CHAPTER SIX: THE LIMITED COMPETENCE OF MARKETS

The market is the most efficient system ever known to mankind, and yet it too has flaws, called market failures.

As a tool, the market system functions properly only when used correctly.

There are two broad types of market failures.

First are market incompatibles, the production and consumption of goods and services for which the for-profit market system is not designed. Public goods fall into this category.

The second group of market failures are those that result from the improper use of the market by man, and not its irrelevance.

The market deviates from its assumptions because of the greed, ignorance, and incompetence of man, the principal economic agent who operates the system.

This chapter concentrates on market failures resulting from the abuse of the market system.

This is by far the larger of the two types of market failures and government regulation is aimed at preventing them and reducing their effects on the market’s performance.

In this group, the market fails when it deviates from its basic assumptions

Like in all other scientific fields, economic assumptions do sacrifice some aspects of reality in order to focus on the broader mechanisms of the market.

Assumptions are also important in defining the standards of excellence against which we can compare actual performance overtime and in different countries.

But economists do not dismiss these "sacrifices" as unimportant because together they mean that the market is under performing its potential.

Theoretically, market failures prevent the free flow of the market forces of supply and demand to move into equilibrium, resulting in consumers paying higher prices that they would not incur in a perfectly competitive market.

The cost of any market failure can therefore be measured in terms of how much it forces production to be set at a point over or below the market equilibrium point.

Sources of market failures will include: information problems, externalities, imperfect competition, and market swings and instability

First Assumption: Perfect information about the present enabling buyers and sellers to know everything there is to know about the goods and services being exchanged.

The market cannot function without the free flow of information. The private enterprise system is premised on the invisible hand proposition that no one, not even government, controls the free flow of information.

That all decisions are competent, that is, come from a rational weighing of alternatives.

That supply and demand would move steadily into equilibrium is only possible if producers have full information about the preferences of consumers.

Similarly, consumers must know everything there is to know about the product they are about to buy, its quality and quantity, all the alternative sources of its supply, and their relative prices in order to be able to make wise choices.

But information is not cheap nor is the gathering of all the necessary information always practical.

Scientifically testing certain foods and drugs to reveal their quality is beyond the competence of the individual consumer.

Yet the free information assumption of the market does not take into account the role of government in providing vital information about the market.

Relevant information may be judged incomplete if it is not fully revealed such as when hidden in any form the consumer is likely not to know.

Incomplete information includes false advertising, service packages like HMO and insurance packages that hide their full cost to the consumer.

Some product labels such as the description of used cars and sail promotion may contain misleading information.

Relevant information may be judged improper if it is intended to confuse or mislead the consumer into drawing false conclusions.

Information that is too technical, or clouded in too legalistic language the average consumer cannot read nor understand is to be considered improper information. E.g. credit card and insurance information.

The consumer may also be rendered incapable of using information where using all available information may be inconvenient. E.g. patients cannot shop around for the cheapest doctor; nor is it rationally convenient for customers to look for the cheapest gas station in a city.

Market incentives refer to how the market rewards work, or properly speaking, the signals it sends out about the rewards available for work.

In a perfectly competitive market, market incentives are clear, impartial, and draw only willing responses, that is to say, market rewards are exclusively on the basis of ability to work.

But in the real world, market incentives are not perfect, clear, nor reliable due to racism, and bias against women, immigrants, and other minorities.

Some business owners are reluctant to hire minorities like people of Indian origin, the physically challenged, and African Americans in particular.

The Equal Rights Amendment first launched in 1923 and introduced in every session of Congress until it passed in 1972 as the proposed 27^th Amendment to the Constitution and sent to the states for ratification has been ratified by only 34 of the necessary 38 states to make it a Constitutional provision.

Externalities are the costs and benefits of an economic exchange that affects unintended third parties.

Externalities mean that some transactions produce effects (positive or negative) beyond the originally predicted or planned outcome of the transaction– spill-over effects.

The presence of externalities means the market does not achieve total efficiency even while at equilibrium – the idea that all goods supplied to the market are bought or accounted for.

The market is not efficient at equilibrium if there are hidden costs and benefits.

Not even the most careful producer and consumer can avoid externalities, meaning their activities impose more costs on, or yield more benefits to, society than the face value of their transactions.

Unaccounted costs are negative externalities. They mean producers are unable to control all of the effects of their production.

E.g. Pollution as side-effect of production is not easily traceable to the exact producers, most of the time; therefore, the total cost of the product cannot be charged.

Cigarettes finally have finally been recognized as an addictive drug, meaning secondhand smoke is also an addictive drug, but the victims of secondhand smoke – dead or already very sick– were not included in recent action suit settlements with Big tobacco because there is no clear link between secondhand smoke and their suffering.

Externalities also take away from pareto optimality, the assumption that market exchange produces nothing but net, mutual gains.

As long as exchange does not remove all costs, including hidden costs, gains from exchange are not pure.

Besides the market system is full of cheaters who want to give you less than your value's worth.

Market efficiency also presumes parties to an exchange are in full control of their own properties and assets they intend to trade.

But the market has no mechanism for guaranteeing private property– property rights are only protected through the state system.

Pareto optimality also presumes all benefits are paid for and production targets include all possible benefits.

But enterprises cannot restrict workers from seeking new jobs, taking with them their on-the-job improved skills.

Costly Transaction:

Transaction cost is the cost of negotiating an exchange or a deal.

Pareto efficiency also assumes there are no transaction costs.

But transaction costs exist, are large, and could determine who gets what contract.

Exchange does not yield net-gains where there are transaction costs–the cost of doing business: bribes, tips, and other quid-pro-quo to get a business contract. E.g. buying a house.

Labor contracting is a means for coping with the otherwise huge transaction costs associated with organizing a large labor force enterprise on a daily basis.

The presence of numerous producers and consumers in the market mean that no one enjoys market power or can control prices.

All buyers and sellers are price takers.

The consumer is sovereign because he has the final decision as to what is produced, by whom, and how much.

But monopoly, the exercise of market power, is a fact of life in the market economy.

Pure, or absolute monopoly, is a one-firm industry, an industry whose product is produced exclusively by one firm, and entry into the industry is prevented by any number of insurmountable barriers. AT&T before the breakup.

An industry dominated by just a few companies, eg., the automobile industry.

Is monopoly maintained through purposeful, that is, carefully planned collusion by a few firms to prevent entry and/or to hold down supplies in order to artificially increase prices.

Because oligopolies control about 50% of their industry, they do not have to resort to collusion to control prices.

Is an oligopoly at the global level involving the possession of assets in several countries.

The Organization of Petroleum Exporting Countries (OPEC) which was born out of the 1973 Yom Kippur War, when the Arab countries first successfully used the oil boycott of Israeli-friendly industrial countries like the Netherlands, the US, and Japan is the best known cartel in the world.

Whereas an oligopoly must rely exclusively on controlling entry into its industry to be a monopolist, a cartel has the added advantage of state protection.

A monopoly may exist simply because a local market is too small to accommodate sufficient competition. There is no local pressure on such firms to be competitive.

In a typical university town, the university is in a local monopoly position.

Extensive patent protection of a new technology extends monopoly to the innovating firm because no one is allowed by law to make anything close to it.

In spite of the anti-trust law suit brought against it, Microsoft still controls over 80% of the world’s PC industry, its competitors not having sufficient access to crucial Microsoft codes to crack into its monopoly.

Product differentiation within the same industry may put each of the several firms within that industry in a monopoly position.

Though such an industry meets all the important conditions of competition such as free entry and exist, each firm produces a sufficiently differentiated product to be in a monopoly position.

Product differentiation occurs by making the same basic product look different through variations in its quality, packaging and labeling, brand name and advertising. Examples include, canned soup, and pain killers

While it is theoretically possible that each firm offering a slightly differentiated version of a product could set its own prices, it is not possible to deviate so significantly from the industry price less it loses some customers to its close substitutes.

Given the attachment of some customers to its semi-unique product, a product differentiated firm may not lose all its customers even if it raised its prices.

By uniting their labor power, trade unions increase their ability to influence their wages.

The stronger the influence of unions, the lesser the control of market forces in determining wages.

Because of the size of their purchasing power, whole sale purchasers are also in a consumer monopoly position.

Whether monopolies serve any useful purpose remains controversial even while it is undeniable that their presence undermines market efficiency.

Monopolists find it profitable to deliberately set their production targets below or above the market equilibrium level, the point where resources would be allocated efficiently.

As a consequence, too few resources are allocated to products and services produced by monopolists leaving too many resources over to be used in the more competitive sectors of the economy.

E.g. high-tech industries employ relatively few people but make huge incomes, leaving a disproportionately large number of workers to the very competitive sectors like small farm agriculture.

Monopolies, by charging more than market prices, are able to add superprofits to the normal profits of competitive industries.

Thus they impose tremendous costs on consumers and reallocation income from consumers to producers.

A large company that employs about 30-40% of the work-force of a locality is described as a job monopolist, and job monopolies can determine non-market community policies and disrupt the democratic process of decision making. EG. Universities in university towns, General Motors in Detroit.

Monopolies are likely to offer a less competitive product thus avoiding competition which is the driving force for innovation and progress in a capitalist system.

Monopolies are not under the competitive pressure and fear of losing their share of the market unless they are competitive.

Anti-monopoly critics deny any correlation between size and ability to raise funds and the level of innovation.

Similarly productive efficiency, critics point out, comes not from the size of a company but from the full utilization of its industrial plant and a company does not need to operate from several geographically distinct plants in order to attain economies of scale.

Monopolies undermine market democracy of free choice.

Democracy is said to exist only when people are free to decide who should represent their common interest as well as remove those whose activities they judge to be contrary to their interest.

But people cannot walk away from monopolists’ products nor deny monopolies the ability to operate.

Because firms are allowed to grow to the largest extend of their legal ability, they may grow so large they come to dominate the whole economy just as local monopolies dominate their local community.

Giant corporations become completely immune to market forces, in particular market restrictions on economic behavior. E.G. becoming a CEO is highly restricted even when their huge salaries may attract so many.

Private enterprise systems lose much of their economic democracy or popular control to the corporations.

Corporate business decisions affect the whole economy; in any private enterprise system, a larger category of major decisions is turned over to businessmen and yet the people have no way of reacting when their decisions negatively affect them.

E.g. monopoly of strategic defense industries can hold the government to ransom.

Many pro-market economists assume monopolies represent a classic example of imperfect competition which they see as the norm rather than the exception.

That in market economies companies grow large and exercise market power far beyond the assumptions of perfect competition is the norm and not the exception.

Pro-market economists reject the notion of competitiveness as based exclusively on the presence of a large number of firms in an industry.

Other than the number of producers pro-market economists recognize four subtle forms of what they term workable competition.

Given limitations of scarcity, consumption of any product means the denial of others.

Even the pure monopolistic firm is not as free to set any price it wishes, knowing that consumers have a cost-tolerance threshold beyond which they would substitute other products.

Innovative Competition

Monopoly established through innovation is transient, meaning innovators cannot simply sit on their monopoly as they are constantly challenged by new technological advances.

Monopolists are also unlikely to exploit their power if such behavior will encourage the creation of potential competition.

The embarrassment of anti-trust suits, the restriction from possible of government regulation, the fear of public censure, and the fear of superprofits attracting competitors into the industry all act as disincentives to the abuse of monopoly power.

Interproduct Competition

In perfectly competitive markets, no firm can influence the market price.

By contrast, the prices of product differentiated firms is pretty well fixed, meaning they can only get an edge through fierce competition.

Because of the treat of close substitutes, failure to compete will quickly translate huge losses and closure.

The second set of arguments in support of monopolies is based on the often close relationship between large-scale production and cost efficiency.

Unrestricted competition can create market failures in certain industries.

Such industries are referred to as natural monopolies and will include industries whose cost and technical conditions make it unfeasible to have more than one firms in the industry.

E.g. producers of bulky products like cable, water a sewage.

Pro-market economists see a link between mass production, the giant companies producing mass output and successful economy.

Because the firm in a typical competitive market controls only a fraction of the market, only monopolies are in position, therefore, to engage in mass-production and can pass on to consumers relatively low prices.

Small firms in a competitive environment control too small a portion of the market to make the huge savings necessary for innovation in today’s technology-expensive industrial economy.

Only large companies have the guaranteed large profit margins to make long-term investments and the market power to guarantee a return on that investment.

Society's overall objective is the efficient overtime allocation of its scarce resources.

Small firms in a competitive environment operate in the market they are given; they don’t have to plan.

The only way large firms can make and sustain their huge profits overtime is to avoid risk by carefully planning production to suit future market demand.

The only way to become and retain a monopoly is for a firm to be the most efficient planner in its industry.

Contrary to the notion that monopolies are wasteful of society's scarce resources, only the most efficient companies successfully grow into monopolies.

As price takers, small firms are forced to plan for he immediate short-term. Only giant companies plan for the long-term, and so can exert a stabilizing influence upon the economy. Because they have staying power, giant corporations do not have to response to the day-to-day business cyclical swings of the economy.

MARKET SWINGS AND INSTABILITY

Because supply and demand tend to equate at equilibrium, the market is said to be perfectly self-correcting and can avoid being drawn into protracted periods of recision and inflation.

But the Great Depression and ten major recessions since suggest instead that the market is subject to wide swings and instability beyond its intrinsic ability to control.