Market failures
Oct. 25th, 2008 08:19 am![[personal profile]](https://www.dreamwidth.org/img/silk/identity/user.png){kind=small}
snousleI'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.]
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.]
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Another POV...
Date: 2008-10-26 09:59 am (UTC)Business models changed. The banks took on the rôle of loan broker and collecting a commission for making the loan to the borrower and then again when they sold the loan to another entity. So there was no long-term risk involved, they made money on the transactions.
So access to credit was "liberalized" and loans were made that would not have been made in the "traditional" environment. Of course banks also held some of the same "paper", they didn't sell all of it to those that "securitized", "commoditized" or otherwise resold "derivatives". All of which masked the underlying inherent risk of the original loan.
So when the defaults started cascading it affected not only the stocks and mutual funds who had bought the "risky paper", but also the banks themselves.
Since risk was not realistically accessed, there now is a lack of confidence in the stock market and banking sectors. This has caused the stock market to "tank" and become more volatile than normal. Investors don't know who to believe or to trust.
The solution, according to my son, is a return to a more traditional risk assessment of credit. Translated to consumers, that means the days of "easy credit" are over. It will take time for investors to regain trust in banks and the stock market. "Trust" is easy to lose and more difficult to regain. No one wants to take on an unknown level of risk.
So those who were involved in this fiasco believed that the increasing value of real-estate would continue indefinitely, further fueling this type of "growth". In my opinion, this was just not sustainable. Call it a "surge" or a "bubble", or what you will. At some point it was going to change direction.
Chuck