On market failures – perhaps you are too close

I am often involved in coaching and capacity building a different kinds of private sector development experts working in the developed and developing world. I am sometimes shocked when I realize that a practitioners or programme managers in the field involved in market development do not understand some of the basics of how markets work or how to address market failure. This is often made worse by the broad ideological blindness of the organizations that promote market development approaches. I state this based on my experience that when markets and its alternatives are properly explained to teams in organizations, many problems resolve themselves, largely because the way markets function and evolve are better understood. Don’t get me wrong, I love markets. They are amazing in that they can emerge almost anywhere but where we often seem to need them. But I am not blind to their limitations (like how unfairly they allocate gains), nor am I naive about what it takes to get market systems to work.

If you are trying to solve market failures by bringing suppliers and buyers of a particular good or service together you may be too close to the action to really make a difference in the medium to long term. Actually, you might be making it harder for markets to evolve, as trust that is weakened when something does not work as it should or as promised is not easily forgiven in the real world, making 2nd attempts very hard if not impossible. There are many reasons why I say this.

Firstly, a market failure is a symptom that something else is wrong. It could mean that knowledge about the product or service, or how or why it is used, is not available or costly. This could imply a deeper failure (knowledge related) that people do not understand the value, the impact or the modalities of the good or service, or how the good or service will affect them or what it might depend on. Or the supplier is not able to demonstrate or explain how a good or a service can be used, or that it will address a particular need.

Secondly, modern markets are tightly intertwined and interdependent on other markets and other forms of allocation beyond markets. For instance, the service for quality management advice needed by food producers is dependent on many other services, including management consulting, HR consulting and sufficient demand for companies that are for quality accredited. It may also depend on some technical expertise in the form of a service about the product itself and the regulations it must comply with. These different markets co-evolve and depend on each other. Furthermore, this quality management service is also shaped by domestic and international regulations, standards and norms. Lastly, this service may also be specific to a particular service or product type, so the potential impact of the service or particular good may be easier (or harder) to guess so that a potential buyers of the service can figure out if this money might be spent in a better way. Remember that spending money on the wrong thing (adverse selection) is also a market failure if this is caused by an inability to thoroughly evaluate the expected benefits of alternative choices.

Thirdly, most services and products traded in markets also depend on related or supporting networks and hierarchies. For instance, few market services or products used by businesses can be used if that business (a hierarchy) does not have a management capacity, or absorption capacity (to figure out how the product or service will impact the rest of the business) or a functional capacity (internal expertise to use the product/service optimally). Many first time users of products and service depends on social networks to evaluate alternatives.

Fourthly, many services are not provided only by the private sector, but also by public providers and not-for-profit organizations (and even via networks). The more generic the service, the more likely that it wont succeed as a private service (because business typically pays for additionality, generic solutions can often be developed in-house (via hierarchy). Many “business services” in developed countries are provided by private, public, not-for-profit (networks) or hybrid models. Multilateral development organizations often promote “commercial” business services even when in their own countries these services are also available as public or hybrid services. Often services are first provided by the public sector, and the complimented by the private sector as demand becomes more specialized. Or services are provided by the private sector, until the public sector realize that it is in fact a public good or service and that it should in fact be provided by the state. But often, in the long run, products and services provided in the public sector are also provided in the private sector, and vice versa. The order depends not only on the context, but also on the dependency and interdependency of the markets, as well as the costs and efficiency of the alternative means of provision.

Lastly, in the words of Mark Granovetter, markets are deeply embedded within a societal context. Markets are part of the society, it reveals what a society values, how much it trusts, and how much it values people keeping their promises. You cannot isolate a market from the context, optimize it and then insert it back in the society. The societal context provides the trust, the enforcement and even information flows that makes it possible for markets to work. Out of this society a whole range of institutions emerge, some in the form of organizations, others in the form of norms, habits and routines.

During training sessions on how markets work, practitioners are often surprised to find out that markets are only one way a society allocates goods. The other way is through networks (often not in exchange of currency), or through hierarchies (organizations that allocate resources internally). When markets are new, they often emerge first as networks. Over time a group of people that know each other socially formalize their transactions, and out of this markets emerge. This is why we often advise practitioners that when one form of allocation fails, the solution is often to stimulate the others. So when a market fails, first try networks or hierarchies.

We often use a case study to illustrate the point. A service provided in one country by the private sector as a commercial service, is provided in another country as a public service. In a third country, the service is provided by an association as a network good. Pairs of practitioners from different countries then assess the three cases and must make a recommendation. It is quite funny to see how people from different parts of the world disagree on what constitutes a commercial service (market transaction), what constitutes a public good (allocation via hierarchy) and when a network transaction is better.

On the point of designing markets. While it is true that some markets are designed, these designs are often carefully planned and regulated. Think of mobile phone spectrum or broadcasting rights. It is not so easy to design markets that needs many actors to cooperate and that depends on many other variables that you cannot control through regulations. Even if you could use regulations, you might have the problem of not being able to change something if you need to.

In the end, markets learn and adapt. Actors in markets experiment, they learn from each other, and they adapt. This takes time, much longer than the life of a development programme. Ask yourself, why does a market for cigarettes develop in a prison within hours, but a market for tomatoes can take years? We have to understand the preconditions and the evolution of markets much better if we want to assist the evolution of societies and their markets.

To solve market failures, we often have to move one level up to where societies turn broad and generic policies about the society into organizations or targeted interventions. This may still mean working with the people doing the transactions to learn from them, but often the solutions will lie in institutions, policies and eventually maybe in regulations and standards.

There is more value to the value chain than adding value to products

I am supporting value chain practitioners in various programmes where I am coaching, teaching, supporting, pushing and pulling experts. This is one of the perks of my job as I get to look over the shoulders of practitioners working all around the world on commodity, agricultural, manufacturing and service value chains.

While marking some assignments for a course I am tutoring for the ILO I realized that many practitioners are trapped in a particular chain, just like the actors that they are trying to empower. With trapped, I mean that they are working with the actors and the chain for the benefit of the chain. They completely miss the broader impact of their work. (I know that this is often more the fault of the people who design programmes, more about this elsewhere in my blogs).

Let me explain.

For me a value chain is something we construct so that we can understand a part of a sub-system. If you are diagnosing a tomato value chain then it is true that you are getting a deeper understanding of the tomato system. But you are also gaining an insight into an agricultural system, a regional system of stakeholders and communities, but also an insight into the national or maybe even global economy. While some value chains exists in a very formal way, with contracts linking the different actors, most value chains can rather be described as temporary social phenomena. Temporary because they tend to change over time.

Back to my main argument. While it is true that value chains are known by their end products or markets, there is more to a value chain than just the conversion stages of a product/service. Value chains show us how an economic system works. It show us how responsive institutions and supporting organizations and indeed a whole society is towards economic activities of a certain kind. Value chains also tell us some fluffy yet important things about the society it is framed by. It tell us something about the social relations, the search costs (finding people to do business with), the social capital (how well we trust each other, how easily we collaborate), the enabling environment, and the returns on investment and effort in different parts of the system.

So if we find that tomato farmers are not very sophisticated, that they have poor market relations, that entry barriers are very low hence nobody has an incentive to invest, that suppliers are dishonest, that there are some new market niches developing but that nobody knows, that intermediaries have disproportionate power; I am not surprised at all. In fact, your findings are rather typical, even predictable in some sectors. What I am surprised by is if you treat this like it is a unique finding contained only to the tomato farming sector. The chance that these characteristics are contained only to those involved in the tomato chain is rather slim. This is the real risk of having a too narrow product focus.

Yes. Value chains are known by their end markets or products. But no, we are not locked into a product. We want to understand the system better so that we can support the emergence of institutions, market systems and interventions that make the whole system work better. Those issues that I outlined before in my tomato example can be verified in the sectors or crops around it. In my experience, many crops or business sectors sometimes have similar challenges. Therefore instead of trying to work at a low scale with some tomato farmers, you could possible be working with 10 crop types in a region, involving 1000s of farmers, and maybe a dozen supporting institutions. Few extension services for instance focus on one crop, they often handle a variety of crops, animals and markets. So you have to try and understand what each kind of economy activity (like farming with tomatoes) have in common with other business types or farms, and then what is unique. When you do this you often find that the actors in the chain have far more in common than the product or crop. They could all be equally unskilled, equally under-capitalised, equally vulnerable to market fluctuations, equally exposed to poor contract enforcement, or monopolies. This is how we get to real systemic interventions.

But the idea should never be to promote some products. This is the job of business people and entrepreneurs, not development practitioners. No, development practitioners should try to understand and strengthen the system. We make the features of the system that is overlooked or not visible to stakeholders more apparent. I also dislike it when practitioners start with an hypothesis that profit is unfairly distributed, or many of the other typical biases that exists in this field. The simple truth is that investments in economies flows to where there are (visible) returns. If it becomes more profitable to invest in retail than in manufacturing or farming, then this tells us something about the system. It is an important finding in itself which then allows us to ask the next question “how to make farming more profitable for investors (farmers and the poor are also investors)?”.

Your value chain has more value in it than the value added at each stage of the chain. What is valuable is the insight you are gaining about how a part of the economy works. Don’t become a product promoter. Be a system builder.

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