Market failures

[snousle]

I've been thinking about the subject of "market failure" lately, in particular a scenario that I haven't seen discussed anywhere before. Perhaps those who know something about economics can offer some comments.

Imagine that, in a certain market, wheat farmers can choose between two kinds of wheat. One costs $19 a ton to grow, and farmers sell it for $20 to get a $1 profit. Another kind only costs $18 a ton to grow, but is more sensitive - on average, one out of ten years, a heat wave kills the entire crop and the farmer gets nothing.

Farmers are tempted to grow the $18 dollar wheat, but in the long term it is unprofitable because of the crop failure risk, which wipes out any advantage of doubling their profit in the good years. However, if substantial numbers of farmers do grow the sensitive wheat in a gamble to extract short-term gain, their presence in the market drives down the price towards $19, so that farmers growing the robust wheat make no profit whatsoever and are either forced to gamble on the sensitive wheat themselves, or go out of business immediately.

In other words, because some farmers choose to take an unsustainable risk, all farmers are forced to do the same thing. Now, this is arguably not a market in which all actors are rational - but all markets have some irrational actors. So this seems like a fairly realistic, easy to understand system in which market failure is inevitable.

This might not be the best example, but I get a strong sense that the market does not deal very well with risk/profit tradeoffs - and maybe that's related to why the market in mortgage-backed securities got so completely out of control?

[Edit: The discussion has promopted me to ask a more precise question. Regardless of the price of wheat, growing the robust wheat is more profitable in the average year, while growing the fragile wheat is more profitable most years. When most people choose the higher likely return in preference to the higher average return, this is by definition a market failure, because the result is less efficient than the optimum. Does this situation ever actually occur? Does it, in fact, occur almost all the time, and drag down the whole economy by inviting major failures? That is the question.]

Comments

[bbearseviltwin.livejournal.com]

I realize that your example is extremely simplified for the sake of clarity but it doesn't take into account diversity. Not all farmers are going to be monocroping, doesn't make sense biologically or economically. In the example you used only the most foolish of the farmers would have had wheat as their only crop. Just to avoid the very scenario you described. Now of course with our current economic melt down that is a different situation entirely. To continue the farming metaphor, the farmers had pushed production beyond normal capacity on marginal crop land by using synthetic fertilizers. Suddenly these fertilizers are either not working or in the case of credit, no longer available. The price the farmer recieves has dropped below the profit level and they can no longer afford to buy it.
That is a bit of stretch but I hope you get the idea

[snousle.livejournal.com]

"Wheat" in this example is just a placeholder; I'm wondering if there are any general principles that describe the role of risk-taking in competitive environments. I'm not sure that diversity is a solution, because that's just another way of paying money to reduce risk; the situation that concerns me is where the market is inefficient because all the actors get forced into situations where they either lose money for sure, or are forced to take unsustainable risks in the hope of short term gain.

Another way of looking at it: suppose you had a slot machine where you could put in a $20 bill, and either it would give back $21 (say 90% of the time) or it would keep the whole thing. If you REALLY needed a dollar, the temptation to borrow $20 and get it for free would be very strong, because you'd probably succeed. But you couldn't make money this way over the long haul. Is playing that machine a "rational" choice, or not?

[bbearseviltwin.livejournal.com]

economics is a very complex subject and frankly seems to be more like art than science at lest to the laymen like myself. What I was trying to say is that your example only involves one factor, as does my introduction of diversity, all diversity does is reduce the risk. There are many other factors involved some of them not subject to being analyzed, such as in your example, the likelihood of unfavorable weather in any particular year. What it boils down to is a need to be able to know with some degree of certainty exactly what the risks are both long term and short term. Only then can you make a rational choice. In the slot machine situation, one has to figure the risk verses the rewards. A 90% chance of making a dollar against a 10% chance of loosing everything. Not a choice I would make.