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

[kevynjacobs.livejournal.com]

In other words, an unregulated free market is inherently unsustainable.

[snousle.livejournal.com]

Um, no, far from it, I am merely pointing out that some inefficiencies may be inevitable.

Incidentally, "free market" does not mean "unregulated". It is almost universally acknowledged, even among libertarians, that regulations are required to avoid coercion and monopoly formation.

[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

[danthered.livejournal.com]

I can't quite tell from this what you've posted if you accept or reject the notion that the market per se has agency.

[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?

[snousle.livejournal.com]

I'm not sure I understand the question. The "market" is just a list of things people are buying and selling and the prices at which the transactions occur. It's the people that make the decisions, the market merely pairs them up.

[danthered.livejournal.com]

Okay, yes, good, this is a "no, the market does not have agency" answer, and I agree with you — you are correctly using "the market <verb>s in response to <noun>" as shorthand for the buyers' and sellers' decisions and behaviour. Some people talk as though the market per se acts, reacts, behaves, etc., and some people actually believe it. They tend to be the ones who babble at length about the divine infallibility of the invisible hand of the free market unfettered by obtrusive government regulations, and so on.

[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.

[bbearseviltwin.livejournal.com]

sounds like a case of people forgetting that the map is NOT the territory

[gloeden.livejournal.com]

Yes, the situation happens. A perfect example would be pre-Dustbowl America.
Another exists or did exist in many rural societies in the Third World
The tendency to overfarm or to rely on crops that offer high reward but exhaust the land or lead to market instability has not been uncommon.
The same thing exists when countries willingly go into industrial production but make no provision for dealing with pollution or the destruction of the rural component of their country. Leading to high reward in the marketplace for their relatively cheap industrial products, but destabilize their environment and lead to inflation and urban blight.
So the reward, over time, is lost due to the high costs to the population in terms of bad living conditions and expensive imports to replace the lost agricultural component.
Another good example existed in the real estate boom in certain Asian countries. The profit reward was so great that overbuilding and scandalously easy credit meant that when the market collapsed, there was no way to mop up the damage. Rationally, there should have been controls or regulation. But greed makes bad economic actors of us all.

[gloeden.livejournal.com]

This tendency to think of markets in that way in a direct reflection of the Economics profession becoming more reliant on mathematical theorizing.
Psychological motivations and custom were removed in the name of scientific rigor.
There are those in the profession, including myself, who reject the purely mathematical approach. But we are definitely in the minority.

You forgot...

[ursine1.livejournal.com]

Another factor is the commissions that are also involved, so brokerages foster continual trading.

Chuck

"free market" does not mean "unregulated".

[ursine1.livejournal.com]

Incidentally, "free market" does not mean "unregulated". It is almost universally acknowledged, even among libertarians, that regulations are required to avoid coercion and monopoly formation.

I beg to disagree. "Free market means unfettered by regulation" is still being bandied about. Some claim that the current meltdown is due to governmental interference of the "free market".

Chuck

Another POV...

[ursine1.livejournal.com]

My son and I were talking about the causes of the current economic meltdown just yesterday. Specifically the banking sector. My son's hypothesis is that the business model for banks had changed. Traditionally bankers assessed the risks for loan at a local level. This meant that higher down payments and more stringent credit requirements were needed in order to secure a loan or mortgage. But the bank "held the paper", which means they took on the risk of default.

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