Saturday, November 15, 2008

Market signalling and market failure (I)

There is a discussion about the implications (the day after),for the future of capitalism , of the current financial crisis. There is the notion that whether it was a failure ,it was only a Government one. This way ,seems for some analyst specially in Latin America, the best one to protect the future of capitalism .
No matter the intentions ,the fact of the matter is that both markets and Government fail. Government has failed systematically in Latin America , with some exceptions, to provide better health care , education and environment protection and it does not seems to be a big deal for politicians, who are the main responsible in charge of Government. Markets have a risk propensity which is in the nature of profit maximization. For that purpose ,it is a necessary condition an institutional framework to clear the way for price signals ,basically in terms of the quality of information . Otherwise, those signals do not have the proper information for both the best decisions, and efficient allocation of resources. In such a case, welfare level fall. as a consequence of the wrong ,inefficient decisions. Ackerlof called the market for lemons. In the lemon market model ,economic agents have no way to get the information about the quality of the good ,except by observing the average quality available in the market. In the current financial crisis, that information did not came properly from the risk evaluation agencies .Besides, the market can not correct by itself such a problem, and the result turns out to be to acquire a lemon. The problem in this case, was that such huge amount of lemons exceeded the necessary to heal the cold.
Markets fails to overcome such a distortion ,and like a computer program with a virus into its software, it will a result but it will not be the best one. Fail also means that market are unable to solve, what it is other institution failure, in this case government. This the way capitalism has worked all the way since the eighteen century .The empirical evidence suggest that such a failure probability, can be reduced ,by optimal regulations based on efficient institutions.
Capitalism like democracy ,are not among the best alternatives ,but they both work among the whole available . They are the first best, compared to other combinations such as dictatorship and state controlled economy. So, capitalism does not need distortions about the nature of market behaviour , to get protected from those who do not believe in markets forces to create wealth.. It needs a clear understanding about the way it works and the role of information ,its quality and institutions design with a clear sense of what it is expected from them .
Markets also fails in a variety of situations, standard in the microeconomics books . Let just mention public goods, asymmetry of information(insurance industry), externalities, common property goods and the like. In all those failures ,markets can not solve by themselves ,what it is wrong about price signalling (given an institutional framework) , and that is the reason because they fail to get resources used in the best alternatives to improve welfare levels. Markets works on the assumption of perfect information , homogeneity ,zero transaction costs and values (institutions),on the side of producers and consumers. Most of these conditions are hard to find in real world, therefore on the aggregate, it means that only after trial and error , markets get a higher welfare level for society. Thus, after this mess melt down, it will become clear the relevance of better regulation ,not necessary more, and better global institutions , for global economy to get into the path of growth and prosperity.-