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.

10 thoughts on “Market Failure and Income Distribution: Notes for Economics in Two Lessons

  1. No request for praise, for what is to me one of the better sections, clear and concise.
    The last paragraph leaves out growth, which dominates allocative efficiency in the medium and long term. The theory of growth is less well febeloped

  2. ..(sod smartphones) than that of efficiency. This has left the door open to specious claims like Laffer’s. As we discussed earlier, monopolies are rarely innovative, and the search for rents distracts managers and investors from that for growth-creating opportunities.

    Aside on the opening paragraph. Some potential markets face ethical barriers, notably people, non-regenerating body parts and sex. A few ideologues are reject these barriers, but the general view is against them. You can’t analyse these non- markets in efficiency terms much. There is a serious allocstive problem for the short supply of donated organs, solved top-down by doctors using s calculus of need.

  3. I found this somewhat unconventional approach to time-worn issues complicated. Firms want market power and don’t want to pay for some of their costs. Yep. Public goods are often provided at above marginal cost to recover the costs of their provision. Privatizing assets if done foolishly can deliver private gains. Yes and all this can be interpreted in distributional terms.

    What is your core point?

  4. A characteristically clear and accessible explanation of the problem John. From an economists view politics – including the Marxist’s beloved class struggle – is mostly about the endless search by all interested parties to create or appropriate economic rents.

    The only suggestion I’d make is to change this:

    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

    to simply this:

    Market failures arise either when market prices don’t reflect social opportunity costs

    Then you needn’t have to argue with the Tyler Cowens of this world about what a market is and its role in human relations – bucketing Becker might be fun but is a bit beside the point. And in fact all your subsequent discussion focuses on mispricing rather than the corner solution of no trade.

  5. Since I have spent a lot of time looking at R&D tax incentive program, my attention quickly falls into that groove as soon as I hear about market failure. I am just wondering, because it is common sense that in R&D area a lot of free lunches (knowledge spillovers) are from large firms to smaller firms. Empirical evidence also supports that small firms tend to be on the receiving end of spillovers. So the equity story goes the other way in this case.

  6. @Sam B

    Studies? Evidence? You might be right but without good evidence one cannot accept this hypothesis just because it sounds plausible. There is the (alleged) issue that big firms stop being innovative and stop doing ground breaking R&D. Is this true? I don’t know. If they tended to fall off on R&D then who is doing the bulk of the cutting-edge R&D? Government and mid-sized enterprises maybe? Again, I don’t know.

    Are big enterprises doing real ground-breaking R&D or just tick-and-flick, doctored, window-dressing exercises that qualify for R&D tax incentives without being real, cutting edge R&D? Again, I don’t know. I just pose the questions.

  7. I see a great analasys but no proposed solutions, which i guess would be posted in the next part.

    I argue that high marginal tax of 90% is a crucial way that would curb all those market failures and also improve income distribution. Curb is operative word here, not remove it or correct it fully.

    Previously i explained few times how high marginal taxes remove incentives for search for excessive gains. Almost al of those market failures come from searching for massive incomes. Some of it comes from reaching for fame and some for survival of some firms. But majority of described market failures is incentivised trough pursuit for huge incomes.

    With capital gains and bonuses treated as regular income and taxed at 90% all this pursuit for massive incomes by owners and managers would be removed from the system.
    It wasn’t for nothing that the largest increase in human prosperity happened under 90% MTR and that increased wages caused inflation and stagflation under HMTR. It wasn’t for nothing that drop in HMTR was followed by wage increase decopuling from productivity increase.
    First JFK reduced HMTR from 91% to 75% in 1963. Decoupling of wages from productivity started around 1967. Owners and managers already felt the ability to raise their incomes taking it from workers.

    90% tax or HMTR works in removing incentives for managers and owners to give themselves everlager parts of profits, thus leaving it more for wages and investments. Outragous incomes of managers moves firms to operate under credits instead of their earnings leaving them vulnerable in crisis. Bankers bonuses showed how looting their own firms bankrupted those firms due to leverage/doing operating expenses on debt.

    90% MTR is not crucial for public finances but for curbing incentives for looting their own firms and other employees by managers and owners.
    Would bankers go for toxic assets if there was no monetary reward for it?
    Would managers go for reducing workers wages (in real terms) if they would not benefit from it?
    Would managers switch to temp workers if they would get no more bonuses?

    But most importantly, would there be so much money in political campaigns and media available for bribes if there was HMTR?

  8. @Sam B
    What is bad about it? Is the purpose of R&D only for large firms or should R&D be used to help all of the society? Should it not be available to all if it is funded by all (government spending)?

  9. JQ, in a sense I admire your frontal attack on “Economics in One Lesson” in “Economics in Two Lessons” by using the notion of ‘opportunity cost’, about which the proponents of Economics in One Lesson should know – eg Friedrich von Wieser.

    In another sense, Economics in Two Lessons may be seen as perpetuating the flawed methodology of extrapolating from an agent’s (micro) reasoning to ‘the economy’ (ie the system). Please correct me if I am wrong in asserting that:

    a) In the incomplete market case the notion of opportunity cost is no longer defined even for 1 non-marketable thing of interest to humans unless there is only 1 individual in ‘the economy’.

    b) The notion of ‘social opportunity cost’ is again well defined if and only if there is unanimous agreement in an economy with many agents on what this cost is or the economy has only 1 agent.

    c) With reference to derrider derider at #4 above, the approach encourages to edit out any new theoretical knowledge gained since around 1900.

    Still, perhaps your Economics in Two Lessons is the way to go to have an impact on these anachronistic teachers and practitioners of economics. Only time will tell.

  10. Based on my observations of my partners job as an editor, books are past it. This needs to be subscription based reference site that you can update as you see fit.

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