Market Failure in Theory and Practice

Zoé Hamstead

A central question in the study of public policy is: when should governments intervene? The view of welfare economics is that the presence of market failures rationalizes government intervention (Howlett & Ramesh, 2009). However, since some degree of market failure is always present and government’s ability to mitigate these failures is limited, welfare economists have also described a goods and services typology – based on varying degrees of exhaustiveness and exclusivity – to determine whether goods are best managed privately or publicly. In addition, decision types, with varying degrees of “collectiveness” of the deciders and “publicness” of those affected by the decision may bear on this question. According to Munger (2000), the government should be powerful enough to control actions which affect many people but restrained enough to avoid enforcing private choices. These deductive approaches begin with assumptions about the nature of goods and services and the functionality of governments, then apply these principles to hypothetical and real situations.

By contrast, recent empirical approaches have found that these typologies cannot consistently explain market failure nor government success in mitigating externalities. Zerbe and McCurdy (1999) argue that attempts to apply market failure diagnostic tools in public policy decisions are misguided because externalities are better defined by the transaction costs involved in their mitigation (if negative) or provision (if positive). If an externality exists, it is because transaction costs of eliminating it are at least as high as its cost to society. Classic examples of supposed market failure, such as free-rider problems associated with lighthouses, have, throughout history, been solved by a variety of institutional types with minimal government intervention. Using game theory experiments of collective action problems and empirical case studies of commons dilemmas, Ostrom has explored conditions under which people cooperate for a common good. Her experimental findings suggest that, contrary to welfare economy theory, the world is not comprised solely of rational egoists. There are also “conditional cooperators” who act for the common good, and “willing punishers” who shame non-cooperators (Ostrom, 2000). The degree to which commons scenarios become tragic depends on the relative proportion of these types, the characteristics of the good or service in question, as well as additional user characteristics and governance structure (Ostrom, 2009).

National resource management is a multidimensional commons dilemma in which resources are rarely delineated by jurisdictional boundaries. Users may have differential use rates and impacts, as well as differential incentives to maintain the quality or quantity of an open access good. An example of regional water quality management in North Carolina (NC), where a mixture of regulatory types are at play, can help demonstrate the role of market failure, collective action, and transaction costs in natural resource management.

Following roughly a century of water quality impairment, in 1997 the State devised a voluntary cap-and-trade mechanism to manage wastewater discharges of nitrogen in the Neuse River estuary. With very limited trading activity, by 2006 dischargers in the basin had reduced total nitrogen loading by more than double the State’s requirement. With the exception of setting the total discharge allocation for the group, the dischargers devised all rules of trading. Although it ostensibly formed in order to take advantage of a flexible compliance mechanism which could help some dischargers avoid costs and others earn rents, in practice the organization of dischargers functioned as a self-regulatory agency (Hamstead & Bendor, 2010), charging “non-compliers” by a system of graduated fines. In the eyes of the state, individual exceedences were not considered violations because the group as a whole remained within its total allocation. However, as a collective body, the association viewed individual exceedences as violations and used fines, peer pressure and information sharing to bring members into “compliance.”

Due to the non-excludable and exhaustive nature of the resource, the estuary may be defined as a classic example of a commons. However, the welfare economics approach does not explain dynamics involved in the policy’s success. The State’s overarching regulation was a necessary incentive for pollution reduction. Yet, the means through which overcompliance was achieved is related to user and resource characteristics; these facilitated collective action and self-regulatory practices. The design of graduated fines represents collective decision-making and norm formation by “wiling punishers.” When “violations” occurred, fines were aggregated and used for collective pollution reduction projects that would have been otherwise infeasible. Moreover, trusting relationships formed over time among utility managers facilitated information-sharing, technology-sharing and the articulation of a common purpose. These factors, alongside intimate knowledge of their challenges and abilities in improving water quality, allowed for avoided transaction costs in contrast with reduction strategies administered at a higher level. Well-defined user group boundaries, resource boundaries, monitoring ability, organizational legitimacy, and level of trust among participants, found to be associated with successful collective action (Ostrom, 2009), have all played a functional role in efficient pollution reduction. While Zerbe and McCurdy’s framing of commons dilemmas in terms of transaction costs is useful for understanding how the combination of regulatory and self-regulatory mechanisms played a role in the program’s success, Ostrom’s formulation of conditions under which collective action is possible helps explain the means through which transaction cost savings were achieved. We might then reframe the question as: How can government help facilitate the conditions under which externalities are managed effectively and efficiently?

Hamstead, Z. A., & Bendor, T. K. (2010). Overcompliance in water quality trading programs:  findings from a qualitative case study in North Carolina. Environment and Planning C:  Government and Policy, 28, 1–17.

Howlett, M., & Ramesh, M. (2009). Studying Public Policy: Policy Cycles and Policy Subsystems (3rd ed.). Oxford: Oxford University Press.

Munger, M. C. (2000). Analyzing Policy: Choices, Conflicts and Practices. New York, NY: W.W. Norton & Company, Inc.

Ostrom, E. (2009). A General Framework for Analyzing Sustainability of Social-Ecological Systems. Science, 325(5939), 419–422. doi:10.1126/science.1172133

Ostrom, E. (2000). Collective Action and the Evolution of Social Norms. Journal of Economic Perspectives, 14(3), 137–158. doi:10.1257/jep.14.3.137

Zerbe, R. O. J., & McCurdy, H. E. (1999). The Failure of Market Failure. Journal of Policy Analysis and Management, 18(4), 558–578.