Market Failure and Income Distribution: Notes for Economics in Two Lessons
For quite a while now, I’ve been working through my book-in-progress, Economics in Two Lessons (partial draft here), focusing on applications of Lesson 2
Lesson 2: Market prices don’t reflect all the opportunity costs we face as a society.
Thinking about the standard market failures (monopoly, externality and so on), I’ve come to the conclusion that I need to say more about the interaction between market failure and income distribution. I’ve already looked at the opportunity costs involved in income redistribution and predistribution, but different kinds of questions are coming up in relation to issues like monopoly, privatisation and for-profit provision of public services.
The discussion here and at Crooked Timber has been very helpful in stimulating my thoughts, but I need to do a lot more clarification. Some preliminary thoughts are over the fold: comments and criticism much appreciated.
Market failures arise either when market prices don’t reflect social opportunity costs or when markets for some good or service don’t exist at all, so that some other method of allocation must be used (examples include household self-sufficiency, gift exchange and public provision). It might be thought that the problems are more severe in the case of non-existent markets. Indeed some followers of Lesson 1 see the expansion of market transactions as a universal solution to social problems (the blog Marginal Revolution runs a series of posts under the Heading ‘Markets in Everything‘, which now runs to over 1300 entries).
In reality, however, markets with the ‘wrong’ prices (those not equal to social opportunity cost) are often worse than no markets at all. The core problem is that a divergence between prices and opportunity costs creates a potential ‘free lunch’, that is, an opportunity to make profits without any net contribution to the production of useful goods and services.
Free lunches are beneficial for those who get to eat them. Precisely for this reason, strenuous efforts are made to secure free lunches by generating divergences between prices and opportunity costs. Among the ways of doing this, which will be discussed in this section
* Securing monopoly control of unregulated markets
* In regulated monopolies, obtaining a rate of return higher than the opportunity cost of the capital invested
* Avoiding the costs of waste disposal by engaging in unregulated pollution
* Providing publicly funded services at a price greater than the cost of provision
* Obtaining ownership of public assets through privatisation, at a price below the value of the asset
All of these free lunches are available only to owners of capital and all (with the exception of unregulated pollution) have become more readily available over the last few decades. Conversely, the forms of redistribution (taxes and transfers) and predistribution (unions and minimum wages) that benefit workers have declined in significance. This is both the cause and the result of the growing inequality of wealth and power that has become glaringly obvious in the last decade.
The costs of market failures aren’t confined to problems with the distribution of income. First, the search for ‘free lunches’ is costly. Firms may incur high costs keeping competitors out of their markets, or lobbying politicians to keep pollution laws lax, or in regulatory litigation aimed at keeping rates of return high. These activities are profitable enough, for the firms concerned, to justify the expenditure of many billions of dollars every year.
Finally, when prices don’t reflect social opportunity costs, productive resources are used in ways that don’t yield a social benefit equal to their costs. Consumer choices are similarly distorted. The resulting allocation of resources is, in the standard terminology of economics, ‘inefficient’. I’ve argued earlier that this term is misleading, but whatever term is used, the presence of market failures means that the resources available to society aren’t being used in the way that would yield the greatest benefits, for any given distribution of income.
It follows that policy adjustments that can reduce allocative inefficiency have the potential to improve the wellbeing of society. Economists have devoted a lot of attention to these potential gains, while often neglecting the bigger issues of income distribution (or ‘equity’). In what follows, I will look at both equity and efficiency.