Market Failure

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*.

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." ?

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.

Arnold,

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.

Arnold,
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.

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.

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

Simply one of the best quotes ever. Nice.

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!

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

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".

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).

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

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.

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.

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:

http://www.edspresso.com/index.php/2006/05/why-we-dont-have-a-silicon-valley-of-education-michael-strong/

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.

Externalities?

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.

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!

Joe

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.