The Lemons Problem: No Road

As is well known by any sophomore economics student, it is orthodox to claim that there are three kinds of market failure: information, externalities, and economies of scale. However, in some ways these are the least important “failures” of markets. I have been thinking about the problem of the failures of markets in a larger context....Here, it seems to me, are the REAL market failures, all of which involve the failure of the state:

1. Government fails to foster, or actively removes, what Hayek called the “infrastructure” of market processes. Infrastructure includes a system for defining and trading property rights, a legal system for the adjudication of disputes, and a monetary system to facilitate exchange.
2. Government creates, or fails to remove, impediments to market processes. Such impediments might include taxes, subsidies, regulations or standards that distort prices and information.
3. Markets fail to perform efficiently because of informational asymmetries, externalities in consumption or production, or large economies of scale in production.

Type 1 market failure arises from inadequate infrastructure, type 2 market failure results from poorly designed policies, and type 3 market failures are caused by flaws in market processes themselves. The hierarchy here goes from 1 (most profound) to 3 (manageable, might require minor state action to correct, though it is not obvious that the state won't just make things even worse).

Now, you can't blame type 1 failure on markets. That would be like thinking your car is a lemon because there is no road. It's true that the car won't go, but the problem is that it is surrounded by trees. The car, as cars go, may be perfectly fine.

Charging markets with type 2 failure is like blaming your car for breaking down after you put water in the gas tank and sand in the crankcase. Again, the car is as good as a car can be. But it can be ruined by idiots who decide that a water burning car would be better for the environment.

Only type 3 is really a market failure; type 1 and 2 failures are malfunctions of government management of markets.

Consider how important these distinctions are in diagnosing problems. In all three cases, the car won’t go! Should you conclude it is a lemon, and trade it in? A new car won’t help if the real problem is bad roads or bad maintenance; the new car will soon break down also. Unless we can think more fundamentally, the result will be an endless cycle of expensive trade-ins, none of which get us anywhere.

And that is where we seem to be going. Or, not going.