine if more regulation (or deregulation)
is the right move without considering the temperature
and pressure of water.
¹ Deadweight loss refers to the welfare that is lost either by the consumer
or the producer because prices do not allocate products and services
efficiently.
² Pareto Efficiency refers to the principle of achieving a market price and
quantity that maximizes producer and consumer surplus.
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