Free Liberal

Coordinating towards higher values

Why You Should Stop Worrying and Learn to Love "Market Failures"

by , Doctoral student, American University Department of Economics

I hate the term “market failure.” It’s loaded and casts an unnecessarily dour shadow on markets, which have no agency or goals themselves and so cannot in any meaningful sense “fail” at anything.

Nevertheless, the reality that the term signifies – any number of departures from a perfectly calibrated and competitive market – is pervasive in the world. Anyone interested in how human society works should be fascinated by market failures and always on the lookout for them. A world without market failures is stale, mechanical, and uniform. That is not the world we live in.

The liberal tradition is diverse in its reaction to market failures. At the libertarian end of the spectrum you will find a lot of skepticism of market failures due to a suspicion that advocacy of some government intervention is lurking around the corner. This suspicion is, I think, a little too paranoid but it has a kernel of truth to it. Intelligent people on the left-liberal end of the liberal tradition do not want government intervention for the sake of government intervention, so they’ll often justify their policy views by invoking a market failure.

Market failures offer the prospect of constructive intervention, although they are of course no guarantee that intervention will be constructive.

I want to draw attention to the fact that economists who study market failures typically think about them in relatively apolitical ways, despite whatever political interest of libertarians or left-liberals is in play. Economists are interested in market failures because they help us understand how the world works. In many cases market failures actually help to explain why private actors would exhibit pro-social behavior that we might typically expect of a government. A good example of this is one of my research interests — the economics of apprenticeship training.

Apprenticeship is a common job training model in Central Europe, and it is increasingly popular in the United States. It provides general on-the-job occupational training (i.e., training that would be beneficial working for a wide variety of firms) while a worker is productively employed and earning a wage with a firm. A persistently interesting question around apprenticeship training is why it even exists and persists in the first place.

In 1964, Gary Becker pointed out that in a world free of market failures, firms would have no incentive to provide apprenticeship training because trainees could be poached by competitors immediately after receiving training. Becker’s work implied that if anyone had an interest in financing general training it would have to be public institutions (or workers themselves), not profit-seeking firms.

The problem with Becker’s approach to general training is that in the real world we do see employers paying for training and sharing the benefits of training with workers. Something must be wrong with Becker’s understanding of the competitive pressures facing firms. A variety of responses to Becker have been offered, all of which rely on market failures and market imperfections.

Katz and Ziderman proposed that the information asymmetry between employers and workers (a commonly cited market failure) gives firms an incentive to provide general training in order to learn more about the productivity of their own workers.

Acemoglu and Pischke point out that information asymmetry between an employer and their competitors will also generate an incentive to provide apprenticeships or other general training. They argue that this information asymmetry between firms reduces the wage that competitors are willing to pay to attract a poached worker. By dampening the competition for incumbent workers, the information asymmetry provides the employer with some latitude to make training investments without fear that her workers will be poached.

There is a wide literature that provides similar but slightly different market failure explanations for why we see firms financing apprenticeship programs, which we would not expect to see under perfect competition.

The key point is that in the literature on employer-based training, market failures are associated with firms and workers helping each other out, while perfect competition is associated with a situation in which only the government or some other outside actor can encourage a firm to act pro-socially. This result is not universal – sometimes market failures are pernicious – but it is nevertheless widespread.

My experience is that non-economists with some exposure to economics tend to see market failures in stark, political terms. Market failure goes hand in hand with interventionism, and “market failure economics” is therefore an ideologically tainted approach to the science. I submit the example of the economics of apprenticeship to encourage people not to think about market failure in this way. Market failures are deeply important to economics because they explain a lot of what goes on in the world, full stop.

Economics is always going to be relevant to policy, so market failure economics is inevitably going to be a component of the policy debate. As long as the underlying economics is sound, that’s a good thing. If the underlying economics isn’t sound then the solution is not to treat market failure like some kind of boogey-man, it’s to construct a better argument.

About

Daniel is a doctoral student in American University’s Department of Economics and a research associate at Urban Institute. His blog is Facts and Other Stubborn Things