Arnold Kling  

Market Failure

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I want to propose a new definition of market failure. For me, market failure exists to the extent that innovation is blocked by incumbents. If innovators can succeed by out-competing incumbents, then the market is working. If incumbents have a self-reinforcing system that keeps out innovators, then we have market failure.

This post ties together a couple of recent bitter themes. It is not intended in any way to persuade people who disagree with me (if you disagree with me, you may just want to skip the post). It is simply a grand unified theory of my bitterness.

First, why am I bitter about Jonathan Gruber? I am bitter because in my view he has received funding and accolades far out of proportion to his skills. He is being treated as a supreme authority. In theory, that is because his skills are exceptional. Instead, I suspect that, on the contrary, his success has less to do with how he uses his critical thinking functions than how well he has repressed them. In short, he is paid to tell progressives and politicians what they want to hear.

Suppose that we have a group that wants enormous political power. The group rewards people who justify its power by calling them "experts." It punishes those who question its power by dismissing them as "hacks." If you want money and status, you want to be labeled as an expert. In order to be labeled as an expert, you produce analysis that justifies concentrated political power for the elite group.

This process is self-reinforcing. It is like the Harvard-Goldman filter. That filter says that only "reliable" people are allowed to be bank CEO's or policymakers. A requirement for being "reliable" is sharing the views of other "reliable" people as to what constitutes reliability.

It is like the tenure system in academia. Who gets tenure? Above all, it is people who support the existing tenure system.

Incidentally, that is my explanation for why the Internet has failed to alter the academic journal system. People who go through the tenure process have an enormous stake in not changing the process. The process is self-reinforcing.

Of course, incumbents never want to change the process, but markets can force change. So far, all the phenomena that I have been talking about represent market failures, by my definition. There is a market failure in health care. Instead of innovation, what gets rewarded are ideas and policies that entrench the existing system. There is a market failure in finance. Bad firms and bad policies are not weeded out. Instead, what gets rewarded are bank CEO's and policy makers who promise to make the system "too regulated to fail" and who bail out their friends when that promise breaks down.

There is a market failure in education. Educational institutions are evaluated not on the basis of rigorous standards but instead on the basis of a system of credentialism that is self-referential. X is acceptable because X has been certified by Y, which is acceptable because it has been certified by Z, and so on. In order to climb the ladder in academia, you have to display allegiance to the credentialist ideology. You have to reinforce the incumbents and help snuff out innovation. Our program is accredited, and yours is not. So there.

As a high school AP teacher, I have had to suffer through "audits" by the College Board. My students' scores on the AP are not part of the audit. Even if a student gets a perfect score on the AP, that student cannot be said to have taken an AP course unless I passed the audit. Now that I have passed the audit, however, no matter how many of my students fail the AP, my course will count as an AP course as certified by the College Board. Credentialism at its best.

I should point out that I think that reputation systems are necessary. I am not against audits and reputation systems in general. As consumers, we need reputation systems in order to sort out quality. The key is whether a reputation system is reasonably open to innovation, or whether it serves primarily to maintain the status of incumbents.

The reputation system that elevates Jonathan Gruber to a status of supreme authority is not a system that serves the consumer. It serves the incumbents, who want to centralize political power. The relationship between politicians and experts is the most serious market failure of all. It is our version of what I have called the Moral Rot Factor.

Ben Bernanke is one of the most decent people I have ever met. Yet he is part of the moral rot. As Scott Sumner has pointed out ad nauseum, most economic theory favors rules over discretion in monetary policy. Yet Bernanke's ad hoc, discretionary actions and departure from rules are what made him the Person of the Year, everybody's hero. Bernanke, Paulson, and Geithner are heroes for maintaining the Mystique that we have a great banking system that only requires wise regulation. Ultimately, it is Bernanke's willingness to go along with the big bankers' view of the world that accounts for this high status.

Several commenters object that our moral rot is not as bad as it was in the Soviet Union. That is true. Dissidents are not being sent to Siberia. The U.S. today looks less like a one-party state than it did a year ago, but I still do not think that the Tea Party represents a reliable, effective opposition. I think that there is still a high probability that we are on a path to a system in which a political elite ruthlessly rewards its friends and punishes its enemies, leading to a society with much less innovation and much more corruption. I do not foresee gulags and mass murders, but there is plenty of potential for moral rot in cronyism, and that I do fear lies ahead.

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The author at Jim's Blog in a related article titled Mencius and Kling agree writes:
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Philo writes:

Why do you put 'market' into the phrase 'market failure'? A lot of your examples would be classified by other observers as cases of *government failure*.

Scott Wentland writes:

How about: "government failure exists to the extent that innovation is blocked by incumbents. If innovators can succeed by out-competing incumbents, then the regulation (and market) is working." ?

David C writes:

I think this is an excellent clarification of your views on the problems of government.

Re: Philo
Any time a good is in limited quantity or limited quality and can be traded it is a market. The extent of government involvement does not prevent a system from being a market unless the government either completely prevents people from trading (such as transferring schools or changing doctors) or all services are completely equalized. Because of its complexity, equalizing education and health care is impossible, and preventing all forms of trade is very difficult.

And the main point is that governments don't have to be involved for the problem to exist (monopolies, for instance). It's just that it's very difficult to design government to not create those problems.

aretae writes:


It's wonderful. A market is failing IFF new entrants cannot come in to improve the market (for the consumers). A market is not failing if they can. Brilliant brilliant formulation.

E. Barandiaran writes:

I distinguish between (a) market power when incumbents can use their position to block the entry of new traders, and (b) market failure when transaction costs are too high and the critical reason why transactions do not take place. If (c) transaction costs are high because of the market power of private traders or government, I put emphasis on market power rather than market failure.
Although welfare economics put too much emphasis on market failure, recently the emphasis has shifted to market power (as reflected in the large expasion of industrial organization as an important field of economics). There is, however, a tendency to think that any market power should be a source of concern, but this is misplaced--we should be concerned about the abuse of power. It's a great challenge to define ex ante situations in which one may claim that there is an abuse of market power, so it's not surprising that the courts are giving broad authority to review cases in which they may have ocurred.
Given the pervasiveness of government intervention, whenever we analyze a particular market we must make clear how the government intervenes (I'm in favor of expanding traditional microeconomics to include government as a third party in the analysis of any market). Indeed, government has market power in most markets--it can block the entry of new traders. The problem is when its intervention amounts to an abuse of power. The checks and balances of the constitutional order are supposed to prevent abuse, but the judiciary will always be necessary to review particular interventions.
I understand your analysis of particular markets as an attempt to show that government's abuse of market power is a much more serious problem than the abuses of private companies and individuals. You're right. In developing countries everyday we have to deal with abuses of market power, but in some of these countries the most serious problem is the political power of government--that is, the power to block the emergence of new political coalitions. In developed countries, government abuses of market power thrive in times of crisis and emergence of ambitious politicians.

Mike Gibson writes:

Great post, Arnold.

Can I add one more to the list of market failures? Governance. Incumbents reign. Innovation is dead. Long live the Harvard-G Sack credential powerhouse.

Sam Wilson writes:

"It is simply a grand unified theory of my bitterness."

Simply one of the best quotes ever. Nice.

ERIC writes:

Your frustration is shared by many.

It's nice to know that there are still people unwilling to give up. Tough to think that things will change though. Sure does seem almost better to accept things and grab a piece for yourself--if you can forget your morals. Maybe people convince themselves that what they are doing is right to honestly quiet that pesky little voice in their head!? I question that though.

Everybody wants to create their own, personal monopoly don't they!

Robert writes:

I am willing to be convinced that Gruber is a glorified political hack, but I would need at least some evidence that he was making illogical, far-fetched assumptions or statements in his reports.

I did not read anyone criticizing his studies before this week

Frank writes:

As in some other posts in which you write of elites and power, I think you have described what you don't like in terms so general that they apply to virtually any society.

In the characterization of market failure as innovation blocked by incumbents, what is "innovation"? Is it more specific than "anything other than the status quo"? But the status quo and every alternative to it cannot all be instantiated simultaneously.

Perhaps a given alternative to the status quo is not instantiated, but at least it's not blocked. What counts as "blocking"? Presumably this refers to things within human control, but how much more limited is it than that? Does it require the use of "state power"? Does using state power to enforce (a particular version of) property rights or (a particular version of) election laws count as "blocking"? Can private power, if you concede that it exists, be used to block?

Perhaps a given alternative is blocked, but not by incumbents. But who are the "incumbents" if not those in a position to block?

I think you would like to describe, in completely neutral terms, a kind of mechanical procedure that will nevertheless filter out particular results you don't like. This is hard to do unless you implicitly ascribe a loaded content to the apparently neutral terms of your theory. Having the government own auto companies is an innovation, in the United States. I am sure that the Obama administration has a number of other innovations it would like to implement, but for the time being it is blocked from doing so. Yet I doubt this is what you object to.

When you write of the "concentrated" "power" of "elites" (if that's not redundant), you are probably already thinking in terms that are too general. I suspect you should try to be more specific rather than moving to the even more abstract level of "blocking" "innovation".

George X writes:

I want to propose a new definition of market failure. For me, market failure exists to the extent that innovation is blocked by incumbents.

I don't think redefining "market failure" is the way to go (especially since us non-economists usually don't even know the original definition). It's much more interesting to present your idea as an empirical claim; e.g.:

"Most cases of market failure are mediated by incumbents blocking innovation." (Or "almost all recent cases in the U.S.", or whatever other elaboration gets at what you mean.)

Frank: I think it's pretty clear that when Arnold talks about "innovation," he means innovation that makes the economy more efficient. So the government owning GM is new, but pretty unlikely to lead to more efficiency, so wouldn't count as innovation. Whereas GM figuring out a way to shave $1,000 off the cost of producing each vehicle would be new, but more efficient, so it would count as innovation (and, you know, a miracle).

Martin Schonger writes:

Side note: I agree that the post goes a bit too far w.r.t. Gruber.


I think what Arnold has in mind would already has a name, at least in the economic domain:
"Contestable markets" vs. "non-contestable markets" (Baumol).

The following might be a real world example: for Microsoft might be a near monopolist, but its market seems contestable. It does have to worry that everyone switches to say Mac or Android or Linux. It is the threat that matters, even if the threat never realizes. Due to the threat Microsoft gives consumers enough surplus and keeps its reputation high enough such that an aggressive market takeover attempt by say Apple is not profitable for Apple.

Note that in the Microsoft example, due to software production having no capacity/quantity adjustment problem the zero marginal cost of software, the contestability is limited by Microsoft being able to threaten to drastically lower prices and increase sales upon Apple entry. But for reputational reasons it is still a problem.

Gadfly writes:

Arnold, why are you attacking Gruber? He is one of the foremost researchers on health economics because he has done good research. You present 0 evidence to the contrary. It seems that you have never even read his academic work in any detail. You only trash him because you do not like his political position. Nice ad hominem attack.

Michael Strong writes:

Yes, a great post, Arnold.

This is why Hayek's essay, "The Creative Powers of a Free Civilization" is my sacred text.

The combination of public choice theory + "creative powers of a free civilization" = libertarianism because one realizes the scale of damage due to legally enforced credentialism and other forms of regulatory constraints on innovation are arbitrarily large over time. Government funding of universities and university research exacerbates this; it is very difficult to create new universities because government funding only flows to accredited universities, which are those that follow the norms of the existing club of universities.

Both government funding and government regulation enforce the established self-referential institutions. They lock them in far more than the Microsoft OS was ever locked in due to the fact that it was a widespread standard; see my "Why We Don't Have a Silicon Valley of Education" for an elaboration of this argument with respect to K-12 education:

We have the IT revolution in part because uncredentialled teenage boys (including Gates and Jobs) were allowed to mess around with stuff in the 70s. Had IBM engineers had the legally enforced ability to certify who was allowed to work with computers, technologically we'd still be living in 1979, but with slightly smaller mainframes.

Now repeat the same thought experiment, but with legally enforced credentials on who was allowed to tinker with iron, coal, and machinery in the 1770s.

And so forth.

Thus we can speculate that every such constraint on innovation results in arbitrarily large harms to society over time.

Larks writes:


Dan Hill writes:

Everyone knows that if you are going to sell your soul the devil pays the highest price. Reinforcing incumbent power is always the most rewarding choice, but usually not the moral one.

josephknechtdvm writes:

Great post!

Innovation is definitely the key to improvements in everyday life and efficiency yet power is used often more to defend turf rather than making the grass grow better with less water and mowing.

The veterinary profession for years has been trying to innovate professional education for over twenty years. Innovate in that veterinary students get to choose their area of concentration of practice while in school and learn less of things that will have no value in that area. Knowing and applying pig and poultry medicine is of no use to someone practicing on dogs and cats. Yet the American Veterinary Medical Association's Council on Education regulates the curriculum and refuses to allow specialization in the program for various reasons. This has been debated seriously since 1986. Result is that they produce graduates now who do not satisfy any customers from pet owners to farm owners to biomedical researchers well. Specialization is allowed post DVM degree but takes years of additional training(if training is available) and costs and will then allow you to call yourself a specialist in the area in which you wished to concentrate in the first place.

The people making decisions in veterinary medicine do not even think markets are even relevant!


I really like this way of thinking about market failure. And it looks novel to me.

But I think there are important questions about the appropriate time horizons for labeling a particular firm "incumbent" or "innovator."

The most difficult governance problem for us as a society, ultimately, is in deciding how long to tolerate failure, or how much failure should be forgiven. Government Motors exists not because anybody wanted to deny new entrants a shot at building a better economy, but because few people would deny mercy to an infirm elder of our economy.

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