10. The Efficient Society (Part 4): Market Failure, Corporations and the State

Note: This post is the tenth in a series. Click here for the full listing of the series.

Chapter 6 of The Efficient Society is all about market failure, and the main point is that although the situation is often framed as if the vast majority of markets work fine but occasionally there is a market failure, the truth is closer to the idea that almost all markets fail and it takes a lot of work to gradually construct more functioning markets.

For the most part the chapter is a pretty straight forward account of the various well known ways in which markets fail, generally similar to what Tom Slee covered in 'No One Makes You Shop at Wal-Mart' - externalities, assymetrical information, etc.. Wikipedia also has a good article on the topic of Market Failure which is worth reviewing if you want an overview.

What gets more interesting is chapter 7 where Heath talks about how corporations are primarily created and grow for the purpose of overcoming market failures of one form or another. Some of these failures occur for no other reason that markets take place in a certain time and space.

For example, why have an assembly line all owned by the same company rather than allow independent assemblers to come together in a market and offer their best price to, for example, take a partially assembled product and add one more piece to it before selling it on to the next assembler and so on.

The reason is that an assembly line actually consists of a series of very localized monopolies. Imagine if each person on the line was able to demand whatever price they wanted of the next person down the line before passing down the item being assembled. The next person on the line would have little choice but to pay an amount close to the final value of the product being assembled because where else are they going to get a partially assembled product to add their piece to?

Heath notes that this logic explains why corporations will often buy up suppliers or distributors in order to avoid being held captive by a local monopoly. And a similar reasoning explains why people with specialized knowledge are retained on a salaried basis rather than working on contract (because they have a monopoly on specific knowledge that the firm needs).

I remember my dad talking once about a company that decided to contract out some of the technical work they used to do in-house, because that was part of the business philosophy of 'getting lean' and not carrying more staff members than necessary. Of course, the factory quickly realized that in the relatively small town they were located in - there wasn't anybody else who could do the job of the people let go, and they were soon rehired for a much higher amount of money on a contract basis.

Heath notes that rather than relying on people to follow their self-interest, as is intended in a market, companies instead go to great lengths to build a sense of teamwork and get employees to put the companies interest ahead of their self-interest. They want their employees to cooperate to achieve company goals while at the same time competing for promotion within the company. The primary way companies secure the efforts of their workers is of course to pay them, but it quite clear that companies see significant value in getting workers to 'buy in' to the company rather than simply work for a paycheque.

The chapter concludes with a discussion of how market failure in the insurance industry for health care led to the growth of large health management organizations (HMOs) in the U.S. Companies providing the insurance didn't have the know-how to determine what was medically necessary and what wasn't, so the market ended up providing more and more services to customers since for each customer an additional service was a free benefit, but the increase to their premiums didn't show up until later after the insurer tallied up the cost of all the medical procedures done.

And, as in every classic prisoner's dilemma, any individual customer had no incentive to stop the rise in premiums by having less work done for themselves, since they would suffer the whole cost of not having the procedure, while the benefit of the lower premiums would be spread across all the plan members.

By combining the organization doing the medical procedures with the insurer that would eventually have to pay for them, the new integrated Health Management Organization could control costs and stop the increase in premiums.


The discussion of health care leads naturally into chapter 8 which talks about the role of government in solving market failures. Heath gives a couple of examples of Prisoners Dilemmas that the state often plays a role in solving:

1) Enforcing a switch to unleaded gas (ideally for a self-interested individual, they continue to buy the cheaper leaded gas, but everyone else switches to unleaded so they get the cheaper gas plus benefits of air that doesn't have lead in it - hence the prisoners dilemma).

2) Providing security services (better for me if my neighbours get together to do this and I reap the benefits of a safe neighbourhood without having to help out.

Heath notes that although corporations can fix some prisoner's dilemmas, they can't do much about those where the benefits from fixing the dilemma don't provide a monetary reward sufficient to pay the necessary employees and make a profit for a company. If moral suasion can't fix the dilemma, and money can't fix it, then the coercive power of the state is the only option left.

Heath notes that with respect to insurance, competition between companies takes place not on the basis of offering a lower price, but rather on the basis of denying coverage. Because companies insure only a subset of the population, the biggest driver of their profitability is ensuring that they don't provide insurance to people who are high risk. As a result, insurance markets tend to end up charging extremely high premiums to higher risk clients, they often leave a number of people entirely uninsured and there is a huge amount of overhead consumed by paperwork with respect to verifying and disputing claims.

In this environment, the efficiency gains from having a single insurer that needn't spend money on all the administration required for screening clients are large and outweigh the lost efficiency from having a monopoly provider. This is a major reason why governments are so heavily involved in providing insurance to their citizens.

A final point is that Heath comments on how GDP does not measure income but instead measures the value of transactions that take place through markets. Therefore, a country which organizes more of its transactions through the state rather than through a market may have a lower GDP than a country that uses more markets and less state intervention, but the difference in GDP reflects a difference in the structure of transactions, not a difference in actual income (as measured by goods and services provided).