Saturday, January 8, 2011

Market failure books

Long overdue are my thoughts on How Markets Fail by John Cassidy and The Myth of the Rational Market by Justin Fox. My initial thoughts were that the former was much more readable and flowed better than the latter although it may be because of the different focus. Cassidy's book approach market failure in the "traditional" economics sense - summarizing the evolution of economic theory through the Arrow-Debreu framework and its implications. This narrative is one that I am familiar with and he does talk about efficient markets but the essence of the book is that market failures warrant government intervention. The critique is that almost the entire economics profession bought into the argument that competition leads to the most efficient outcomes without much regard for the fact that competitive markets can behave perversely as well. Unfortunately, the profession was so invested into this dogma that it ignored regulation altogether.

We have all heard this argument before and I am sympathetic but unconvinced. Once we talk of market failure it is not hard to see market failures everywhere but is each and every one worthy of intervention? The academic research on the size of market failures and the social cost of inefficiences is severely lacking if the basis for government intervention is some kind of cost benefit analysis.

Fox's book approaches market failures from the financial side and here economics like Fama, Shiller and Thaler feature prominently. The book points out one of the ironies of the Efficient Market Hypothesis - if a market becomes efficient either through price discovery or some other information aggregation feature, doesn't this mean it has to be inefficient in the first place? This question had always been in the back of my mind when sitting in finance courses at the Simon school but was definitely one of those questions that I thought was too stupid to ask. (Incidentally, I wonder what they're teaching these days over there - certainly EMH but perhaps not with the gusto and faith that they did when I was there.)

Again, I am sympathetic to the argument that markets are not rational some of the time but when is intervention justified? Both books are great complements because of the coverage. Although there is some overlap in discussion there was not as great an overlap as I would have expected. However, I though Cassidy's book was more readable than Fox's.

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