Market Failure or Success

Market Failure or Success

The New Debate

Edited by Tyler Cowen and Eric Crampton

Recent years have seen the development of new theories of market failure based on asymmetric information and network effects. According to the new paradigm, we can expect substantial failure in the markets for labor, credit, insurance, software, new technologies and even used cars, to give but a few examples. This volume brings together the key papers on the subject, including classic papers by Joseph Stiglitz, George Akerlof and Paul David. The book provides powerful theoretical and empirical rebuttals challenging the assumptions of these new models and questioning the usual policy conclusions. It goes on to demonstrate how an examination of real markets and careful experimental studies are unable to verify the new theories. New frontiers for research are also suggested.

Chapter 1: Introduction

Tyler Cowen and Eric Crampton

Subjects: economics and finance, industrial economics


Tyler Cowen and Eric Crampton Market failure remains one of the most influential arguments for government intervention. Throughout the twentieth century, most of the market failure arguments were based on theories of public goods and externalities. These theories suggest that market participants will fail to produce certain mutually beneficial goods and services. To provide a simple example, individuals may not voluntarily contribute towards a protective missile system because they hope to free-ride on the contributions of others. Although aspects of these theories can be traced back to the beginnings of economics, the modern formulations were laid down by Paul Samuelson, James Meade, Francis Bator and others in the 1950s. Since that time, and despite some significant differences (for which see Cowen, 1988), a consensus developed that governments should provide at least a few basic public goods, such as national defense, but that markets do the best job of providing most goods and services. This consensus fell apart in the 1970s and 1980s, as economists constructed new market failure arguments. These new challenges were based on the idea of information and informational imperfections. And in these arguments, more than just a few markets are bound to fail. Rather, if these arguments are correct, we can expect market failure whenever information is imperfect or distributed asymetrically. The new wave of market failure ideas included StiglitzÕs Ôefficiency wageÕ hypothesis, George AkerlofÕs Ômarket for lemonsÕ model, Oliver WilliamsonÕs notion of opportunistic behavior,1 and network and lock-in effects, stressed by Paul...