Markets have delivered world-changing innovations across history. Consider the rise of the mobile phone or the acceleration of medical interventions in recent decades and the vast improvements they brought to many lives.
But there’s a down side. Highly scalable technologies can generate such large profits that they increase income disparity between those selling the technology and others (think of Silicon Valley gazillionaires). Or, they can shore up the power of specific actors to shape public decisions in their favor and as a result deliver less of a good or service (or unleash more harm) than the world would otherwise want. The overall result is a market that falls short of pareto-optimal. (This term defines a form or inefficiency: if the market fails to allocate scarce resources in a way that delivers the highest total social welfare, it is not pareto-optimal.) To better understand why profit alone may fail to deliver preferred outcomes, let’s consider specific ways in which markets fail.
Market failure occurs in particular situations where costs and benefits of a given activity cannot be fully allocated to all participants by prices that markets would generate. The result is the over- or under-provision of services and goods. The system fails to produce outcomes that its participants would otherwise prefer. Markets fail when, left to their own devices, there is insufficient incentive to produce what economists would call the efficient, pareto-optimal solution.
Residents want street lighting, but no individual would pay for it, the cost of organizing a customized system to share costs and manage are too high, and companies cannot find business models that would make it efficient to provide street lighting for everyone. Absent a collective intervention, such as local government, street lighting would be undersupplied.
Public goods—vaccines, street lighting—are involved in one type of market failure. Pollution and congestion also create market failure. See this discussion of climate change as a market failure.
To better understand market failure, let’s map out three situations in which markets tend to fail.
First, if production entails increasing economies of scale, the winning firms can become monopolies that charge too much, thereby limiting consumption that would otherwise be beneficial, which explains why telephone services were heavily regulated much of the last century and some of the current debates about the consumer impacts of dominance of firms like Amazon.
Second, markets tend not to work for public commodities—the street lighting example, or national defense. Such cases involve commodities that are open to all (nonexcludable), where one person’s use doesn’t preclude another (called nonrivalry), and where no person can opt out of using the good (nonrejectability). For these common needs, the service or good is ripe for exploitation by free riders who would otherwise opt out of paying, and firms tend not to enter.
The third type of market failure happens when production or consumption has externalities. Negative externalities include pollution: the costs imposed by pollution are borne by many but the benefits accrue to the producer and the end user. Positive externalities include the case of home renovation (renovating your house increases the value of others in the neighborhood, but as the full benefit is not realized by the investor, people tend to underinvest in renovation). Source used in this paragraph.
If you want to explore this topic in more depth, economist Edward Morey offers a more detailed teaching note discussing market failure (he identifies six types of causes: common property, externalities, public commodities, excess market power, lack of markets, and distortions in capital markets).
Lack of information can drive market failure. Economists call this information asymmetry. Individuals who are unaware of the potential effects of poaching may hunt endangered species and impose greater costs on everyone than they would want to. In a sense this market failure means that rational decisions are not made because knowledge is lacking. If people were better educated about the impact of their actions on others and their environment, they might make different decisions. The reduction in smoking in the West over the past half-century is the result of correcting an information asymmetry.
And in other cases, a lack of markets (for instance, for the absence of markets for air or oceans) can mean that the effects on these things are excluded from consideration by communities and firms whose consumption decisions affect them.
Investment in innovation and research may also be subject to market failure because these activities cost more to a firm than it may be able to recoup from the market even though they deliver net benefits to society. Uncertainty–in the form of unpredictable returns to investment–also plays into this form of market failure. One antidote is industry consortia or collaboration to share costs and pool risks in developing new technologies.
Global challenges at the heart of NEXT Lab involve market failures. Markets alone cannot deliver the best solutions for reducing the pollution impacts of air travel, increasing the quality and accessibility of higher education, providing the new vaccines we need, or enabling healthcare information to flow across stakeholders with the right protections and ease.
But how can one organization make a difference when the usual business incentives fail to deliver a preferred outcome? To inspire your thinking, let’s look at one antidote to a market failure: The XPrize Foundation’s work on oceans.
The thinking behind the XPrize is that a well-designed prize—which includes not only money, but also guidance, support, and publicity—can incentivize change in cases where the market would otherwise fail. The XPrize Foundation has created three efforts to address unmet needs to improve our oceans:
- The Wendy Schmidt Oil Clean-Up XChallenge
- The Wendy Schmidt Ocean Health XPrize
- The Shell Ocean Discovery XPrize
As XPrize’s Dr. Jyotika Virmani explains,
They all fit within the overall vision we have to be on an unstoppable path to a Healthy, Valued, and Understood Ocean by 2020. We have a number of post-Prize activities underway, so we have impact stories as well. The Wendy Schmidt Ocean Health XPrizes were designed to provide the impetus for technological innovation that would not otherwise take place.
New physical technologies are needed to both map and clean up the oceans–but so too is the availability of useful data that can in turn spur other innovations. In November 2016 XPrize and its offshoot HeroX launched a related effort, the Big Ocean Button Challenge. As we are learning from the XPrize experience, designing the right sequence of prizes and challenges is key.
In general, the XPrize Foundation asks the following questions in pinpointing potential prize domains:
- Is the market failure clearly defined?
- Will successes and failures stretch the bounds of art, science or engineering?
- Will the results spark a new industry?
In our first NEXT Lab class, we traced how one set of prizes did exactly this, thanks to our class guest, Dr. Virmani.
Then, in our six NEXT Lab projects, teach eam’s early research allowed them to develop their initial thinking about market failures in order to set the stage for your creative thinking about the potential for partner organizations to work with others to address the global challenge. In our final class, we return a full circle to the ideas behind the XPrize Foundation’s approach to consider what teams uncovered about the other ways that innovation might be supported in a given challenge domain. What might the next XPrize tackle?
photo source: https://www.flickr.com/photos/uw-eric/3281195599/