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.

Entrepreneurs and markets

While most entrepreneurs depend on functioning and competitive markets to survive, there are those entrepreneurs that actually thrive in imperfect markets. These are the entrepreneurs that creates a business around something like an information failure, high costs of finding suppliers or customers (brokering), or overcoming economies of scale (for instance by leasing expensive equipment on a pay-per-use basis).  Their services or products are valuable to the societies that they create their businesses in, as they overcome barriers to entry and barriers to upgrading. However, there are long term consequences to an economy that is riddled with market failures especially when these failures become very profitable for some. But more about that later.

Anecdotal evidence would suggest that entrepreneurs that exploit market failures to create new markets often earn disproportionate returns. They take huge risks as governments could address the market imperfection if it had the will, the competence and the resources to do so. Once these entrepreneurs are established they often have near monopoly market dominance. Unequal income for me is not such a big problem (it basically tells me there are many systemic failures), rather unequal opportunities is a much bigger issue as it is more widespread. For instance, can the cycle of inter-generational poverty be broken in a society? Can a child from a poor rural location one day choose to become a lawyer, engineer, or teacher; or are they trapped with few options? Is the society creating opportunities only for a few entrepreneurs that have connections and that can protect their interests, or are we creating markets where many entrepreneurs can compete in?

In a European country, with layers and layers of competition and market policies, most entrepreneurs compete on a more-or-less even playing field with markets that are carefully designed, or regulated as they emerge. In Africa, many entrepreneurs are competing in markets where government actually introduce imperfections, largely because markets and competition is not trusted (it is called the Law of Unintended Consequences). The situation is also made worse in that our market regulating and shaping institutions are often not resourced sufficiently and over-run with both creating market systems and coping with ongoing change.

How to overcome this situation?

Industrial policy in developing countries cannot be driven only from the perspective of trade and industry, as many other departments (or policy areas) are introducing market failures into the system in for instance health, education, science and agriculture. These conflicting policies then creates market imperfections that if exploited by a few entrepreneurs will lead to huge profits and a firm market footing. Society may benefit in the short term from a particular solution being available, but in the long term society may be stuck with a market that very quickly develops its own interests that may not necessarily be in the interests of the wider society.

Furthermore, market institutions must recognize and identify the patterns that plays out repeatedly in a society, and try to address these. We should not celebrate when one entrepreneur jumps on an opportunity (although this is still better that nothing). We should celebrate when many entrepreneurs are crowded into a market. I don’t know whether it is naive to ask policy makers to also think about the unintended consequences of their decisions. This is the reason why we’ve had to delve into complexity theories to try and curb the damage being done by well-intended policies.

If we do not succeed in building the right market systems that are based on fair competition we will forever be creating opportunities just for a few entrepreneurs. In the meantime, we depend on a few entrepreneurs that combine intelligence about an opportunity with the right resources and the right competences.

Book announcement: Understanding Market Failures in an Economic Development Context

This is the long awaited book on Market Failures. The cover page illustration of the hard copy is by Lina Stamer and is an image that I use when I present the popular training session on how to address market failure in a practical way.

The book is available for free as a E-book, or a paperback edition can be ordered here. More books are available on the Mesopartner online bookstore.

The official description of this publication is:

Many development practitioners are familiar with the phrase “market failure”. However, not many people relate to the topic in a practical sense. Many remember boring lectures in universities where market failures were presented as abstract theoretical concepts in economics 101. In this book, Dr. Shawn Cunningham takes a perspective that the clues to begin to address market failures are in the world around us. He argues that the characteristics attributed to each market failure by clever scholars actually provide some clues to development practitioners about ways in which to address the imperfections that hinders market based transactions. Shawn also argues that market failures cannot be addressed by business management principles, and that typical market research instruments will provide little information on how to make a market system where there is demand, supply and supporting institutions work better

Some market related reading

Thank you all for the comments and e-mails on my previous posting regarding markets. I promise to continue that thread in a few days time.

Here are some of my favourite books on markets!

To read more about market systems, their histories, and a broad overview of the topic, start with Reinventing the bazaar: a natural history of markets by John McMillan. Other authors that have helped to popularise the topic are Levitt and Dubner with their Freakonomics books, or Tim Harford with The Undercover Economist. For the more serious readers, take a look at John Kay’s Culture and prosperity: the truth about markets: why some nations are rich but most remain poor or Lindblom’s The market system: what it is, how it works, and what to make of it.

All of these and other books are available on our Amazon storefront!

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Market failure or marketing failure, or just old ideas under new labels

I am often stunned at how development agencies and practitioners justify their interventions to support enterprises as “overcoming market failure”. To me it seems there is a huge misunderstanding of what a market failure is, and how one can intervene to overcome the under-performance of markets. Over the last 8 years I have done intensive research into market failures, so let me do some copying and pasting from my thesis (Cunningham, 2009). The sarcastic comments where of course added in today ;-). Sorry Anja and Lucho, this is not the summarised version yet.

Here is the theory part….

Although economists describe perfectly competitive markets, in the real world markets do not always perform perfectly or optimally. When markets do not perform in an optimal way economists refer to the situation as a “market failure”. The MacMillan Dictionary (1986) describes market failure as “The inability of a system of private markets to provide certain goods either at all or at the most desirable or ‘optimal’ level”. Reference is made to the allocation of resources not being at the desired or optimal level. Samuelson and Nordhaus (1992:741) define a market failure as “An imperfection in a price system that prevents an efficient allocation of resources”. In this definition reference is made to the importance of the price system being able to reflect the true costs and value of a product, with natural monopoly, imperfect competition, asymmetry of information and externalities cited as examples.

Market failures are often visible in the forms of the growth of monopolistic firms and other non-competitive organisations, and when factors of production stand idle or certain kinds of opportunities are not pursued by business. Markets also fail when externalities such as water and air pollution are not included in their costs by firms, so that they make private profit at the cost of society. Roberts and Boudreaux (2007) explain that when a market fails this is effectively caused by failures in the institutional arrangements that support the market.

What this means in practice

Thus addressing market failure is about getting markets to perform more efficiently or optimally in the way that resources are allocated or decisions made regarding the production of goods and services. While certain interventions will be aimed directly at the market, other interventions are needed at the institutional level, and only some will be aimed directly at enterprises.

So a quick test here would be for you to check how much time you are spending working with enterprises, and how much time on market systems and the supporting institutions (which could be organisations, but mostly means far more than this).

It takes time. Lots of it.

At this point it is important to realise that it takes demand and supply some time to find the right signals such as price. Unfortunately us development practitioners don’t like this part, but it can take a long time (sometimes a decade) for a market to figure out what the main drivers are (price, quality, value, etc). In a healthy market there is a range of product offerings at different prices targeting different customer profiles. These offerings may have very little relationship with the original products and firms that created the market in the first place.

So it takes time, that is why a market can be described as a dynamic system with feedback loops.

“But firms dont know what to produce or who to sell to – there is a market failure!”

This argument is held forward mainly by small enterprise development practitioners, although even academics in business schools sometimes argue that you can solve a market failure through better marketing.

It is important to distinguish between the economics concept of market failure, and the business management result of a marketing failure. In marketing management literature a marketing failure implies that a firm has made a poor judgement in its marketing strategy, or that marketers have failed to understand that marketing should not be seen as a functional discipline but as an integrative business process. When firms fail to capture a market share due to poor marketing strategies, this can be referred to as a marketing failure. The solution too marketing failure is not in economics or sociology, but in better business management.

The verdict

So how can a development practitioner claim to assist in overcoming market failure by assisting a firm to write a business plan, or by helping a firm to find a venture partner or a new customer? Or how can a university justify developing a product for a firm using state funds in order to overcome market failure.That is just bad development practice. Even if you could somehow justify these interventions on some sub-clause somehow related to a market failure, it remains highly un-systemic and the “failure” will persist.

Recycling old ideas under new labels

I suspect that despite huge international policy pressure for development programmes to address market failure, many practitioners are simply recycling their old tools like poverty alleviation and small enterprises development under new labels.

Perhaps it is best if  you just call what you are doing marketing and business management support, then at least you can refer to a whole pile of business management books.

PS.

Bear in mind there is a whole group of people that dispute that market failures even exist (I even agree with many of their arguments), as well as many groups that believe that markets are evil and should not exist (I agree that markets ARE NOT ALWAYS the best transaction mechanism). But let us leave something for another day.

References:

CUNNINGHAM, S. 2009. The role of market failure in the utilisation of Quality Management services by the tooling industry. Ph.D Thesis, North West University,

PEARCE, D.W. 1986.  Market Failure. In Macmillan dictionary of modern economics. Pearce, D.W. (Ed.).

ROBERTS, R. & BOUDREAUX, D. 2007.  Boudreaux on market failure, government failure and the economics of antitrust regulation. In Library of Economics and Liberty – EconTalk.  Liberty Fund, Inc., Indianapolis, IN. [Web]  http://www.econtalk.org//archives/2007/10/boudreaux_on_ma.html [Date of access: 2 February 2009].

SAMUELSON, P.A. & NORDHAUS, W.D. 1992.  Economics. 14th ed. New York, NY: McGraw-Hill.

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