Marshall McLuhan said, “the medium is the message.” But economists say, “the price is the message.”
The penultimate chapter of our Econ 101 textbook is all about market failures, and the ways market participants or the government can shift costs and maintain a successful market.
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Key takeaways
This chapter starts by explaining the “magic of the market,” a way to look at the stuff around you a little differently.
Uncertainty gripped the oil market when Russia invaded Ukraine in 2022. Energy embargoes threatened to make crude oil more scarce, so prices rose to account for lower supply. Refiners then passed their higher costs to consumers, pushing the average gas price in the U.S. above $4 a gallon. That pain at the pump may have made someone consider public transit or a switch to an electric car if they could afford it, even if they didn’t follow the news and didn’t understand why prices went up.
In this way, markets convey important economic information through prices. When they’re working right, all participants are motivated to adjust their behavior in ways that make themselves better off. The book cites economist and thinker Friedrich Hayek, who compared the market to a supercomputer that takes in information and sets prices: “The remarkable thing about this massive computational device is that it’s not really a machine at all. Nobody designed it, and nobody is at the controls.”
Kind of a trip! We also learned what happens when markets fail, calling for public policy solutions or, in some cases, private bargaining. That’s because these interactions don’t happen in a vacuum, there are external costs that aren’t borne by the buyer or seller.
Think about the pollution your combustion engine puts in the air, for example. Beyond your price at the pump, you won’t pay for the effect your carbon emissions have on society.
There are lots of ways markets lead to inefficient outcomes that leave some people worse off than they could be. But how do we fix these failed markets? First, we have to get a handle on those costs.
👆 This example from the book is focused on fishermen downstream from a banana plantation. The plantation uses pesticide, and the runoff poisons the fish. More bananas produced per year means more pesticide and a higher cost borne by fishermen, but the growers have set banana prices and production levels based on their own costs alone.
How could we fix this? Maybe the farmers negotiate a way compensate fishermen, or the government imposes a tax on bananas. In either case, the growers should adjust their price or production levels in a way that minimizes the costs imposed on fishermen.
There are a few levers governments can pull to address market failures. The book lays these options out in a handy grid.
Going back to our car example above, you could avoid pain at the pump and reduce your carbon footprint by purchasing an electric vehicle. But they’re expensive, so the government offers subsidies to lower the total cost to encourage buyers. When those subsidies went into effect, Tesla lowered its prices to make more vehicles eligible, sending its own message to competitors entering the space.
Now, insuring that car is a whole other case of market failure, but we’ll talk more about that below.
Important definitions
Social dilemma: A situation in which individual actions, by companies or people in a market, can lead to inefficient outcomes, worse than if everyone had worked together.
External effect: When a given action imposes costs or benefits on an outside party, not considered by the person taking the action. These effects can often lead to market failure.
More from the show
Asymmetric information can lead to conflicts of interest and market failure, and we see that a lot in the insurance market. Just look at this scene from “Seinfeld.” But moral hazard happens all over the place, even contributing to 2023’s historic bank failures.