GLOBAL DEVELOPMENT AND ENVIRONMENT INSTITUTE

The Limitations of Markets: Background Essay

Neva Goodwin
December 2005

Tufts University
Medford MA 02155, USA
http://ase.tufts.edu/gdae

Copyright 2005 Global Development and Environment Institute, Tufts University

The Limitations of Markets: Background Essay

The Limitations of Markets: Background Essay

Neva Goodwin

There are a number of ways in which economic theory affects both the study and
the practice of business. Economic theories may be offered to explain how businesses
operate; students and teachers of business generally ignore some of the less realistic
portions of these explanations, while making use of the more practical aspects.
Economic theories are also used as justification for government policies that regulate or
otherwise affect business.
There is an especially relevant part of economic theory that describes how
socially optimal results can come about through perfect markets that allocate resources
according to societys most preferred uses. This theory is important because it is the
theoretic underpinning for policies and prescriptions that have significantly shaped the
modern world. Recommendations to reduce trade restrictions to privatize utilities,
prisons, or water distribution to reduce regulations on businesses and generally to get
the government out of the way of the free operation of markets all are supported by
the theory of perfect markets.
Business leaders and voting citizens as well as policy makers are influenced in
their decision-making by the idea that a perfectly free market can produce a social
optimum (a best of all possible worlds). Because this idea is so influential, it is
important to understand the conditions that must be met for the theory to work. The
theoretic prediction of the optimality of market outcomes presupposes a number of
requirements, which can be grouped into three broad categories: (1) the assumption of
perfectly functioning markets; (2) market-oriented patterns of motivation and behavior,
on the part of both individuals and firms; and (3) the universal existence and scope of
markets.
This essay will begin with an emphasis on (1). We will then touch briefly on the
second and third requirements, and end with (4) a comment on the important issues that
are buried in the concept of the most preferred uses for resources (referred to, above, in
the statement that socially optimal results can come about through perfect markets that
allocate resources according to societys most preferred uses).

1) THE ASSUMPTION OF PERFECTLY FUNCTIONING MARKETS

The predictions of standard economic theory the expectation that freely
operating markets will produce a certain kind of optimality only hold good as long as
the markets are not marred by serious imperfections. Such imperfections, sometimes
referred to as market failures, include situations in which markets are affected by a
number of issues. These issues, including public goods, externalities, transaction costs,
and market power, will be described below.
1

The Limitations of Markets: Background Essay

In concluding the discussion of each of the topics in this section we present a

short description of solutions. As we put forth suggestions for how to rid the market of
imperfections, we also discuss reasons why some market failures are likely to endure. As
the different kinds of market imperfections are described below, you should ask yourself:
How often does this issue arise in the real world? How important is it? and, How should
it affect my understanding of business policy, and of public policy?

Public goods
Some goods cannot, or would not, be well-provided by private individuals or
organizations acting alone. A public good is one where the use of it by one person does
not diminish the ability of another person to benefit from it (technically called
nondiminishable or nonrival), and where it would be difficult to keep any individuals
from enjoying its benefit (nonexcludable).
For example, if a local police force helps make a neighborhood safe, all the
residents benefit. Public roads (at least those that have no tolls) are also public goods, as
is national defense. Publicly-provided education and quality childcare are public goods
because everyone benefits from living with a more skilled and socially well-adjusted
population. A system of laws and courts provides the basic legal infrastructure on which
all business contracting depends. Environmental protection that makes for cleaner air
benefits everyone.
In a community where public services have failed to keep abreast of
private consumption.... in an atmosphere of private opulence and
public squalor, the private goods have full sway. Schools do not
compete with television and the movies
A community decision to have a new school means that the individual
surrenders the necessary amount, willy-nilly, in his taxes. But if he is
left with that income, he is a free man. He can decide between a better
car or a television set. The difficulty is that this argument leaves the
community with no way of preferring the school.
(John Kenneth Galbraith, The Affluent Society (Mariner Books, 1998,
40th Anniversary Edition.) The first quotation is from p. 191; the second
from p. 198.)

Because it is difficult to exclude anyone from benefiting, public goods cannot

generally be bought and sold on markets. Even if individual actors would be willing to
pay if necessary, they have little incentive to pay because they cant be excluded from the
benefit. The term free riders is applied to people who seek to enjoy a benefit without
paying for it. Because of the problem of free riders, it often makes sense to provide public
goods through government agencies, supported by taxes, so that the cost of the public
benefit is borne by the public at large.
Solutions: By definition, the only broadly applicable way to make public goods
available is to supply them through some kind of collective action. Often this implies

The Limitations of Markets: Background Essay

government, but the collective action could also be on the level of a family or an industry
group. Disagreements around this subject are generally not about what kind of
institutional response is required when something has been identified as a public good.
Rather, disagreements tend to revolve around whether something is a public good; and, if
it is, how much of it the society is willing, collectively, to provide.

Externalities
Markets are sensitive only to benefits or costs that can be translated into
willingness to pay on the part of buyers, or into costs incurred by sellers. An economic
choice or action by one economic actor that affects the welfare of others who are not
involved in that choice or action is called an externality. In defining externalities we
focus on effects that impinge on third parties through non-market channels. More
specifically:
*

A negative externality (sometimes referred to as an external cost) exists when

an economic actor produces an economic cost but does not fully pay that cost. A wellknown example is the manufacturing firm that dumps pollutants in a river, decreasing
water quality downstream.

A positive externality (sometimes referred to as an external benefit) exists

when an economic actor produces an economic benefit but does not reap the full reward
from that benefit. Positive externalities are less well-known, but can be vitally important
to individual and societal well-being. Examples include parents who, out of love for
their children, raise them to become decent people (rather than violent criminals). In so
doing they also create benefits for society at large. Similarly, when one person gets
vaccinated against a communicable disease, she not only protects herself, but also
others around her, from the diseases spread. In both cases there are social benefits from
individual actions: Well-educated, productive citizens are an asset to the community as
well as to their own families; and disease control reduces risks for everyone.

When a market transaction affects the welfare of third parties who are not involved
in the transaction, the market behavior of the economic actors will not reflect all the
preferences of, or all the costs to, everyone affected. This is because the costs or benefits
affecting the particular actors differ from the costs or benefits to society as a whole. For
example:
*

If the cost of polluting is not borne by the polluters, they will not feel an economic
motivation to reduce their creation and discharge of wastes.

If employers do not benefit in full from the cost of providing training to their
employees, they are likely to provide less of that training than is socially desirable.

If the price of water or of petroleum is set below the true cost to society of using
these resources, this will produce an incentive to use too much of them.

The Limitations of Markets: Background Essay

In general, each of these examples involves a situation in which there is a

difference between private and social costs (or benefits); as a result, the monetary
incentives of the marketplace encourage socially undesirable behavior. If all of the things
that flow through an economy are paid for according to their full social as well as private
value (including things that have negative value), this will provide the motivation for
these things to be produced in proportions that correlate precisely with their full value.
That is a good first approximation for a definition of economic efficiency. If economic
activities affected only the actors directly involved in decision-making about them, we
might be able to think about economic activity primarily in terms of individuals making
decisions for their own benefit. But we live in a social and ecological world, in which
actions, interactions, and consequences are generally both widespread and interknit. If
decisions are left purely to individual self-interest, then from a societal point of view too
many negative externalities will be created, and too few positive externalities: The streets
might be strewn with industrial wastes, while children might be taught to be honest in
dealings within their family, but not outside of it. Market values and human or social
values do not always coincide.
Environmentalists and economists are often on different sides of policy
questions. The concept of externalities is one on which they could be
expected to agree, at least, in concept; it is unfortunate, therefore, that
environmentalists so often misunderstand what this term means to
economists. Environmentalists may say (and they often do), When
economists use this term it shows how little they care about the
environment; they dismiss it because it is external to the economy.
This is a misunderstanding: in fact, if economists sometimes prefer not
to recognize serious externalities this is not because they do not
matter; rather it is because externalities matter so much that they can
upset the whole apple-cart of mainstream economic theory.

Some of the most important externalities have to do with the economic activity of
resource maintenance1: Relying on markets alone to coordinate economic activities
allows many activities to happen that damage or deplete the natural environment, because
the damage often does not carry a price tag, and because people in future generations,
who will be most affected, are not direct parties to the decision-making.
Solutions: The standard economic response to this topic is Internalize the
externalities! For example, find ways to charge businesses the full cost for the pollutants
they emit, or raise the price of coal, gasoline, etc. to represent the full cost of the
increased risks to the economy from global climate change, as well as the health and
environmental damages from burning fossil fuel. One economist has made the rather

1 Contextual economics (as formulated, for example, in the introductory textbook, Microeconomics in
ContextHoughton Mifflin, 2005) identified four basic economic activities. These include production,
distribution, consumption, and resource maintenance.

The Limitations of Markets: Background Essay

extreme suggestion of tying retirement benefits to the earnings of each persons children.2
There are many cases where intelligent and imaginative means can be found to
internalize externalities, but the difficulties are also many, including the following:
*

The actors who impose negative externalities on society often do so with impunity
because they possess political and economic power. For example, some automobile
manufacturers and some firms in the petroleum industry are worried about results that
might show that their products are posing a serious danger to society. While other firms
in these industries have addressed the dangers of global climate change in constructive
and creative ways, the less progressive firms have funded scientists to dispute the
findings of the far more numerous and well-reputed scientists who put out the reports of
the Intergovernmental Panel on Climate Change (IPCC), and have used the results to
support massive lobbying of governments to prevent action being taken to tighten
automobile emissions standards3.

Defining the precise cost or benefit in question is difficult, can be costly, and,
again, is complicated by interests. Who is in a position to perform such calculations?
Whose figures can be trusted? While cost-benefit analysis is often touted as the solution
to these problems, it is often marred by data inconsistency, by difficulties in quantifying
values that may be unquantifiable (such as the value of a life), and by the motivations of
those collecting and evaluating the data. As has been noted by Frank Ackerman and

2 The justification for this idea, put forth by Shirley Burggraf (The Feminine Economy and the Economic
Man: Reviving the Role of Family in the Post-Industrial Age), is that it is costly to raise children; those who
have none have more opportunities to save for their own retirement, and parents who have given up such
savings opportunities should be rewarded by the state. One questionable assumption (among several) in this
proposal is that better parenting produces children with higher earnings.
3 The website www.exxonsecrets.org provides a comprehensive list of organizations that Exxon-Mobil has
funded since 1998, indicating how Exxon-Mobil funds climate change skeptics. The site lists 125
organizations. Greenpeace also reports on Exxon-Mobils attempts to prevent climate change action. See
A Decade of Dirty Tricks (2002) at http://www.stopesso.com/pdf/Dirty_Tricks.pdf and Exxons
Weapons of Mass Deception (2002) at
http://a520.g.akamai.net/7/520/1534/release1.0/www.greenpeace.org/multimedia/download/1/50571/0/exx
on_long.pdf, which provides some details of the links between Exxon-Mobil and organizations attacking
the climate change consensus.
In recent decades General Motors has led the effort to fight against increased emissions standards;
GMs political successes have probably contributed to its loss of economic competitiveness against foreign
competitors, such as Honda, which are, instead, preparing for a world in which more externalities, such as
the environmental impact of carbon emissions, will be internalized. A Dec. 8, 2004 article in the NY Times
mentions that GM (along with seven other automakers) filed suit against the state of California over the
states law to regulate greenhouse gas emissions (see
http://www.nytimes.com/2004/12/08/business/08auto.html?ex=1260248400&en=7e162bf9a583e2a5&ei=5
088&partner=rssnyt). The Union for Concerned Scientists recently criticized an ad campaign by the Auto
Alliance, an automaker lobbying group that includes GM, Ford, BMW, Toyota, and others. See
http://www.ucsusa.org/clean_vehicles/avp/automaker-v-the-people-alliance-ad-fact-sheet.html. For a
March 22, 2005 NY Times article on the ad campaign, see
http://www.nytimes.com/2005/03/22/business/media/22adco.html?ex=1269147600&en=70d951945fa991f
e&ei=5090&partner=rssuserland. This article notes that Honda is not a member of the Auto Alliance and
recognizes that CO2 emissions remain a significant contributor to global warming trends. Honda also got
the highest ranking by the UCS in their evaluation of emissions by different automakers (GM ranked the
lowest), see http://www.climateark.org/articles/reader.asp?linkid=37091.

The Limitations of Markets: Background Essay

Lisa Heinzerling,
In practice, most cost-benefit analyses could more accurately be described as
complete cost-incomplete benefit studies. Most or all of the costs are readily
determined market prices, but many important benefits cannot be meaningfully
quantified or priced, and are therefore implicitly given a value of zero. Thus [this
methodology] systematically disfavors protection of goods that, like health and
environmental protection, are priceless. (Priceless: on knowing the Price of
Everything and the Value of Nothing. New York: The New Press, 2004; p. 40)
*

Intelligent institutional design can sometimes overcome the obstacles of politics

and measurement, to create laws or regulations that do successfully internalize
externalities. Markets for trading emissions permits provide some good examples.
However, it is highly unlikely that the functions of creating or maintaining such systems
can be internal to any market system. The internalization of externalities requires an
external force usually government to set and enforce rules.

Transaction costs
Transaction costs are the costs of arranging economic activities. In many standard
economic models as distinct from the thinking that goes on in actual firms transaction
costs are assumed to be zero. If a firm wants to hire a worker, for example, the academic
economist may assume that the only cost involved is the wage paid. In the real world,
however, the activity of getting to a hiring agreement may involve its own set of costs.
The firm may need to pay costs related to searching, such as placing an ad or paying for
the services of a recruiting company. The prospective worker may need to pay for
preparation of a resume and transportation to an interview. One or both sides might hire
lawyers to make sure that the contract terms reflect their interests. Because of the
existence of such costs, some economic interactions that might lead to greater efficiency,
and that would occur in a transaction-cost free, frictionless idealized world, may not
happen in the real world.
Solutions: The increased availability of information on the Internet is an example
of a technology breakthrough that can provide good solutions to a market failure; websavvy individuals and firms are increasingly able to shorten the time and decrease the
cost of finding a good fit between skills and job requirements. While this may increase
the digital divide between individuals who can, and those who cannot, use this
resource, one can imagine a future in which web-literacy is raised to the level of oldfashion reading literacy. Other ways of reducing transactions costs include programs to
provide legal and other assistance to less-well-resourced individuals and firms. Some
such programs are charitable, such as the Service Corps of Retired Executives
(http://www.score.org/). Others are run by governments, at various levels, and others are
initiated by businesses.

The Limitations of Markets: Background Essay

Market power
In the standard economic model all markets are assumed to be perfectly
competitive, such that no one buyer or seller has the power to influence the prices or
other market conditions they face. Since perfect competition is central to the conception
of perfect markets, it has been extensively analyzed. There are a number of conditions
that are required in order for perfect competition to exist, to wit:

Each market must involve trading in one homogeneous good, so that price, rather
than other considerations, is the overwhelming influence on consumer choice. That is,
any one unit of the good must be virtually identical to any other.

Each market must have no significant barriers to entry, including no brandname loyalties, and no need for high levels of advertising, as well as no technological
and financial barriers to entry.

There must be no increasing returns to scale, because increasing returns create

barriers to entry. If the technology of production allows vastly lower costs to larger
producers than to smaller ones, then the industry will come to be dominated by a few
large firms, creating an oligopoly (or even monopoly) rather than perfect competition.

All factors of production must be mobile. That is, labor, capital, and raw
materials must be able to be moved from one location to another, rather than being at
the mercy of a single local firm or industry.

There must be numerous, small buyers and sellers, all of whom are compelled
to be price takers since they cannot acquire significant market power.

Information about the market must be freely and equally available to all
actual and potential market participants. That is, everything one needs to know about
prices, quantities, and qualities of goods and services for sale must be public, or readily
accessible, knowledge.

These assumptions imply additional features of perfect competition. For example,

consider the assumption that a perfectly competitive industry is made up of numerous
small firms and consumers, all of them price takers. This implies that the market plans of
each buyer and seller are independent, and that collusion between firms or consumers to
influence prices is impossible (since there are so many other participants in the market).
While competition does exist in the real world, and is, indeed, becoming
increasingly fierce through the combined forces of globalization and the information
revolution, nevertheless many firms do have market power. For example, when there is
only one firm (a monopolist) or a few firms selling a good, they may be able to use their
power to increase their prices and their profits. A large multinational corporation with the
ability to place large orders with suppliers anywhere in the world has considerable power
over the terms on which its suppliers can sell to it. Workers may also be able to gain a
7

The Limitations of Markets: Background Essay

degree of market power by joining together to negotiate as a labor union. A government,

too, can have market power, for example when the Department of Defense is the sole
purchaser of military equipment from private firms.
Perfect competition also assumes that there is a homogeneous product, made by
numerous firms that are small relative to the market. Indirectly, this implies that there are
no significant economies of scale, nor advantages of bigness in general; for if there were,
a few firms would be able to become large, drive others out of business, and dominate the
market. However, economies of scale are widespread in production and distribution. So,
too, is product differentiation. Under these circumstances, firms will not all stay small.
Some will produce enough to benefit from economies of scale, lowering their costs and
enabling them to force others out. Some brands will become well-known and sought
after, whether for reasons of social status or technical characteristics.
Indeed, as firms become bigger, it appears that they gain some organizational
advantages, perhaps going beyond the technical economies of scale in production. That
is, there may be some advantages to bigness in general. Many corporations now function
internationally, and have revenues in the tens of billions of dollars. The decisions of
individual large corporations can have substantial effects on the employment levels,
economic growth, living standards, and economic stability of regions and countries.
Governments may need to factor in the responses of powerful business groups in making
their macroeconomic decisions. National leaders may fear, for example, that raising
business tax rates or the national minimum wage may cause companies to leave their
country and go elsewhere. Many corporations have the ability to influence government
policies directly, through lobbying, campaign contributions, and other methods.
Solutions: There is a long literature on monopoly, oligopoly, and how to protect a
market from such imperfections.4 It is well recognized that free market forces,
unhindered, will inevitably produce concentrations of power. Government actions, such
as the granting of patents and other forms of monopoly rights, can also contribute to the
creation of market power. Proposals to restrain market power run the gamut from active
enforcement of anti-trust law to new suggestions for funding research and development in
order to replace a patent approach to intellectual property with other mechanisms.
4 Any policy- or business-oriented Principles of Microeconomics textbook will discuss at greater length
the legal and other means available to restrain market power and preserve market competition. Historical
and political overviews of antitrust policies in the United States are provided in
Policy Watch: Developments in Antitrust Economics by Jonathan B. Baker, American University,
Washington College of Law Journal of Economic Perspectives, Vol. 13, No. 1, 1999
Antitrust Policy: A Century of Economic and Legal Thinking by WE Kovacic, C Shapiro (Journal of
Economic Perspectives, 2000). This may be viewed at
http://econwpa.wustl.edu:8089/eps/le/papers/0303/0303006.pdf.gz.
Some other aspects of this subject are available in books such as:
American Agriculture and the Problem of Monopoly: The Political Economy of Grain Belt Farming by
Jon Lauck (University of Nebraska Press; 2000)
Rebalancing the Public and Private Sectors: Developing Country Experience by O. Bouin, Ch.A.
Michalet (A publication of the OECD Organization for Economic Co-operation and Development; 1991)

The Limitations of Markets: Background Essay

(2) MARKET-ORIENTED MOTIVATION AND BEHAVIOR

In addition to the presence of perfectly competitive market structures, the
prediction of socially optimal results in the standard economic model also assumes
particular patterns of motivation and behavior. Both firms and individuals must conform
to defined standards of economic rationality firms by maximizing profits, and
individuals by making well-informed market choices that maximize their own wellbeing.
To use a common phrase for this pattern, participants in the market must behave
as homo economicus. This means that individual economic agents look only to their own
self-interest, seeking to maximize only their own individual well-being. References to
such behavior as "rational" unfortunately seem to imply that economists consider
anything other than pure selfishness to be somehow silly, or irrational.
There are many reasons why this simplified view of human motivations, while
covering a lot of circumstances, is nevertheless often inadequate. Humans (like other
animals) have, to be sure, evolved with a strong instinct to do what it takes to survive.
People are born with a range of characteristics, including greater or lesser tendencies to
greed and aggressive competition. But the range of common human characteristics also
includes responsiveness to expectations, a desire to cooperate, empathy, and concern for
those in need. Sometimes concern to protect others, or for an ideal, or for how one is
perceived, can even be stronger than the survival instinct.
The standard economic model abstracts to a highly simplified view of human
nature that assumes only one basic drive: the drive to get what one wants. We all know
that models must be simpler than the real world; what is the importance of the particular
kind of simplification put forth in the neoclassical economic model? One answer is that
day to day business activities depend as much on cooperation as on competition. In work
groups, and in other coordinated activities within a firm, competition is a constructive
driver of some behaviors, but the enterprise would likely fall apart if the sense of
cooperative endeavor towards a common goal were entirely replaced by individual
striving for personal advantage. Business management has much to do with motivating
people, from managers to the shop floor. While it is rarely safe to rely solely on good
intentions, the opposite assumption, of purely self-interested behavior, tends to be a selffulfilling prophecy.
Another problem with the basic neoclassical model, in which purely decentralized
decisions lead to efficient outcomes, is the assumption that people have easy access to all
the information they need to make good choices. This static analysis ignores the time it
might take for a person to make a decision, or the time it might take for a factory to gear
up to produce a good. In the real, dynamic, world, getting good information may be
difficult, and planning for an uncertain future is a big part of anyones economic
decision-making.

The Limitations of Markets: Background Essay

A manufacturing business, for example, might be considering whether or not to

borrow funds to build an additional factory. If the companys directors were able to know
in advance exactly what demand for its products will be like in the future and what
interest rates will be along with additional information about things like future wages,
energy costs, and returns on alternative investments the decision would be a simple
matter of mathematical calculation. But the directors will have to guess at most of these
things. They will form expectations about the future, but these expectations may turn out
to be correct or incorrect. If their expectations are optimistic, they will tend to make the
new investment and hire new workers. As is well known, optimism can be contagious; if
a lot of other business leaders become optimistic, too, then the economy will boom. If, on
the other hand, people share an attitude of pessimism, they may all tend to cut back on
spending and hiring. Since no single business wants to take the risk of jumping the gun
by expanding too soon, it can be very difficult to get a decentralized market economy out
of a slump. This illustrates one manner in which human behavior that is different from
the model of homo economicus can affect the macroeconomy.
Information and expectations can also affect the interactions of individuals and
firms at the micro level. Asymmetrical information frequently goes along with and
helps to foster asymmetrical power. Newspapers in recent years have carried many
stories about insider trading the situation in which stock-brokers, individuals inside
companies, or others, have special information about what some firm is about to do, or
problems it is about to encounter. It is often illegal for these insiders to decide to buy or
sell stocks based on such insider knowledge, as this is seen to confer an unfair
advantage. With reference, again, to the theory of perfect markets, when there is such an
asymmetry of information prices are not set in a manner that will bring about the best of
all possible worlds.
As mentioned earlier, the expansion of market information on the web is helping
to remove some of these asymmetries; a small avocado producer in Latin America can
now find out enough about prices around the world to improve her bargaining position
vis--vis the local single purchaser. Nevertheless, those with large resources still can
know much more about the worlds of finance and business than those with fewer
resources.
Thus, to the extent that the formal expectation of socially optimal results depends
on the existence of idealized market, the reality of individual, not-perfectly-rational (in
the sense of entirely self-interested), and not-perfectly-informed human action may create
market failures.

3) THE EXISTENCE AND SCOPE OF MARKETS

In addition to asking whether markets are functioning perfectly or are close
enough to perfection to support standard policy conclusions we have to ask about
whether markets exist at all. There are plenty of places where they do not: In the United
States we do not have formal, efficient markets for husbands, for body parts (though there

10

The Limitations of Markets: Background Essay

are illegal, international markets for some organs), or for the probable future earnings of a
child who is learning to play the violin.
The free market model assumes that markets exist for, and are used to allocate,
everything that affects economic wellbeing. That is, it is assumed that society relies
completely on the market for all economically relevant resource allocation. This general
statement has a number of more specific implications. Total reliance on the market
implies that there are no free goods or services. Everything of value that a wife does for a
husband, a father for his children, or a friend for another friend, is paid for according to a
price that has been determined through the market.
Full scope for the market implies a definite, and limited, role for the government.
In negative terms, the government must avoid any distortion of prices, or any actions that
would undermine market mechanisms. There must be no subsidies, price supports, price
controls, or taxes or tariffs on particular goods. And the government must certainly avoid
direct, nonmarket distribution of particular commodities to individuals. At the same time,
the government must ensure that contracts and property rights are enforced, creating the
legal and political environment within which the market economy can function.
While this is not quite a call for total inaction, it implies a smaller role for
government than exists in virtually all nations today. It also suggests some logical
inconsistencies. For example, the government's role in creating the framework for the
market may need to include the creation of policies to address environmental and other
externalities. However, it is often impossible to implement such policies without having
some distorting effect on prices.
Finally, if the market economy is to make an optimal choice between present and
future consumption, there must be markets existing today for future investments and
future consumption of particular goods. Here the theoretical requirements become
somewhat esoteric, calling for a complete set of futures markets in which commodities
are traded across time periods. For example, in addition to ordinary markets for
refrigerators and cars, there must be markets in which consumers can buy options to
purchase refrigerators and cars five years from now, at prices that are specified today.
The same must be true for all other goods and all time periods. In reality, futures markets
are well established only for bulk agricultural and industrial commodities and for some
types of financial investments; for other goods and services, futures trading is the rare
exception, not the rule.
There is much fungibility between paid and unpaid economic activity. An
individual can receive comfort at a time of stress or bereavement from a friend or from a
paid counselor. People who are sick or disabled can be cared for by family or by paid
nursing staff. The elderly can live at home, with paid or unpaid help, or in special
facilities. Such facilities may be entirely marketized, or may include a component of
charity, such as volunteer work. If, as we assume, the ultimate goal of any economic
system is human well-being, in the present and the future, then it is important to continue
the debate over which approach, or combination of approaches, ultimately works out best

11

The Limitations of Markets: Background Essay

for all concerned (recognizing that there may be some irresolvable conflicts; what is best
for A may simply not be the same as what is best for B). But standard economic analysis
only looks at that part of the world that operates through markets. This is one reason that
its optimality predictions and prescriptions may not address the realities of the world we
live in.
4)

HUMAN NEEDS AND EQUITY

There is another, deeper reason why standard economic prescriptions may not, in
fact, lead to a social optimum.
We began with the statement that economic theory describes how socially optimal
results can come about by freeing up markets to allocate resources according to societys
most preferred uses. In concluding this essay we address the issue of how we can define
and identify societys most preferred uses.
Value in economic terms is synonymous with price. The social preferences that
are visible to standard economic analysis are what economic actors in a society are able
and willing to pay for. Demand is ultimately dependent on consumer demand; that is,
firms may demand parts and other inputs from suppliers, and raw materials from primary
industries, but they only do so on the expectation that the final products will be bought by
consumers. The only consumer demands for goods and services that are visible to the
standard economic model are those that are backed up by a consumers ability to pay.
This has several implications.
The model does not take into account non-marketed production, such as the care
given to children, the sick and the elderly by family and friends. There is nothing in
standard models that assures that these sorts of production will be supplied in adequate
quantities and quality.
There are important categories of people especially, but not only young children
whose preferences are either not taken into account by the market (because they are not
in a position to make market decisions), or whose uninformed preferences are heavily
manipulated by market forces.
There is nothing in the model that assures that resources are distributed in such a
way that people can meet their basic human needs. If a few rich people have a lot of
money to spend on mac-mansions while many poor people lack the money to pay for
basic health care, free markets will motivate producers to respond to the demand for macmansions, but not to the need for basic health care.
The standard model claims a kind of justice, in that people are paid in some
relation to the value of what they produce. This claim is open to a number of arguments.
Production is normally a cooperative affair, so that it is hard to determine precisely what
portion of the output is due to the efforts of which worker or supervisor, or CEO. The

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The Limitations of Markets: Background Essay

allocation of income among workers in an enterprise has much to do with power: it is

easy to find instances where a CEO is able to keep his income and bonuses rising even
while the firm is declining in profitability and workers pay and pensions are being cut.
Moreover, the value of the product depends entirely on the composition of demand. In a
highly unequal society where the poor have little money to buy bicycles while the rich
are spending millions for yachts, incomes will reflect a value of the product that is very
different from the well-being value.
All of these issues relate to the point raised at the beginning of this section:
Value is a word that has important meanings in most human discourse, but these
meanings are very different from the economic equation: value=price.
Clearly, although market systems have strong advantages in some areas, they
cannot solve all economic problems. To some extent private non-market institutions may
help remedy the market failures that result, for example, from the inability of markets to
supply enough public goods, or to prevent the production of negative externalities. For
instance, a group of privately-owned factories located around a lake may voluntarily
decide to restrict their waste emissions, because too much deterioration in water quality
hurts them all. Or a widespread custom of private charitable giving may enable poor
people to turn some of their needs (e.g., for food) into effective market demand. But
sometimes the problems are so large or widespread that only governmental, public
actions at the national or international levels seem to offer a solution.
Real-world choices are not limited to either (a) a system where a centralized
government exerts total control or (b) the radically free market system described in the
standard economic model. Because of the existence of public goods, externalities,
transaction costs, market power, questions of motivation, information and expectations,
and concerns for human needs and equity, economic systems cannot rely on free
markets alone if they are to generate human well-being. Actual market-oriented
economies always include a mixture of decentralized private decision-making (regarding
actions that do, and that do not, operate through markets) along with more publicoriented decision-making.

Neva Goodwin is co-director of the Global Development and Environment Institute at

Tufts University; inquiries can be directed to neva.goodwin@tufts.edu.

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The Limitations of Markets: Background Essay

REFERENCES
Note: The Featured Collection on Market Failure, within which this essay is embedded,
offers a wide range of references and cases on the topics discussed here. The following
references are merely intended to supplement these.
Everything for Sale: The Virtues and Limits of Markets by Robert Kuttner (Chicago:
University of Chicago Press; 1999). The BOOK points out several industries (including
health care, education, and telecommunications) where unregulated markets fail to
produce optimal results.
A related ARTICLE by Kuttner was published in The American Prospect. It is available
at http://www.prospect.org/print/V8/31/kuttner-r.html.
The Limits of Market Organization, Richard Nelson, ed. (New York, Russell Sage
Foundation; 2005). The BOOK includes chapters by 12 different authors, divided into
sections on the following areas where markets alone cannot adequately organize an
economy: infrastructure, natural monopoly and equitable access; human services; science
and technology; and protecting the public and the state.
What Money Cant Buy: The Moral Limits of Markets, by Michael Sandel;
LECTURES from 1998 that discuss problems with commodification; this may be found
at www.tannerlectures.utah.edu/lectures/sandel00.pdf.
1995 TESTIMONY before the International Congress of Advertising and Free Market on
market failures in advertising may be found at
http://www.ftc.gov/speeches/azcuenaga/lima.htm.

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