Market failures, Behavioral Economics and Value.

Today, let’s analyze the issue of market failures.

First of all, what is a market failure? An easy way to define it is to say that, a market failure, is what happens when a free market, does not deliver the most efficient allocation of resources. Why could this happen?

There are many possibilities; asymmetric information, lack of, or loosely defined property rights, the case of public goods… Most noticeably now, with the emergence of behavioural economics, we may even list “irrational consumers” as a market failure.

This is a very interesting issue, which Ariely talks about extensively in his many books.

The premise is, that if consumers are irrational, we cannot expect markets to be “perfect” in the classical sense. This leads us to ask many questions such as: How irrational can we be? Why are we irrational? And, should we implement policies to prevent irrationality in markets?

The quick answer to the latter question, is more or less no, but let’s elaborate.

First of all, what do we define as irrationality? Is, for example, buying expensive brands, yet equally good to other products irrational? The key to understanding this, is to understand how we measure value.

Value, is a very complex issue, and this falls under the study of behavioral economics. We know that since we are rational, we choose higher value to lower value when possible. But the question of how we construct this value is altogether much more abstract and complex, and indeed, includes many elements which escape rationality, such as genetics, circumstantial phenomena, and the role of society, as opposed to individuals, as a judge of value for many things.

Its easier seen with some illustrative examples. Think for example of paintings and artwork, it’s clear that valuations can be very subjective. Now how about something more common. Bottled water. Why do so many people prefer bottled water over tap water? Does it taste better? Is it cleaner? More nutritious? These are the reasons most people would give when asked the question. Surprisingly, or perhaps not, the fact is that in most cases, neither of the above mentioned reasons is objectively true.

Objectively, all water tastes the same, but that doesn’t stop people from  believing the opposite, and saying that they notice the difference, moreover, they probably DO taste a difference, or at least feel a difference, for why else would they purchase the bottled water?

The same applies to a study conducted with Coke and Pepsi. When asked to taste and rate the two drinks, blindfolded, most people chose Pepsi over Coke. However, when the drinking and rating was done openly, the people knew which was the Coke and which was the Pepsi, Coke won overwhelmingly.

What does this tell us? Are people lying about their preferences? Have they been brainwashed by CocaCola advertising? The answers, are much more complex than that.

The main point to extrapolate from here, is that value is complex, and what at first hand might seem irrational, is more often than not perfectly rational, though the why is what escapes us.

So do market failures exist? Indeed they do. Do they justify the high levels of regulation and intervention? 99% of the time they don’t.

More often than not, market failures can be addressed by the market itself, in the form of providing incentives to change the way the market works. In reality, there is no such thing as “perfect” markets, or “perfect” competition. Rather, what exists is a continuing process of perfection, so we should be talking really of perfecting markets. Most of the time, this process is inhibited by institutional barriers, which is in itself a failure of the “market” for politics and law.

Indeed, a failure of the political system should be unsurprising to behavioral economists, since the irrational market participants, are also the same who form the irrational electorate. Unlike in free markets, however, it’s rare that these problems will be addressed due to weak incentives by both voters and politicians.

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