Markets Never Fail

8/2/2019 Markets Never Fail

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Markets Never Fail

Fred E. FoldvaryDept. of Economics, Santa Clara [email protected]

Session 6.4: The State Versus the Market, IAPEE Conference, Las Vegas, April 4, 2006"Private Solutions to Market Failures: Is Government Always the Answer?"

Abstract

Mainstream allegations of market failure are based on misunderstandings of markets,governance, and ethics. This paper dissects the categories of alleged market failure:

externalities, public goods, market structures, asymmetries, irrational behavior,injustice, and lack of sustainability. The analysis reveals that none of thesephenomena contain any inherent market failures...........................................................................................................................................................

Almost all economists believe in the doctrine of market failure. Every widely-usedtextbook of economics presents the doctrine that markets fail. The mainstream viewin economics is that an economy with "perfect competition" would be efficient, butthe real world has no perfect competition, and market outcomes are inequitable, somarket failure is ubiquitous. Markets always fail, and the only issue to be discussed isthe degree of failure. That degree, it is said, is especially severe in the case of publicgoods, externalities, informational asymmetries, and economic justice.

The meaning of "market failure"

Market failure is distinct from entrepreneurial failure and human failure (such as dueto bounded cognition). Market failure is a systemic inability of voluntary economicdynamics to provide the ends desired by the public, systemic meaning a failure whichis economy-wide and persists over time due to the inherent structure of free markets.

The three ends desired by the public can be categorized as efficiency, equity, andsustainability. Efficiency in this context means that the market provides the goodswhich people demand at prices that cover all the long-run marginal costs, with thecosts borne by those using the good. Sustainability means that the global economycan be expected to provide at least the current standard of living indefinitely.

The full meaning of market failure requires a clear understanding of the meaning ofthe "market." The textbooks and academic literature seldom venture into what


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"market" means. A "market" is usually defined vaguely as a context in which there isbuying and selling, or hiring and renting. The term "free market" is usually leftundefined, and implicitly treated as a synonym for "market."

The concept of a market economy has meaning in contrast with a non-market

economy. The logical contrast is with coercive harm. A pure free market is aneconomy in which all human action is voluntary. Any involuntary action, inflictingcoercive harm, is therefore outside the market. The two sets of agents which applycoercive harm are private thieves and governmental officials.

Market failure is therefore the failure of a free market, rather than a market afflictedby governmental or private coercion. When slaves are bought and sold, or rented,there is a market, but not a free market, and the distress is not a "market" failure.

But it is not sufficient to say that a free market consists of voluntary production,

exchange, and consumption. This brings the analysis to a deeper level, as we need tounderstand what it means for human action to be voluntary.

As Jack High has pointed out, "voluntary" action implies an ethical rule by which someacts are morally permitted and other acts, the involuntary ones, are morally evil andthus prohibited (High, 1985). To have a universal meaning of voluntary action, andthus of the market, this moral standard must itself be universally applicable tohumanity. This universal ethic would be a natural moral law, based on human naturerather than any cultural practice or personal viewpoint.

John Locke (1690) described natural moral law as being derived from two premises,biological independence and human equality. Independence is the biological fact thathuman beings think and feel as individuals. Equality is the proposition that there isnothing in human biology that entitles one set of human beings to be masters overanother set which has slaves.

A unique universal ethic can be derived from these premises (Foldvary, 1980). Theuniversal ethic has three basic rules:

1. Acts which have welcomed benefits are good.2. Acts which coercively harm others by initiating an invasion, are evil.3. All other acts are neutral.

In this context, the term "harm" is distinguished from a mere offence. In an offence,the distress is due solely to the beliefs and values of the person affected. In contrast,coercive harm involves an invasion, an unwelcome penetration into the legitimatedomain of the victim. So if a person is offended by what someone says, this is due to


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his beliefs and values; this act is not coercively harmful, and is designated as morallyneutral by the universal ethic.

The universal ethic also provides a meaning for moral rights and liberty. A moral rightto X means that the negation of X is morally evil. For example, a person has a moral

right to possess a car because the negation of that possession, i.e. theft, is morallyevil. Since the universal ethic is the expression of natural moral law, the moral rightsbased on the u.e. can be called "natural rights." Society then has complete libertywhen its laws are based solely on the universal ethic, with legal rights congruent withnatural rights.

The natural rights to property begin with one's own body and life. The right to one'sperson then endows the person with a right to his labor, which implies a right to thewages of his labor and the products of labor.

The universal ethic can now be applied to give meaning to the concepts "voluntary"and "intervention." An act is voluntary if it is either morally good or neutral. An"intervention" is defined here as an act which changes what voluntary action wouldotherwise do. Governance is morally proper when it acts as an agent of the universalethic, prohibiting and penalizing evil acts, but not intervening into peaceful andhonest action. The pure free market is defined as an economy in which there is nogovernmental intervention, and in which private coercive harm is effectivelyprohibited and penalized.

Negative externalities

Every economics textbook I have examined depicts negative externalities as a marketfailure. Markets allegedly fail because a social cost such as pollution or congestion isimposed on persons and not on those who buy or rent the product. But by theuniversal ethic, pollution which invades the property of others is an act which ismorally wrong and outside the market. The pollution of other people's property is atrespass which, in a free market, requires compensation. This compensationinternalizes the cost, eliminating the externality.

The optimal amount of pollution is not zero, but that amount for which the marginalcost of eliminating pollution equals the marginal benefit of less pollution. Normally,the cost of reducing more pollution rises as more pollution is reduced, and the socialbenefit of eliminating more pollution declines with greater reduction. When polluterscompensate others for the damage, then the optimal amount of pollution will tend totake place, as a polluter will weigh the cost of compensation with the cost of pollutionreduction. If the transaction costs are low, the affected parties can negotiate anefficient outcome. If there are too many persons affected for negotiations to beeffective, then government, acting as an agent for the people, can levy a pollutioncharge equal, so far as can be measured, to the social cost. Such a charge does not


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correct a market failure, but rather enhances the market by preventing trespass.Excessive pollution is therefore not a market failure, but a government failure, thefailure by government to enforce the property rights of the victims of pollution.

The same analysis applies to congestion externalities. If a large store opens in a

neighborhood and there is increased traffic and more congestion, the market has notfailed. If the streets were privately owned, the owners would see a profit opportunityand charge higher tolls. If the streets are owned by the government, then congestionimplies a failure to charge a toll sufficient to eliminate the congestion. In a congestedhighway or street, each car imposes a negative externality on the other drivers byincreasing the crowding. A toll just high enough to eliminate the congestion istherefore like a pollution charge, and prevents rather than corrects an externality. If aprivate owner of a highway fails to apply a congestion charge, this is anentrepreneurial failure, since there is no systemic reason to not apply the charge.

Positive externalities

Market failure is also alleged when the externalities are positive, people receivingbenefits which they do not pay for. The allegation is that there are fewer beautifulfront-yard gardens because the owner is not compensated for benefitting hisneighborhood, when folks would pay to have more of this beauty, but don't becausethey can be free riders.

The retort that government correction would be worse does not eliminate theproposition of market failure. Clearly, this is a systemic situation, and can be non-trivial. Also, the fact that some benefits are provided even when they receive no

compensation does not eliminate the proposition that if people could be made to payfor additional benefits, they would pay, but they cannot be made to pay in a marketcontext, and so the market fails to provide goods for which there is a demand.

Suppose the government could determine what each neighbor would pay to havemore beauty, and charges them for that. The charge would not be an intervention,since that is what the person is willing to pay. But in fact there is no way to find outthe subjective values people have for more beauty, and to also charge them thatamount. It is possible to reveal the amounts people would pay if the actual paymentis determined independently of their stated values, a process called "demandrevelation" by which a person whose stated value changes the outcome pays thesocial costs of doing so (Tideman and Tullock, 1976). But people can lie if the amountthey pay depends on their stated values. Since the externality cannot possibly beeliminated, then the market cannot fail, since failure needs to be defined in a real-world context. The inability to do what is impossible cannot be designated a "failure."One can only fail if it is hypothetically possible to succeed.


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Moreover, one cannot ascribe market failure to today's significant positiveexternalities, because no economy today is a pure free market. Governance in a purefree market would be contractual rather than imposed on people who are not harmingothers (Foldvary, 1994). Contractual governance would be both greater and lesserthan government is today. It would be lesser, because it would not impose taxes andrestrictions on peaceful and honest human action. It would be greater, because a

contractual agreement would provide rules that would be considered discriminatoryby democratic government today. For example, today there are retirementcommunities that require minimum age limits for residency, something nogovernment today could require. A marriage is a type of contractual governance inwhich the parties agree to provide each other with positive effects, whichgovernmental law would not require.

The covenants, bylaws, and deeds of private communities can and do deal withpositive and negative externalities. They can require people to have well-kept frontlawns. Likewise, a night club can have a dress-code, enhancing the positiveexternality of nicely-attired attendees and avoiding the negative externality of having

to look at slobs. Thus, when a potential externality (such as the color of the exterior ofa house) is regarded by the community as significant, it can be mandated in itscovenants. People can then move into communities with the covenants they prefer.Contractual governance can thus provide for positive externalities, and if peopleconsider them important enough, there will be communities that require these.

The voluntariness of such communities exits at the level of choosing to join it. Onceone is a member, then there may be rules which they may not like, but they acceptthem as part of a package that provides for greater benefits than if they were notmembers.

There is therefore no systemic failure by markets to provide positive externalities.Some external benefits are provided even without compensation. Others arecompensated or provided by contract. The fact that would be more positiveexternalities if we could determine all subjective values is not a market failure if thisdetermination is biologically impossible.

Excludable public goods

The next allegation of market failure concerns collective goods. Almost all textbooksand economists claim that markets fail to provide sufficient public goods because offree riders who cannot be made to pay.

Public or collective goods are nonrival, in contrast to "private" goods for which thegreater use by one person implies less for others. With collective goods, each personuses the entire good, and is not affected by others who use it, such as watching amovie in an uncongested and quiet theater. Some economists define "public goods"


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as also being nonexcludable. However, Paul Samuelson's (1954) landmark paper onpublic goods defined only two classes of goods, public and private, the latteroccurring when the total amount equals the sum of the individually consumedquantities, as with rival goods. Good which are both excludable and nonrival arecalled "club goods."

Markets do not fail to provide club goods, because exclusion implies the ability tocharge for entry and for continuing use. Almost all goods and services provided bygovernment are excludable. A highway is excludable, as reckless drivers are stoppedand expelled. Many governmental services are excludable by proximity; aneighborhood park is used mostly by the residents of the neighborhood, others beingexcluded by the transportation cost. Even national defense is excludable, as thoseoutside the country are excluded from the protection, and those who enter illegallycan be deported.

Most public goods provided by government are territorial, and to the extent these are

wanted services, they become capitalized into higher land values and land rentals.This extra rent provides the means to finance the goods, the optimal quantity beingthe amounts for which the marginal rent generated equals the marginal cost of thepublic good. The rent is a private good, the total rent being the sum of the individualrents. Thus when a private agent can collect the rent, the rent provides the means forprivate-sector provision (Foldvary, 1994).

Nonexcludable collective goods

Market-failure advocates seem to have a stronger case for non-excludable public

goods. For example, basic research can benefit society as a whole, and once theknowledge becomes public, it becomes non-excludable. One can well argue thateducation and the alleviation of poverty benefits society overall, not just thoseimmediately affected, and these benefits are non-excludable. These benefits also fallinto the class of positive externalities. Being non-excludable, the public benefits aregreater than those obtained by the contracting parties.

The market-failure argument for non-excludable public goods and positiveexternalities presumes that people are narrowly self-interested, so they will choose tobe free riders. But in fact, human beings have two basic motivations: self-interest,and sympathy.

In The Theory of Moral Sentiments (1790), Adam Smith wrote: "How selfish soeverman may be supposed, there are evidently some principles in his nature, whichinterest him in the fortune of others, and render their happiness necessary to him,though he derives nothing from it except the pleasure in seeing it" (p. 9). Theseprinciples are manifested in "sympathy," a feeling of affinity, solidarity, accord,generosity, and empathy with a person, group, culture, organization, or other entity.


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"Nature, therefore, exhorts mankind to acts of beneficence, by the pleasingconsciousness of deserved reward" (p. 86). Sympathy can apply to an idea or project,like a religion, wildlife conservation, or helping the needy.

Henry George (1879, 462) stated similarly, "If you would move men to action, to what

shall you appeal? Not to their pockets, but to their patriotism; not to selfishness, butto sympathy. Self-interest is, as it were, a mechanical force - potent, it is true;capable of large and wide results. But there is in human nature what may be likenedto a chemical force; which melts and fuses and overwhelms; to which nothing seemsimpossible. 'All that a man hath will he give for his life' [Job 2:4] - that is self-interest.But in loyalty to higher impulses men will give even life."

There are also of course self-interested motivations for donating benefits. A donormay seek the prestige that comes from being recognized as a philanthropist. Anothermotivation is a sense of moral duty. The dutiful and prestige-seeking motivations arecomplementary to the sympathetic motives, so the self-interested motivations arealso worth cultivating. Benevolent sympathy overcomes the problem of free ridersunable to cooperate in the provision of a non-excludable public good. If a person has

benevolent sympathy for a community and its goods, he will not wish to free ride; theact of contributing itself provides satisfaction, or even joy.

Sympathy is generated by social entrepreneurship. A philanthropist might not onlyprovide charity but also stimulate others to give. He creates institutions - traditions,festivals, symbols, organizations, - that elicit greater sympathy from a commmunity.Benevolent giving is also promoted by mutual-aid fraternal societies, many of whichflourished during the 1800s and early 1900s, before they became preempted bygovernmental programs (Beito, 2002).

If such sympathy is lacking, this implies that the public does not value the activitythat highly. The lack of provision is not a market failure if people do not value theprovision. Moreover, a lack of private-sector provision today may be due tointerventions that prevent firms from acting jointly. For example, joint basic researchmay be inhibited if not explicitly prevented by anti-trust laws, and there are in facttrade associations which promote mutually beneficial activities, to the extentpermissible without violating anti-monopoly laws. The benefits of belonging to tradeassociations can induce the members to avoid being free riders.

The argument for market failure for non-excludable public goods and positiveexternalities therefore has to explain why mutual aid and sympathy would fail toprovide the public goods wanted by the public. It is not sufficient to merely assumethat the only motivation is narrow self-interest, because there is in fact abundantcharitable and philanthropic giving. Would anyone argue that there the amount ofchurches is insufficient? There are numerous churches of many denominations in allAmerican cities, where the financing is private.


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The case for market failure in the provision of non-excludable public goods itself failsby assuming deficient amounts of sympathetic provision, when it is that verysympathy that implies public demand.

Market failure for imperfect competition and monopoly

The neoclassical-economics benchmark for market efficiency is perfect competition,with many tiny firms producing an identical product. The efficiency comes from eachfirm being a price taker, selling all its output at the market price, and therefore theprofit-maximizing quantity is that for which price equal the marginal cost. Ease ofentry and exit induce zero economic profits, so the price is also the minimum averagecost. Government can do nothing to improve this outcome.

The market-failure doctrine alleges that when competition is imperfect or non-existent, the price is above marginal cost, and the market fails to be maximally

efficient. But economics analysts seldom explain the meaning of "perfect" and"competition." The term "competition" in this context does not mean "rivalry," butrather "the absence of pricing power." "Perfect" does not mean ideal or desirable, butrather "complete." "Perfect competition" thus means nothing more than the completeabsence of pricing power. In "imperfect competition," there is some pricing power;there is no inherent implication that such a market structure is bad.

In monopolistic competition, there are many small firms, but they producedifferentiated products, so each firm confronts a declining demand curve. Eventhough making no economic profit in the long run, the firm produces at a pricegreater than its marginal cost, a situation with excess capacity, as each firm could

produce more at a lower average cost, but at a quantity greater than that whichmaximizes profit. Moreover, product variety induces competition by advertising,adding to the costs of production, cost which often merely induce customers to switchbrands.

However, the greater cost of goods relative to if the industry had one identicalproduct is offset by the value people place on product variety. Since product varietyhas a benefit, its absence has a social cost. Including the marginal social cost ofeliminating differentiated products, the price of a good in monopolistic competition isnot necessarily above its social marginal cost. Moreover, the advertising financespublic-goods media such as television.

An oligopoly being an industry with a few firms, not only is the price above marginalcost, but there can be lasting economic profits not to due entrepreneurial innovationbut to the cost of entry. Economic profit as such is not a social cost and thus not anindication of market failure. The social cost is the reduction in quantity relative to agreater number of firms.


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But an industry with a few firms implies economies of scale that lower average costwith increasing size. The public would not benefit from splitting up the firms, as thiswould increase average cost. But market-failure advocates could argue in favor ofgovernment intervention to set the price at marginal cost, increasing quantity relativeto the profit-maximizing quantity.

But such a policy would need to consider the market as global rather than national.For example, the U.S. automobile industry has only a few firms, but the planet hasmany car makers. Moreover, with technological products, competitive advantagerequires continuous innovation, which requires investment. Price fixing and lowerprofits can lead to the social cost of less technological and marketing progress. Onlywhen the oligopoly involves the value of natural resources such as oil is there a casefor the price and the profit not being a result of entrepreneurship. (Natural resourcesare examined below). Thus the mere existence of oligopoly is therefore notnecessarily a market failure, when all social costs are taken into account.

In the case of monopoly, the case for market failure depends on the cause of themonopoly. Clearly, monopolies due to governmental restrictions on competition arenot market failures. Copyrights and patents confer monopoly privileges which may be

justified by inducing creation and discovery; a consideration of such intellectualproperty is beyond the scope of this paper. Franchises such as local cable servicesare monopolies whose failures are due to the governmental protection fromcompetition.

Another source of monopoly is collusion among oligopolists. Such collusion is illegal inthe United States. Would such collusion be a market failure? Economic theory as well

as historical evidence tells us that such collusion often breaks down as there is anincentive to cheat by providing more at a lower price, until the others also lower theirprices.

But suppose the cartel does not break down or there is a dominant firm. If the productis not a natural resource, then an economic profit is an inducement for competitors toenter, if the fixed cost is not prohibitive. It may take some time, but eventually, forexample, alternative products will appear if users are not satisfied with the dominantproduct such as a computer operating system.Moreover, as technology advances, the new versions compete with the prior versions,and high prices prevent users from buying the new versions. Thus overall, the mereexistence of dominant firms does not necessarily indicate that the public is worse off.

If there is a large fixed cost and a small marginal cost, then the firm is a naturalmonopoly, and there may not be any actual or potential competition. Advancingtechnology is making industries such as electricity and even water provision lessnaturally monopolistic (Foldvary and Klein, 2003). At any rate, if a resource such aswater is a natural monopoly, the market does not necessarily involve a monopoly


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exploiting the users by charging more than average cost. Another possibility is thathomeowner associations and other private communities would jointly own the watercompany.

As analyzed by Oliver Williamson (1985), asset specificity, the specialized use of

assets not easily transferable to other uses, determines the contracting process. Ifthere is little asset specificity, competitive market contracting is effective. With highasset specificity, governance within an organization is efficacious as agentseconomize on bounded cognition while protecting themselves against opportunism. Ifa community is dependent on a particular natural monopoly, its incentive will be toown it. Vertical and horizontal integration prevent the problem of natural monopoly,which is why residential associations own their own streets and transit services.House owners also own their back yards rather than rent them, to prevent payingmonopoly prices. Therefore, the mere potential of monopoly does not inherentlyimply market failure.

Finally, some have pointed to network externalities as a possible market failure, as aninferior product can become established and then becomes difficult to replace. This isthe strongest argument in favor of market failure, but it is much stronger in social andcultural spheres than in the commercial realm. As Israel Kirzner has argued, in thecommercial context, there is a profit opportunity for entrepreneurs to innovate andmarket better products, overcoming or adapting to the older networks. For example,Apple computer has made its computer compatible with the PC format.

But, as Kirzner also argues, in the social and cultural sphere, less efficient patternscan persist, such as the irregularity of English-language spelling, when considerednarrowly. The English language would be even more efficient if everybody spoke

Esperanto, a constructed language with no irregularities. But giving up traditionallanguage and spelling would amount to losing part of our cultural heritage, so eventhere, it is not clear that there is a market failure to replace the network.Measurement would be more efficient in the metric system, yet the USA persists inusing traditional inches and pounds; but these traditional measures could be morefitted to usual human usages. Swimming would be less costly if people swam nude,but it would cause distress to most people. Thus there are social costs in culturalchange.

There is, however, one area where the market does fail. When there is a dictator, themarket will usually fail to overthrow him. Those who are brave enough to oppose himwill be killed, or suffer terribly. So the proposition is not that markets always succeedin everything, but that markets do not fail to provide wanted services in the contextof a pure free market. When there are interventions, then markets may not succeedin eliminating them.

Informational asymmetry


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Another allegation of market failure invokes asymmetries of information, where oneparty is much better informed than the other, such as when someone has his carrepaired. The first line of defense against market failure from this source is theprohibition of fraud, since fraud is a type of theft, and is outside the market. In aproper contract, all parties are competent and informed about the terms. Caveat

emptor should apply when the buyer has more knowledge of his usage, but caveatvenditor should apply when the seller has better information.

Moreover, reputation is an effective antidote to lack of knowledge. One may not knowmuch about cars, but one can have confidence the company providing the services.

The market also provides sources of information, from publications such asConsumers Reports to organizations such as the Better Business Bureau, to theInternet.

Thus the ability to sue for fraud or damages, the incentive of firms to have a good

reputation, and the availability of information from many sources, undermine theallegation that the mere existence of informational asymmetry is necessarily amarket failure.

Irrationality as market failure

A more radical challenge to market success is the literature on economic psychology,which posits that cognition is bounded and that people fail to maximize possiblegains. (The allegation of "bounded rationality" is better termed "bounded cognition,"since it is the processing of information that is bounded rather than rationality itself.)

The existence of human character flaws such as excessive confidence, bias towardsrecent and readily available data, and anchoring on some past event, does not makehuman action irrational. Human action is rational when human beings economize inthe pursuit of the ends, and when preferences are consistent (thus transitive, as whenA is preferred to B and B to C, then A should be preferred to C).

When a person is overconfident and trades stocks in the mistaken belief that he cando better than average, this is a human failure rather than failure of the overallmarket. When the owner of a stock is anchored on the price he paid, and refuses tosell as the price declines, this is also a human failure, or entrepreneurial failure. Thereare winners and losers in financial markets, and the winners are those with betterknowledge about economics, finances, and personal and mass psychology. So humanfoibles do not constitute market failure.

Distributional injustice as a market failure


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Finally, the market-failure doctrine claims that even if markets are efficient inproviding goods, they fail to provide equity. Critics of markets often point to today'sinequalities of income and wealth as outcomes that should be corrected bygovernment.

Neoclassical economics, as expressed in textbooks and the academic literature,claims that there is a necessary trade-off between equity (justice or fairness) andefficiency. If the rich are taxed and the wealth is redistributed to the poor, the rich willhave less incentive to produce and invest, resulting in a lower amount of wealth,which may make the poor less well off. Nevertheless, some limited redistribution isadvocated in the name of social justice.

But the ethic that tells us the meaning of the market is the same ethic that tells usthe morally proper laws and policies. Therefore, a pure free market cannot possiblybe unjust.

By the universal ethic, doing good does not absolve evil. The universal ethic makes itmorally wrong to tax wages no matter what the funds are used for. Theft does notbecome proper if the thief transfers the money to the poor. Thus, social justice cannotbe enhanced by immoral means.

Moreover, the outcomes of today are not free-market outcomes. One cannot point toany actual distribution as a flaw of the market, since intervention has affected theoutcome. Governments throughout the world are engaged in massive redistribution,including subsidies and grants to the wealthy.

Economic justice therefore cannot predetermine any particular outcome, but mustexamine the initial distribution of resources and the process of exchange, and thenaccept whatever outcomes result. A voluntary process of exchange is morally neutral,so what remains is to examine the initial distribution of resources.

The ultimate and original factors or inputs into production are land and labor. Wehave already concluded that self-ownership endows a person with a complete right tohis wages and the products of labor. But land, defined as all natural resources,exclusive of any improvements, is not a product of human action, and so self-ownership cannot apply to the ownership of land.

Natural resources and rent

We have to begin, as did John Locke (1690), with the premise of human equality,which entitles every person to an equal access to unclaimed natural resources. As


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labor must necessarily be applied to natural resources, private possession is justifiedand may be claimed. But Locke included the proviso that one could fully own featuresof nature only if there were also quantities of similar quality freely available to others.

If that situation does not hold, as indeed it does not in much of the world, then the

implication is that the title holder does not properly own the total rights to the land.He should be entitled to the rights of possession, to have an effective market, butthat does not entitle him to the yield, or rent, of that land.

To examine this issue more deeply, we need to recognize two sources of land rental.One source of rental from land is the presence of civic infrastructure. The presence ofstreets, parks, public transit, and other territorial amenities increases the demand tobe located then and pumps up the rentals and site values. If the provider is a privatefirm, then it has the moral right to the generated rental, subject to contracts with thelocal residents. This provider could be a proprietary community, owned by acorporation, or a civic association.

If the provider of the public works is government, then government may properlycollect the rental, as it has generated that rental. If the funds instead come fromtaxes on wages (including sales taxes paid from wages), then a worker-tenant isdouble billed, as he pays a higher rent and also higher taxes. Also, if the funds comefrom non-land sources, the landowner is effectively subsidized, obtaining rental andsite value paid for by others.

The tapping of site rentals or site value to finance civic works such as mass transitrelates to the issue of natural monopolies, goods for which there is a declining

average cost, and where the marginal cost is below the average cost. In a freemarket, the provide can charge the user the marginal cost (which can be zero if themarginal cost is trivial, as with elevators), and pay for the fixed costs from the siterentals generated by the service, such as hotels financing elevator costs from theroom rentals.

Thus one source of income inequality is land rent which is generated by civicinfrastructure paid for by taxes on wages and business profits. Landowners becomewealthier at the expense of workers. Attempts at redistribution are largely futile,since much of the taxation is on those having higher wages, rather than landowners,and the transfers received by lower-income folk then enable them to afford higherrents, and some significant portion of the welfare ends up with the landlord.

This inequality is caused by intervention, not the market. When the infrastructure isprovided privately, then this redistribution does not take place, as the residents arenot taxed, but instead pay for the civic goods from their rentals or assessments ontheir units of property.


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The other source of land rental is the natural features of the area: the climate,proximity and access to waterways, soil quality, forests, etc. New York City and SanFrancisco, for example, are located places suitable to harbors. Las Vegas could notfunction without the availability of natural sources of water. The natural rent of suchland can be tapped for public revenue without hampering the market or intruding into

self-ownership. Such taps would also eliminate a source of inequality to the extentthat land value is held unequally. If, on the other hand, all communities arecontractual, then the natural rent would be collected by contract along with therentals generated by civic goods.

The option of using land rent for public revenue creates an opportunity to increasethe efficiency of the economy by shifting taxation from wages and capital to land rentor site values. This shift would also reduce the inequality of income distribution. Thus,the tradeoff between equity and efficiency is an unnecessary one; it is possible tohave more of both, relative to current outcomes.

Therefore, the allegation that markets fail achieve justice is doubly false. It is falsebecause the criterion for justice uses the same ethic that determines the market inthe first place, making true free markets inherently just. It is also false becausegovernment today creates more inequality than necessary, and so inequality today islogically a government failure, not the failure of a non-existent free market.

Sustainability

The use of fixed natural resources such as oil and copper necessarily uses up the

available sources, so it cannot be a "market" failure to use them up. A market canefficiently allocate use, since as the good gets used up and reserves diminish, theprice rises, and users economize by substituting other goods or using the resourcemore efficiently.

For renewable natural resources, if the universal ethic requires that wildlife and thehabitat of the earth be preserved, then that is what a free market does. Market failureimplies that markets within their ethical constraints are failing to be sustainable, butthat is not the case if the ethic that gives the market its meaning also prohibits thedestruction of the commons, the atmosphere, oceans, rivers, underground waters,the soil, and the wildlife of the planet.

Conclusion

The claim of mainstream economic thought that markets fail is not justified. Thefailures ascribed to externalities, public goods, market structures, asymmetries,injustice, and lack of sustainability, are due to misunderstanding or ignorance of the


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ethics, governance, and economics of markets. There is plenty of entrepreneurial andhuman failure, but no inherent systemic market failure.

Free markets never fail.

References

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Foldvary, Fred. 1994. Public Goods and Private Communities. Aldershot, UK: EdwardElgar Publishing.

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