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ANATOMY OF MARKET FAILURE
URL: http://www.spatialgovernance.com/economics/611lec04.htm
© John S. Cook - Created on 6 July 2004
Last modified
05/04/11 11:01
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1. PARETO CRITERION AND OPTIMA |
Introduction
Generally, modern markets put a price on commodities. In so far as this is a measure of
'willingness to pay', the price mechanism has enormous practical
consequences in economic activity. However, although price quantifies 'willingness to pay', this notion needs to be differentiated from 'ability to pay'.
Markets are said to 'succeed' when they are seen as allocating resources
to their best uses. Analysing the conditions where markets are seen as
successful helps in understanding how markets can fail to achieve a satisfactory
resource allocation.
The Pareto Criterion
When two people trade to mutual advantage without adverse effects on any
third party, the economic well-being (or welfare) of the parties is said
to improve. In essence, this is the Pareto Criterion for welfare
improvement. This Criterion is not a testable proposition in a
scientific sense. It is essentially tautological in character in that it helps to explain
what is actually meant by 'welfare improvement' or an increase in
'allocative efficiency'. However,
the Criterion depends on further qualifications, principally:
 | An individual who is a party to a trading
transaction is deemed to be the best judge of his or her own welfare |
| A party to a trading transaction does so freely and
is not subjected to undue physical, moral, economic or other form of
coercion in deciding on the terms of a contract for the exchange of
goods or services. |
Pareto Optima
A Pareto Optimum is said to occur when people exhaust their
opportunities for trading to mutual advantage. In these circumstances,
people obtain as much satisfaction as can be obtained from trading as
free individuals. Moreover, since satisfactions in markets find
expression in terms of 'willingness to pay', it follows that commodities
achieve their 'highest and best use' as reflected in market valuations. |
Pareto Optima Issues
While the idea of an 'optimum' in human satisfactions
is attractive, it is also subject to significant qualifications:
| The 'optimum' arrived at depends on an initial
distribution of wealth. in other words, a different initial
distribution of wealth might lead to a different 'optimum' |
| Both the initial distribution and the 'optimum'
arrived at may be distinctly inequitable |
| Parties trade in accordance with the laws regarding
property, contract and liability; and changes to this legal regime can
influence the kinds of agreement that people are willing or able to negotiate |
The Pareto Optimum follows an algorithm where
increasing the volume of trade to mutual advantage allows ascendancy to
a peak of human satisfaction. This is like a walker who seeks to ascend
to higher ground by taking steps upward and eventually reaches a
position where there is no immediate higher ground. However, just as the
walker may look around from one peak and see higher ground on another
peak, it is also conceivable that a new optimum might be found from a
new starting point. Thus, it makes sense to think of a family of
potential Pareto Optima rather than a single Optimum.
Summary
Generalising on aspects of human economic behaviour often becomes
simplistic and misleading. However, simple ideas can become attractive
in popular discussion that engages the public in the rationale for
changes to public policy. Yet engaging the public is necessary if
government is to be democratic. The reality is much more complex; and
simple questions regarding the efficacy of markets require numerous
qualifications if answers are to approximate the truth. |
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2. THE ROLE OF INFORMATION AND
KNOWLEDGE IN CONSUMER CHOICE |
Knowledge Assumptions and
the Pareto Criterion
The Pareto Criterion rests on an assumption that people are the best
judges of their own welfare. However, this assumption is questionable in
a number of circumstances, as in cases of:
| children - where the law specifically acknowledges
diminished responsibility for personal actions |
| people displaying obsessive or addictive behaviours
- alcohol or drug dependence and gambling, for example |
| people with diminished mental faculties |
| people seeking professional or technical advice as
a discrete service or as part of a larger purchase |
| decisions that may occur under various degrees of
uncertainty and involve considerable risk |
Caveat Emptor
In markets where it is reasonable to expect buyers to be well acquainted
with the consequences of a purchase, an ancient Roman principle of
caveat emptor - let the buyer beware - is an appropriate social
policy. Thus, the law requires people to be responsible in circumstances
where that is a reasonable thing to expect.
Caveat Venditor
In some markets, sellers have a superior knowledge of what is involved
in a transaction. Where there is a substantial information asymmetry
that gives the vendor superior knowledge, the common law usually
requires doubts in relation to a contract to be resolved in favour of
the purchaser. In seeking professional or technical advice, a purchaser
implicitly acknowledges |
Producer Warranties,
Indemnities and Disclaimers
Some producers provide warranties that set out the terms under which
they will hold themselves liable for defects in product or services.
Disclaimers set out things for which producers will not accept
responsibility. These statements can influence the contracts in which
that consumers and consumers are prepared to engage. However, on some
aspects of trading, the law requires that producers accept liability and
attempts to circumvent these requirements through warranties and
disclaimers may be
Australian Trade Practice Legislation
Both Commonwealth and State Governments have legislation governing trade
practices. The
Trade
Practices Act 1974 (Cwlth) contains a number of provisions
directly related to maintaining integrity in information processes;
especially false or misleading representation (at
s.53) and unconscionable conduct (at
s.51AB). The Australian Competition and Consumer Commission (ACCC)
is responsible for many aspects of the administration of the Trade
Practices Act.
Fair Trade in Queensland
The Queensland Government has legislative powers regarding the conduct
of business in Queensland.
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3. INSURANCE |
Insurance in Managing Risk
Risk arises out of uncertainty. Thus, people may be fairly certain that
accidents will occur but quite uncertain as to which individuals will
become victims and when these events might occur. Insurance is a special
form of contract that involves a spreading of a specific risk between
policy holders. The contract involves payment of a premium by the
insured and payment by the insurer in the event that the specified risk
actually occurs.Integrity in Information
Processes
Insurance depends on the honesty of both the insurer and the insured in
insurance contracts. This dependency finds expression in terms such as
'utmost good faith' and 'uberima fides' in how the contracting
parties should behave. Insurance is subject to two corrupting influences
in particular that are referred to as 'adverse selection' and 'moral
hazard'. |
Adverse Selection
People might be inclined to seek insurance if they perceive premiums to
be low and to avoid insurance if they perceive premiums to be too high.
An important aspect of insurance is the capacity of an insurer to set a
premium that is commensurate with the risk involved. |
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4. THE ROLE OF MARKET POWER |
Market Power and Capacity for Economic
Coercion
Market power involves situations where one party is able to assume a
dominant position in the striking of a bargain. Usually this involves
some degree of economic coercion where one person has a degree of
monopoly control over a commodity for which another person has a
particular need and no readily available alternative. Strictly speaking,
'monopoly' refers to a market condition where there is a single seller -
and monopsony refers to a situation where there is a single buyer.
However, a situation of absolute monopoly may be rare. More usually, the
monopoly may exist within a localised area and alternatives may be
available though at some distance and with some economic penalty in
attempting to access them.Instances of monopoly
occur where there is a single supplier of a good or service in an area.
Some degree of monopoly might exist also . Examples of monopsony might
occur if there is a single mill in an area to
Where there are many producers and consumers of a
commodity, a person who does not receive satisfaction in one place can
readily find alternatives in other places. However, when producers or
consumers of a particular product are few in number, and there are no
close substitutes in trying to negotiate supplies or sales, the effects
of market power become more evident.
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5. EQUITY CONSIDERATIONS |
Discrimination and Differentiation
A capacity for differentiation is a function of the observing
power of an individual. A person is able to to see a difference between one circumstance and
another. This observing power can have positive effects in assessing the
suitability of using some person or thing for a particular task.
However, it can also have negative effects in discriminating unfairly on the basis of a
difference that ought to have no real bearing on the outcome. Typically,
the kind of distinctions that may or may not deserve differential
treatment include where a person lives, whether a person is male or
female, a person's ethnic origins, religious persuasion or age.
In dealing with public policy issues, some forms of equity
considerations become particularly important, as in:
| spatial equity - where people are not made to
suffer unduly from a lack of essential services on account of where
they happen to live - a matter of some importance in remote parts of
Australia |
| racial non-discrimination - |
| anti-discrimination law - |
| inter-generational equity - involving a sustainable
use of resources that do not diminish the capacity for future
generations to survive |
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