Market Failure and the Market Process

Market failure, which I am defining here as a market not reaching the equilibrium condition where quantity supplied equals quantity demanded, is ubiquitous. 

Every time we walk into stores, we see market failure happening: shelves and shelves of goods sit, waiting for buyers. This is excess supply (surplus), a market failure. If the market were in equilibrium and perfectly clearing, then when you (the marginal consumer) walk into a store, you should see only the good(s) in the precise quantity you want to buy at the price that precisely equals your willingness to pay for the marginal unit. Nothing else should remain. You’d make your purchase and then the store would close up shop, having sold everything it was willing to sell at a price determined by the interactions between buyers and sellers. Obviously, such an outcome does not exist. Some of the goods we want exist in surplus. Some exist in shortage. And, consequently, the market has failed.

But this failure is vital to the workings of the market, broadly called the “market process.” As Hayek reminds us in his famous article, “The Use of Knowledge in Society,” the elements needed for a market to perfectly clear (complete knowledge of preferences, complete knowledge of available resources, complete knowledge of relevant information) are not known ahead of time. If they were known, goods could simply be allocated; the market becomes a trivial optimization problem. Rather, they are revealed through the workings of the market itself.

There are two ways to conceptualize how the market process forms prices and transmits this relevant knowledge. The first, as developed by Leon Walras, is to treat the economy as a giant auction (what he called “tâonnement,” or “trial and error”). People make bids, and those bids are accepted or rejected by sellers. Where there is excess demand, the price gets bid up. Where there is excess surplus, the price falls until the market reaches equilibrium. 

There is some truth to the Walrasian auction story, but it falls short of explaining reality. Some markets do have an auction process and the price rises/falls until the market clears. Even if we treat the Walrasian auction as a metaphor rather than expecting literal auctions, it falls short. In the metaphorical sense, we have something of a silent auction. A buyer walks into a store and sees the price. It is above what they are willing to pay for the good, so they walk away. That is an “offer” by the seller that is rejected by the buyer. The seller then adjusts their offer until it matches the bid.  The goods are then sold at those prices. But, as I note above, that is not the case for the vast majority of markets. We have perpetual shortages/surpluses.

The second way of thinking about how prices emerge and adjust is through the thought of John Hicks. Rather than being set by people coming together to bid on goods, Hicks argues that prices are fixed (at least in the short run). When the store owner opens the door each day, he has prices that are set. People come in. Some buy at that price, some do not. And, at the end of the day, he closes shop with some inventory unsold, and some in shortage. But changing prices is a costly process, especially at big stores. Shelf tags need to be changed, electronic price checkers need to be updated, and so on. Furthermore, buyers face real constraints as well: fixed wages being the biggest. Given the costly adjustment process and stickiness of consumer behavior, the store owner can more easily adjust the quantity they supply, rather than their price. He must consult inventories, actual spending trends, etc., when making changes. Consequently, the market can be in a perpetual state of surplus and shortage.

There are other reasons for the market to be perpetually in disequilibrium, of course. Given how difficult it is to make predictions, it’d make sense for a firm to want to keep excess inventory on hand. It can help smooth out the consumption cycle and avoid the bullwhip effect where small changes in consumer behavior leads to larger and amplifying changes in inventory management. Further, consumers tend to punish firms more for shortages than surpluses, so holding excess inventory can be a way to avoid consumer ire.

Regardless, the key takeaway here is that market failure is ubiquitous. But, what’s more, it is necessary for the function of the market. When the shopkeep ends the day with excess inventory over and above what he wants to hold, that sends a vital signal to him: your price is too high. If you cannot adjust the price, find something else to adjust. When the customer goes to the shop and sees a price above what they are willing to pay, that sends a vital signal to him: your expectations are out of whack. Find a substitute or reevaluate your desire. These signals only come about when the market has failed.

But let us now look at a more strict definition of market failure. The stricter definition of market failure is not just when the market is in disequilibrium, but that there are barriers preventing it from ever reaching an equilibrium where goods are allocated to their highest and best use. Elements like externalities, high barriers to entry, collective coordination problems, high transaction costs, etc., can prevent the market from reaching an optimal level of price and quantity. It is under these conditions where interventionists will often argue for government interventions to solve market failure. But even under these conditions, the market failure itself is vital to the success of the market process.

A market failure can also be called a profit opportunity. There are unconsummated trades and whoever can consummate those trades stand to gain. Whoever can break down barriers or provide a better substitute can profit. In other words, the market failure creates the very incentive needed to fix it. Clever entrepreneurs find ways to overcome these barriers, solve market failures, and profit. Government intervention is likely not needed.

Does this imply there is no role for the government in market failures? I do not think so, no. But it does suggest limitations for the government. Rather than being an active player, governments can be more of a referee. If there are artificial barriers that cause a market to fail, the most helpful thing to do would be to remove those barriers. Or create solutions that allow for private markets to arise (e.g., changing rules to allow for class-action suits in externality cases). Governments are just like other economic actors. They are limited by constraints and have limited knowledge. There is no reason to think a government could intervene in a market better than the actual participants. For market failure purposes, the best thing a government can do is remove artificial barriers and stay out of the way.

All this is a long way of saying that market failure is something of a misnomer (yes, another one). The market hasn’t failed in the sense it is not working. Rather, it is behaving exactly as it needs to in order to generate the requisite knowledge. It is better to conceptualize market failure as a “failure state,” where some goal wasn’t achieved. In this case, it is more akin to failing an exam in a class. Yes, the exam had a “failure state,” in that the goal (passing it) wasn’t achieved. But necessarily information was acquired: these are my strengths, these are my weaknesses, and this is how I can improve. And that information (to the conscientious student) is how one gets better. Likewise, the market failure creates information on how the market can, too, improve. 

The market has failed; long live the market!