Market Failure

Introduction

The rise of the West during and following the Industrial Revolution has largely confirmed the theories in Adam Smith’s seminal The Wealth of Nations and from other influential economic thinkers, such as David Ricardo and Jean-Baptiste Say. A foundation of classical economic theory is that an ‘invisible hand’ will translate market actors’ self-interest into an optimal distribution of resources for all, or Pareto efficiency, resulting in the maximum utility for all parties within a society given its available resources. In practice, however, this ‘invisible hand’ has created both goods and ‘bads’ for society (Daly, 2005)—both serving the public interest and creating public problems. These ‘bads’, or market failures, occur in many ways that affect various aspects of human existence. When society is disserved by free-market failure, citizens have recourse to government for corrective measures. This rationale is the basis for government intervention when free markets fail (see Eisner, 2006 and Knoepfel et al., 2007).

This essay will, within the context of environmental policy, discuss how the concept of market failure might help policy makers decide when and how to intervene. I will begin by reviewing different types of market failure that are relevant in the realm of environmental policy, along with environmental policy responses that have typically been employed in the face of such market failures. Having established these precedents, I will examine in greater detail the on-going debate in some of the academic literature about when and how governments should intervene in cases of market failure, particularly in the context of government failure. Next, I will explore additional considerations for policy makers before deciding to intervene and, once the determination to intervene has been made, what types of intervention might be most effective in practice given the latest theory and experience. Finally, I will conclude.

Market failure and environmental policy responses

Classic market failures

Market failure occurs in a variety of forms. While by no means an exhaustive list, the forms of market failure discussed below are perhaps the most relevant to environmental policy. For each type of market failure, I also list typical policy responses:

-       Externalities constitute the first of two quintessential market failures relating to environmental problems. Jaffe et al. (2005) provide an apt explanation of environmental externalities and policy responses, to which I defer:

Economic analysis of environmental policy is based on the idea that the potentially harmful consequences of economic activities on the environment constitute an externality, an economically significant effect of an activity, the consequences of which are borne (at least in part) by a party or parties other than the party that controls the externality-producing activity. A factory that pollutes the air, water, or land imposes a cost on society. The firm that owns the factory has an economic incentive to use only as much labor or steel as it can productively employ, because those inputs are costly to the firm. The cost to society of having some of its labor and steel used up in a given factory is internalized by the firm, because it has to pay for those inputs. But the firm does not have an economic incentive to minimize the external costs of pollution.

Environmental policies attempt to equalize this imbalance by raising the incentive for a firm to minimize these externalities. Policy choices accomplish this in one of two general ways—either by internalizing the environmental costs so polluters make their own decisions regarding their consumption of environmental inputs, or by imposing a limit on the level of environmental pollution. (Jaffe et al., 2005)

Thus, the classic response to externalities is to seek to internalize costs in prices. In this way, consumption can be expected to more accurately match societally optimal levels.

-       Public goods are the second quintessential environmental market failure. Public goods are any goods where one person’s consumption does not diminish another’s ability to consume the good (non-rival) and where it is not possible to exclude others from consuming it (non-excludable). Given these conditions, a ‘tragedy of the commons’ scenario often results, where individuals over use the public good, resulting in negative externalities for all. Air is an illustrative example of a public good, where both local pollutants (such as particulates) and globally distributed pollutants (such as CO2) result in negative externalities whose cost is borne by all and where policy intervention may be justified (Knoepfel et al., 2007). For air pollution, policy responses have included command-and-control regulation as well as market-based instruments (such as cap-and-trade and tax schemes) and have ranged from local and regional initiatives to global coordination.

-       Information inequality is another market failure with environmental implications. When a firm knows more about its environmental impacts than the government or the public, this information gap may result in overconsumption as the good’s price signals fail to ‘internalize’ the environmental costs associated with the good. In a different case, consumers might not be informed of a product’s relative benefits to the environment, which may result in consumers’ substituting for a less environmentally desirable product. Policy responses to information inequality usually involve encouraging information disclosure (Eisner, 2006), such as through a public database (e.g., the Toxic Release Inventory in the United States) or product labelling standards.

-       Clearly defined property rights are a prerequisite to free markets. Eisner (2006) points out that ‘under the common-law theories of negligence or nuisance, parties may be held liable for environmental damages’. Examples include noise or air pollution, where a factory’s noise or emissions prevent neighbours from making reasonable use of their property. Applied to other cases, establishing property rights may provide a solution to problems with goods traditionally deemed public, such as water. A government in a water-poor area could consider assigning property rights for its water, providing an incentive to the owner(s) for stewardship and protection (ibid). The owner(s) could then establish a price for access, providing consumers with signals for sustainable consumption levels.

In each of these classical market failures, the case for policy intervention is based on correcting the negative consequences of each market imperfection in practice, and policy makers have become relatively successful in their interventions. Under the public ‘bads’ justification, policy makers intervene when they believe they can take action that more efficiently allocates resources, accounts for negative externalities, distributes public goods, provides more-perfect information to market players, and/or assigns property rights. However, several factors complicate intervention; I will examine the first in more detail in the next section.

Technology and market failure

Modern technology has brought nuance to certain types of market failures beyond their classical definitions. Jaffe et al. (2005) identify two specific types of externalities—knowledge externalities and adoption externalities—and additional implications for incomplete information, which can lead to sub-optimal investment in innovation. I discuss each below, along with potential policy recommendations.

-       Knowledge externalities are an extension of the public-goods market failure described above. A firm that has invested heavily in research and development (R&D) to acquire specific knowledge about an optimal method of pollution abatement or solar power production, for example, may not reap the fair value of the competitive advantage of its investment in the absence of intellectual property rights. Policy interventions have included the granting of such rights through the establishment and enforcement of patent laws; however, proving in court that a competitor illegally copied an idea can be difficult in practice. As a result, firms may under-invest in R&D, which could be justification for a tax to fund public research as an alternative policy measure (ibid).

-       Adoption externalities occur when firms ‘wait and see’ how many other firms will adopt a technology and to what effect. Firms investing in expensive environmental protection technologies stand to gain from waiting to adopt whatever technology is deemed the industry standard, allowing other firms to bear the costs of learning how to use the technology. Observing others’ learning is taking advantage of a public good, a positive knowledge externality. Moreover, firms may decrease regulatory and maintenance costs by adopting widely implemented technologies. For these reasons, firms may be reluctant to become early adopters of environmentally beneficial technologies, leading to slower-than-ideal uptake of the technologies capable of achieving the greatest environmental outcomes (ibid). In response, policy makers may choose to incentivize or even mandate the adoption of certain technologies, for example through Best Available Control Technology (BACT) rules (Eisner, 2006).

-       Incomplete information can take on new disadvantages in the technology context. When little is known about a budding technology, investors may be reluctant to back it, regardless of how technologically promising it may be. This information gap between investors and innovators can establish a disproportionately high cost of capital for development of new technology (Jaffe et al., 2005). Policy makers may decide to intervene by offering low-interest loans to firms engaging in environmentally beneficial R&D. However, when such a policy was implemented in the United States, opponents widely criticized the government as picking winners and losers and ultimately failing in its evaluation of worthy loan recipients, as in the ill-fated case of Solyndra.

These technology market failures demonstrate that policy makers are confronted with a growing list of factors regarding market failure to consider in policy decisions. Policy responses to technology market failures can lack the benefit of established systems or even expectations of long-running systems to which to be applied. Thus, policy responses need to be flexible and resilient to volatile market conditions.

Market failure – an insufficient paradigm

The market failures discussed in section II. can result in an otherwise free market failing to achieve Pareto efficiency. However, an increasing amount of academic literature suggests that the free-market-failure justification for policy intervention might not provide a circumspective view for analysis of when and how to intervene. Below, I review three concepts—government failure, policy lock in, and unbounded rationality—and discuss how, even when a market failure is identified, an appropriate policy intervention might be either unjustified or more drastic than initially conceived.

Market failure and government failure

Policy makers have historically viewed the existence of market failures as sufficient justification for intervention. However, when intervention is not expected to achieve a better outcome than the free market, they should also account for government failure before deciding to intervene. This might happen in two ways. The first is discussed by Hepburn (2010), in which an incapable government is aware of an environmental problem that might justify a market intervention but is unable to effectively deliver environmental protection. The imposition of poorly designed policy might even result in a worse outcome than no policy at all. The second, suggested by Anthoff & Hahn (2010), is that even if a policy is believed to be well designed, past experience suggests that efforts at market intervention rarely if ever achieve their intended level of economic benefit. For both these reasons, policy makers should be cautious when deciding to intervene that they have realistic expectations about their government’s ability to deliver on the policy it implements and that they are not merely imposing unnecessary regulatory costs on firms (and thus society) without achieving environmental benefits.

Market failure and policy lock in

Another consideration for policy makers—and for society at large—is whether the paradigm of market failure is even the right frame for environmental issues. Bromley (2007) suggests a radical departure towards a post-market paradigm will be required. Bromley argues that, as long as society operates under assumptions of a division of politics and economics, where governments and their interventions are the enemies of public interests best served through free markets, we can expect the trend towards environmental degradation to continue. Although I am somewhat less pessimistic about free markets, Bromley’s points merit consideration: perhaps free-market economics has been analysing environmental issues using a flawed model.

This suggestion gains credence when combined with the precautionary principle and environmental pessimists’ assertions that ‘tipping points’ exist in environmental systems, where irreversible damage occurs when a natural system is thrown out of balance by degradation beyond a certain limit. (An example would be with anthropogenic climate change, where a certain amount of warming is expected to cause the collapse of the Western Antarctic Ice Sheet, resulting in irreversible, significant sea-level rise.) One of the conclusions of a Farmer et al. (2001) study suggests that traditional environmental economic models that set to balance marginal damage and marginal cost of pollution abatement fail to account for such tipping points. With this in mind, they conclude that policy makers should be stricter than economic models suggest is necessary. Thus, mindful policy makers would be wise to exercise an increased level of caution with regards increasing certainty environmentally positive outcomes, and may be justified in advocating more drastic environmental policy.

Market failure and behavioural economics

Finally, a growing body of research in behavioural economics suggests that humans might not be as rational in decision making as classical free-market economists have assumed (see Kahneman, 2012). A Venkatachalam (2008) study suggests that the theory of ‘bounded rationality’ (in contrast to the classical economics assumption of ‘unbounded rationality’) should be incorporated into more economic models as it more aptly predicts individual human behaviour. Improvements in accuracy of economic models would provide greater confidence to policy makers faced with decisions of when and how to intervene. Moreover, policy makers equipped with an understanding of the limits of rationality will be better prepared to understand their own psychological biases as well as those that might be expected from other policy makers. This improved understanding of the political sphere would further serve policy makers as they attempt to calculate realistic expectations of what a policy might look like after being subjected to the political process and whether it is worth the effort to propose in the first place.

Conclusion

As market complexity increases, policy makers are faced with the increasingly challenging task of meeting society’s growing demand for environmental goods and services. In this paper, I have, within the context of environmental policy, discussed how the concept of market failure might help policy makers decide when and how to intervene. I have shown that market failure has provided an impetus for intervention in the past and present, and that it still constitutes one of a set of related considerations for policy makers before deciding when and how to intervene in the future. I have discussed forms of classical and technological market failures relevant to environmental policy, along with typical proposed policy interventions. I have also examined more recent issues complicating the market-failure intervention rationale and suggested ways policy makers might account for such complications in policy decisions. Despite the increasing complexity, however, policy makers have a greater array of policy measures available to them. Whether they will succeed in matching policy to social preference, however, remains to be seen.

WORKS CITED

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