BrianH got me thinking about Libertarians yesterday. While I was thinking of interesting ways to belittle libertarian economics, I remembered a very cool idea that emerged a few years ago from this school of thought: dominant assurance contracts.
Many Libertarian economists are very bothered by market failures — they simply don't want to believe that there can be such a thing. Others, like Alexander Tabarrok, take a more constructive approach and look for ways to address market failures without government intervention and without coersion of any kind.
Assurance contracts are a mechanism for private provision of public goods. A private escrow agent collects donations for a public project. If enough people donate then the project goes ahead, otherwise the money is returned to the contributors. This could actually work for goods that are excludable. You might be able to get a private road built this way, for example, since you can use trespassing laws to keep non-contributors from free-riding once the project is complete.
Dominant assurance contracts are a way to provide public goods that are not excludable. The escrow agent (or entrepeneur) agrees to pay the contributors a reward if the project doesn't proceed. If the project does proceed, then the entrepeneur takes a cut as compensation for the risk he took. Tabarrok shows in his paper that this changes the equilibrium of the game. Somebody who values the good will always win by contributing, and no longer has an incentive to free-ride.
For large scale projects a financial market could be established. The Iraq war, for example, might have two financial instruments, one for those who want a share in the entrepeneur's potential profit, and another for those who would gain utility from regime change in Iraq.
I don't know if this idea would really work in practice, but it's a neat idea and I hope somebody tries it.
16 comments:
Many Libertarian economists are very bothered by market failures — they simply don't want to believe that there can be such a thing.
Depends on what you call a market failure. Sure, prices aren't always what you want them to be, and markets can (and have) crash, and monopolies and collusion can and do develop that thwart the idea of the market. Those events can be absolutely tragic, and there certainly is a role for gov't to intervene in those (and other limited) situations.
In the long run, however, market crashes correct themselves, and are usually a sign of the market evolving to move in a more efficient direction (being a net positive). I wouldn't call a crash a market failure.
Sorry I didn't address the true topic of this post.
Richard,
There are other forms of market failure. The term is used very broadly to describe any inefficient allocation of resources.
This generally happens when all of the people affected by a transaction aren't able to enter into the negotiation. For example, if you will be affected by your neighbour building a skyscraper on his residential lot, but you have no legal standing to intervene, then it's a form of market failure. His action has a negative effect on you (perhaps depriving you of sunlight), and that negative effect doesn't enter into your neighbours decision.
The conventional solution is zoning laws. The libertarian solution is (pretty much always) property rights. Presumably (according to a libertarian) you should "own" the sunshine that falls on your lot, and your neighbour should have to buy it from you.
In many cases libertarian solutions make a lot of sense. In general, though, you just can't establish property rights for everything.
... Ami.
Let's take your example. You are calling a reduction in utility via uncontrollable actions a market failure. Would you consider the reverse to be true, that the market fails if you experience an increase in utility via uncontrollable actions? One is good and one is bad, but for one to be a failure, they both need to be.
I would consider there to be a market failure if it was no longer possible (not just for you) to acquire property that doesn't have a skyscraper near it. Theoretically possible, but very unlikely.
Now, I agree that legal limits should be set (as you mention, zoning laws), but great care should be taken when doing so. I'd even agree that compensation should be given by the person putting up the skyscraper for the loss of utility.
The purpose of the market is to allocate finite resources, not to insure that your resources don't lose utility/value. A market failure would have to be a situation where finite resources are no longer available at any price, and most often it's because of intervention in the markets (the USSR was a great example of this). However, I'll freely admit that natural actions (drought, disease, etc) can cause a failure by eliminating resources, though substitution usually compensates for that.
Richard: I'm not quite following your logic. The problem isn't the skyscraper per se, but rather that the economic incentives don't take into account the impact of a given act on all the parties ("externalities").
In fact, if there are postive externalities then it's also a market failure. But maybe I need to refine my example slightly to demonstrate. Perhaps if we put some dollar figures on things.
Lets say that your neighbour can build a skyscraper on his lot at a cost of $100 dollars. His utility from the skyscraper is $110, and your loss in utility is $20. The net gain to your neighbour for building the skyscraper is $10, the loss to you would be $20, and the net loss to society is $10. Your neighbour has the incentive to build the skyscraper, but this is an economically inefficient result.
It could also happen the other way. The skyscraper would cost $100 to build, the neighbour would potentially gain $90, and you would gain $20 (perhaps you could build a parking lot for the residents of the skyscraper). The net gain would be $110, but since your neighbour would lose $10 from the transaction the building wouldn't be build. Of course the example is a little weak here: you could easily pay your neighbour $15 and you'd both make money. But we could come up with other examples where such a transaction would be more difficult.
... Ami.
Ami,
All these theoretical markets are interesting, but can you think of a market that is completely efficient (and therefore not a failure using your standards)?
The only way you can keep actions by one party from affecting other parties is by preventing all actions. That's hardly an efficient market.
I read the linked paper. It’s an interesting proposal, but it reads more like game theory than something with practical value. It’s one of those “It looks good on paper, but doesn’t work when I actually try it.” type of proposals. I wouldn’t object to someone giving it a try, but I wouldn’t line up to be in the first trial.
Ok, I think we have different meanings for "market failure." I've already mentioned mine, and I think yours is actions outside your control that negatively impact you. The rest of my post will go on that assumption.
I'd call that a potential flaw more than a failure. For one minute, let's eliminate this flaw and assume a "perfect" market. What becomes of speculation? It would no longer be feasible to speculate, since utility wouldn't change. What becomes of innovation? The combustion engine severely decreased the utility of the carriage, so was that a market failure, or was that the market increasing efficiency? If innovation could not impact the current utility of an item, for better or worse, it wouldn't happen.
Do changes always improve market efficiency? No, and I would call those rare instances failures or flaws, your choice.
Brian: The goal isn't to prevent the actions of one party from affecting the other, the goal is to take into account all the effects of an action when doing your cost/benefit calculation.
I do agree that market failures are everywhere ("inefficient" means something slightly different, at least for me). That's why I'm not a libertarian.
Still, I acknowledge that trying to correct market failures can cause problems too, so ideas like dominant assurance contracts are interesting. I suspect that they would work in some cases, but other problems with markets would make them impractical in many cases.
The obvious problems is how to educate people about all of the assurance contracts they could invest in. In order to really replace government, there would need be thousands - expecting people to follow and understand them all would be inefficient on its own.
A second problem is that the scheme, as presented, only takes into account positive externalities. You would also have to account for the negative effects, and allow people to bid against a project. This is a minor gripe though, as I suspect the scheme could be adjusted to take this into account.
Why wouldn't you want to be the first to try this? Say for a project to build a local swimming pool or something similar?
... Ami.
Richard: The internal combustion engine was an increase in efficiency because there was a net gain from its existence, so that was not a market failure. The fact that some people were hurt doesn't make it inefficient. It's only inefficient if the net cost was greater than the net benefit.
Innovation is a prime example of the opposite kind of market failure. Because the gain from innovations like the internal combustion engine cannot be entirely appropriated by the inventor, it's likely that a "free" market would not produce enough innovation.
Both patents and government funded research are intended to address this.
... Ami.
Ami,
I don't want to be first, because I don't really think they'd work in practice (at least not on large scale projects). You might be able to get a pool built that way, but there are also other ways to do such projects without government funding. A local community has recently raised money to build a pool by holding fund raiser dinners, selling raffle tickets, accepting donations, etc. That's also an idea that wouldn't work for a large scale project.
As for market failures being defined as not taking into account the net benefit to society... that is usually a difficult thing to measure. To use your skyscraper example, suppose the owner of the property next door perceives that the utility of his property would decrease, but in other people's opinion it increased? The owner is complaining about loss of sunlight, but the desirability (and therefore value) of his property has increased substantially due to being located next to the new building. Do you compensate the property owner for the loss of sunlight, or do you charge him for the increase in market value? And who gets to decide which person is right? After all, the idea value is a subjective proposition.
Brian: The beauty of the scheme is that you are rewarded for participating even if the plan fails. So if you put forward money and the pool doesn't actually get built, you get back your money plus some interest rate. This is in fact what makes the plan so innovative. The only loser is the entrepeneur to starts the scheme.
Yes, all of this is subjective. That's actually an argument in favour of the scheme. If governments have to design a way to adjust the incentives (through zoning laws or taxes, for example) then there's no way to take into account individual preferences. These way people can signal their preferances through a market mechanism.
Again, I agree with you that the scheme wouldn't work that well in practice, but just not for the reasons you state.
... Ami.
Ami, is a market failure anytime there is a net value loss from any specific action? You seem to be picking and choosing here, because even your example, may have a net gain, despite the neighbor losing perceived utility. I don't see the difference in this and the combustion engine, the assembly line, machines replacing manual laborers, and so on. Please show me how that's not the case.
As for truly free markets not producing sufficient innovation, I agree. I don't think gov't-funded research improves the situation (but that's not what you said, is it? All you said was it's intended to solve it), as I think gov't research discourages private research. Patents, otoh, seem a good way to protect and encourage innovation.
Richard:
Ami, is a market failure anytime there is a net value loss from any specific action?
Almost. It could also be a loss from not doing anything. Basically, whenever resources could be allocated more efficiently.
You seem to be picking and choosing here, because even your example, may have a net gain, despite the neighbor losing perceived utility.
Obviously I'm constructing my examples to illustrate a point. Whether there's really a net loss or gain depends on what numbers you choose for the examples, and I'm not claiming they my numbers are realistic. They're just supposed to be illustrative. So, yes, my examples could go the other way too.
I don't see the difference in this and the combustion engine, the assembly line, machines replacing manual laborers, and so on. Please show me how that's not the case.
I'm assuming (I think reasonably) that the overall gain from the combustion engine outweighs the loss to the individual workers.
If that's the case then the action is a net benefit, and therefor not a market failure. [At least not at the level we're discussing - it's likely that the change happened more quickly or more slowly than optimal - but I doubt anybody could find evidence to make that case either way.]
I think gov't research discourages private research
Why do you think that?
Private research money generally goes into things where it's easy to see the commercial opportunity. Basic research is essential in the longer term, but difficult to fund privately.
Even with patent protection, it's not clear that this creates enough incentives. I think most governments subsidize private research through (at least) tax breaks. This is also a form of government funding, but it allows private companies to control where the money goes.
A more controversial topic is whether or not governments should play a role in trying to create competitive advantages in certain industries through targeted research funding and technology clusters. I'm not so sure about this myself.
... Ami.
Ami, your entire premise of "market failure" appears subjective. Not only that, but you also say that any transaction that isn't perfectly efficient (or which could theoretically have been more efficient) could also be deemed a failure. I don't believe perfect efficiency can ever be achieved, so that would mean markets always fail.
Markets, at any given point in time, inevitably contain an inequity. As they arise, the market reacts in a way to correct that inequity. Let's take your example. A puts up a skyscraper, which negatively impacts B. For A to use his skyscraper, he needs a parking lot, and offers to buy B's land. B's upset about the loss of utility, so he holds out for a big payment. A needs that parking lot, so he eventually gives in and pays the price. B experiences a gain in utility. With the profit, B buys some cheap land in the country and gets more sunshine and air than before.
At the snapshot in time you looked at, it was bad for B. Over time, however, the market compensates. We could go back and forth on this one, but my point is that nothing happens in a vacuum. People don't build just one skyscraper in an area, they build several. It's simply more efficient to do so (which is the market at work). What is today a "failure" may well work out to a benefit tomorrow.
Richard: Well, yeah, markets do always fail to some extent. I think maybe the word "failure" is disturbing you more than it should. It's just jargon - don't get so hung up on it.
Just because there is a market failure doesn't mean the market is a bad thing, just that it's not perfect. In some cases the failures are serious enough to warrant intervention, but in most cases they're close enough to efficiency that we just leave them alone.
For every change you make in the skyscraper example to show that there's no market failure, I can tweak it a different way to bring one back in. It was just an example to illustrate the concept of market failure.
If you want a real-world example of market failure, then consider pollution as a fairly straightforward case.
... Ami.
It's just jargon - don't get so hung up on it.
Perhaps you're right, but words mean things.
It was just an example to illustrate the concept of market failure.
Perhaps I am nitpicking too much, but I could much more easily accept the word "flaw" to "failure." These temporary inequities are part of the market evolving towards greater efficiency. I just can't call something a "failure" if it's working in the way it's designed to, whether I like the results or not.
Depending on whether you consider pollution to be part of the market process or not (I see arguments both ways), it could be considered a failure. Regardless of what you call it, it isn't desirable (not even by the producer, as waste reduces efficiency). Markets aren't perfect (look, we agree!), and there are some situations deserving gov't intervention (I think even libertarians would agree, because pollution involuntarily effects more than the producer).
As for gov't funding reducing private investment, why wouldn't it? If you can't lay claim to the fruits of the research, why invest in it?
Richard:
I think even libertarians would agree, because pollution involuntarily effects more than the producer
The whole point is that libertarians (at least the hard-line ones) don't agree. They think that the answer to all market failures is to establish more property rights. Pollution (according to a libertarian) could be eliminated by making sure everything is owned by somebody, and then giving those people the right to sue for damages.
The Internet is a prime example of government funded technology that might have crowded out some private investment (original AOL, Compuserve, Prodigy), but created a platform that facilitated a whole lot more private investment.
Since knowledge is cumulative, private R&D can extend public R&D. It's not an either/or thing.
... Ami.
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