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8.3 The Other Side of Markets

PLEASE NOTE: This book is currently in draft form; material is not final.

Learning Objectives

  1. Understand market imperfections
  2. Understand market failures
  3. Understand externalities

Markets are very useful, even though they don’t always work the way they’re supposed to. As we’re about to see, that can have a cost for everyone. As we live in a free-market economy, in which citizens are allowed to make their own economic choices, we presume that competition is an open free for all, and the market—in the form of businesses and consumers—decides what gets made and who buys how much at what price. As with most things in economics, that’s true, to a point.

So we might always ask, how well does any given market function? Classical economic theory says that markets are perfectly efficient because consumers and businesses simply vote with their dollars, and the best firms and the best products win out. Consumers, meanwhile, only spend their money where they perceive they are getting value for it.

But how can we know if a market is efficient as theory suggests it will be? One immediate problem is that people who worship at the temple of the market assume that everyone has perfect information: Consumers and businesses know everything they need to know to make rational decisions. Think about all the dumb things you’ve ever done with your money, and that pretty quickly should appear to be a really big assumption.

Market Imperfections

Markets are very good at making product and pricing decisions. People do vote with their dollars, and the market eventually responds. But they are not perfect. First, unlike the theoretical markets of free-market dreams, markets are not frictionless—markets face transaction costsThe costs of negotiating and enforcing contracts.. Transaction costs are the costs of negotiating and enforcing contracts. Information held by buyers and sellers is not perfect. Although buyers and sellers do find each other, that’s not without cost. Businesses have the costs of advertising and marketing; consumers have the costs of shopping for the right product at the right price. (Something like e-Bay works in part because uniting buyers and sellers in once place—the internet—lowers transaction costs.) So, for example, you’re usually at a disadvantage at a car lot. The dealer or his representative knows what the car really cost, and what might be wrong with it. The sales representative also has been trained in price negotiation, or at least has experience at it. You, on the other hand, might be very good at your job, but may be inexperienced at price negotiation and may not know what the car is worth. And you certainly don’t know that it needs a new transmission. So markets aren’t always a level playing field.

Markets don’t always make the best choices, despite their reputation for doing so. Consider Qwerty economicsThe way in which various factors lead markets to make less than the best decision.. Qwerty, you may recognize, is the first five letters on the upper left side of the keyboard you are probably now using. If you stop and think about this keyboard, it’s fairly awkward. The letters you use the most, such as A and S, are under your weaker fingers. This was by design. This keyboard was created in the 1800s when typewriters became commonplace. With a manual typewriter, if you type fast enough, you could jam the keys together and have to stop and separate them. This was a problem for rapid 19th century typists, so a keyboard was designed to slow them down a bit and enable them to proceed at a good steady pace.

Then, in 1932, a University of Washington professor, Dr. August Dvorak, developed a new keyboard that was more ergonomically efficient. Typewriters had gotten mechanically better, and the invention of the electric typewriter meant you could type very fast if you were any good at it. A trained Dvorak typist can kick major bunny on the best Qwerty typist.

So why don’t we all use the Dvorak keyboard? It’s better, and we’d all probably like a keyboard that put the most commonly used letters under our strongest fingers. You can convert any late-model Windows computer to Dvorak with a few mouse clicks, and it shouldn’t be too difficult to order a Dvorak keyboard for your computer.

But we don’t change. The short-term cost of retraining an entire nation in typing outweighs the apparent long-term benefits. (I tried a French keyboard once while in Paris on business. French keyboards have the letters in different places. It’s very difficult to type on a different keyboard once you’ve been trained to do one way.) Either way, that’s a market decision, and the market hasn’t made the best decision. Markets sometimes do that. The old Sony Betamax system was much superior to the VHS system, but the VHS system won out. Sony didn’t license its platform to other manufacturers; the VHS patent holder did. So even though Betamax was better, VHS was much cheaper. Apple Macintosh computers were much superior to the early Windows machines, but as Apple (like Sony) didn’t license its operating system to other suppliers, Windows-based PCs won out over Apples on price alone. In each case, greed won out over good business sense.

Market Failures

Imperfections are relatively minor concerns; they add costs to markets, but they don’t keep markets from working. But markets face much bigger challenges than that. Some economists call these market failuresWhen markets fail to produce the best outcome., or cases where markets don’t perform as well as we hope they will. (We should note that people with extreme faith in the power of markets don’t admit that markets might not be perfect. In the eye of some very conservative economists, whatever happens with the market is what’s supposed to happen. And if that means you suffer as result, well, it sucks to be you.)

First, markets have a tendency toward imperfect competitionA situation where competition is limited by collusion or lack of competitive firms in the market.. Remember that in perfect (pure) competition, no firm controls too much of the market, there are low barriers to entry (it’s easy for somebody to get into that market and provide competition), and firms get whatever price the market is currently offering. Very few markets look like this in the real world. Commodities—raw materials, some agricultural goods, airline tickets—tend to operate this way. But even there, firms tend to try to differentiate their products so that they can charge a slightly higher price. (Giving us such puzzling products as “Eggland’s Best,” even though, for the most part, an egg is an egg. By claiming that their eggs are somehow better [they never really say why, and I can’t seem to find Eggland on a map], they can charge a little more for their product. Grocery stores also sometimes charge more for eggs with different colored shells, even though there’s really no difference beyond the way they look.) This is called monopolistic competition. Each firm tries to create its own monopoly by positioning its product or service as being slightly different from its competitor’s offering. What matters here is that positioning your product away from the field gives you a little bit of market power—the ability to set prices. That usually means higher profits, and that’s what most businesses want.

This is a condition that doesn’t stop markets from functioning—lots of firms, selling similar products, each trying to carve out its own market niche. But what happens when some firms come to dominate a market? If we get down to just a few firms, we have what’s called an oligopoly. As these firms dominate their markets, there is less competition and higher prices. Before the advent of foreign imports, U.S. auto firms were an oligopoly, and even now, there’s a relatively small number of firms worldwide that compete in the automobile industry. In the commercial jetliner business, two firms (a duopoly)—Boeing and Airbus—are the dominant players, and while they compete fiercely over this business, they mostly have the field to themselves for the moment.

Left to their own, many markets tend toward just one firm. One company manages to get an edge, and begins to either buy up or push out its competitors. This happens most often in businesses where there are high barriers to entry (it’s either expensive [also called capital-intensive] or technologically challenging to get into the field). As we’ve already noted, it would be relatively simple for you to open a coffee stand, but it’s not likely that you’ll start manufacturing automobiles in your garage (and be successful at it). Only one firm means a monopoly, and monopolies usually mean higher prices and lower quality, because there isn’t any competition to force that one surviving supplier to do a better job.

This happened in the United States in the late 1800s and early 1900s, when business leaders managed to assemble a series of “trusts,” which controlled much of the nation’s (and sometimes the world’s) supply of everything from sugar to oil. For example, John D. Rockefeller, starting from scratch, built a behemoth known as Standard Oil, which at its peak controlled 95 percent of the world’s known oil. He ran a better business than many of his competitors, but he also undersold competitors to put them out of business (and probably arranged for accidents for some who refused to go away quietly).

In the United States, government’s response was to pass a series of anti-trust laws, making it illegal for one firm to control an entire industry and giving government the power to break up the trusts and preserve competition. So, for example, when AT&T (which had been broken up by the government in the 1980s) declared in 2011 that it would buy T-mobile, federal anti-trust regulators said “not so fast,” and filed suit to block the acquisition on the grounds that it would limit competition in the cellular telephone business.

It’s not entirely clear how well any of this works. For example, it took until 1924 to break up Standard Oil, by which point its control of the world’s oil supplies had fallen to about 25 percent. How did that happen? High prices tend to attract more competitors; by charging monopoly prices, Standard Oil had already drilled the wells of its own demise. Similarly, the break-up of AT&T in the 1980s, when it was the world’s biggest corporation and the nation’s dominant phone company, became something of a moot point in a few years as cell phones and satellite communication began to end AT&T’s dominance of local and long-distance telephone service.

The tendency toward imperfect competition takes other forms. As we’ve already noted, participants in markets frequently try to rig them by changing the rules, or by colluding with others. For example, at various times in our history, business has encouraged government to produce rules that limit competition. At other times, firms have secretly joined together to fix prices and avoid competition altogether. In the early 1960s, for example, suppliers of large generating equipment secretly agreed to stop competing (bid-rigging), so that prices would be higher for all firms involved. (Eventually, somebody noticed, lawsuits were filed, and fines were levied.) Firms also have tried to corner the market on some materials, making it difficult for other firms to compete. So although markets are supposed to be inherently efficient, and to generate whatever products are needed, markets may in fact need someone to enforce the rules of the market—to make sure that no one is cheating by finding ways to limit competition.

Markets also are cited for their failure to provide social (or public) goodsThings such as traffic lights and public health systems that the market won’t provide since there’s no way to make a profit from them.: Markets can’t provide public goods such as traffic lights, because there’s no way to make a profit off a traffic light. One could argue that roads and transportation infrastructure in general fall into this category, and probably police and fire protection as well. In economic-speak, social goods are said to be non-rival and non-exclusionary, in that consumption of them does not diminish their quantity and they can be used by anybody. That means it would be difficult for a private business to make money on them. Traffic controls such as stoplights are an example of a social good since they limit accidents, help manage the flow of traffic and can be used by anybody who is driving. And if I use a traffic signal, there isn’t less of the traffic signal for you to use after me. The market won’t provide traffic signals because there’s no way to make them profitable for a private owner, so the only way to get them is gather up some money from everybody (taxes), pool those funds and build what needs to be built.

Markets also suffer from unequal distribution of wealthThe tendency of markets to distribute much greater amounts of wealth to some people, and much less wealth to others.: Because markets generate a lot of wealth but don’t spread it around evenly, market economies can produce extremes of wealth and poverty. This generates problems for most societies. The rich get greedier, no surprise, and the poor get more envious of the rich. This often leads to more poverty, higher crime, and more social problems of all sorts. Plato and Aristotle wrote about this very problem 2,500 years ago, and not much has changed. Figuring out how to fix that, however, remains as difficult as ever, because if we make the distribution of wealth more equitable (more even), we likely also will make the economy less efficient and productive. Striking a balance, I think, is the hard part. Of course, not everyone agrees that this is a problem. Conservatives and libertarians would argue that if some people are poor, it’s their own fault, and that they are more likely to become wealthy and successful if they get going and do something to improve themselves. As usual, the truth is probably somewhere in the middle. There are people who lift themselves up out of poverty, and people who can’t see their way to anything like that. And clearly some people start out ahead of the game. Your parents’ income level is a pretty fair predictor of your income level. (And if you work enough jobs, you will inevitably meet someone who owes his or her position to the wealth they inherited. You will also meet people who are brilliant at business, and, in some sense, deserve what they have.) But what is certain is that poverty has a social cost that extends beyond the poor themselves. Poor parts of every country tend to have higher crime, poorer nutrition, shorter life spans, and generally less pleasant lives. The question, as always in politics, is what to do about that.

Another kind of market failure is externalitiesThe unintended consequences of market activities. These can be either positive or negative. Negative externalities occur when the full cost of using a resource is not borne by the user, such as pollution., which are the unintended consequences of economic activity. Externalities also are said to be the costs not paid for by the user of the resource. Pollution is the classic example of an externality, and the market may not in fact account for the real costs of pollution. So, a smoke stack from a factory, or all the air pollution created by automobiles and most other forms of transportation, does create a lot of jobs and wealth. No problem there. But the cost of the pollution in terms of health and the environment isn’t paid for by the user of the resource, either you or me driving to work or school, or the people who own or work at the factory. That cost is left for society at large.

Nobody really wants to create pollution, yet the market by itself won’t do much about it. Why not? In the example of pollution, we often face the free-rider problemA conundrum that leads firms and people to not do the right thing, because to do so would be to absorb all the cost of that action while sharing the benefits with everyone else.. If each of us owns a factory around a lake, and we’re all dumping effluent into the lake, we will ruin it in a short period of time. So we’d all be better off not polluting the lake. But absent some outside influence, there’s nothing to make any of us stop polluting the lake. One of us might decide to take steps to reduce the pollution we’re dumping into the lake, but whoever does that bears the full cost of that and yet shares the reward with everybody else around the lake, making them, in effect, free riders on our good deed. Moreover, by taking on the cost of cleaning up our plant, we have added to our costs, making our product less competitive with firms that chose not to do the right thing.

Externalities can be both positive and negative. Negative externalities make something worse for somebody else. Positive externalities make something better. A positive externality might be a business that buys an old building, cleans it up and landscapes the outside. That would make neighboring properties worth more—a benefit to those landowners, and totally unintentional on the part of the business. Public education also produces positive externalities, since the people who are educated at public expense will be more productive than if they had not been educated. That generates economic benefits for the rest of society.

Key Takeaways

  • Markets may not be capable of providing needed goods and services.
  • Markets may not account for the full cost of using a resource.
  • The free-rider problem discourages firms from doing the right thing on their own.


  1. Should government step in to deal with negative externalities? Are there costs and benefits, for example, for mandatory pollution controls.
  2. What would be the costs and benefits of unequal distribution of wealth?
  3. Think of some examples of public goods. Why doesn’t the market provide these?