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Understanding market failures in an economic development context.

BOOK ? JULY 2011

DOI: 10.13140/2.1.4734.6562

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Shawn Cunningham Vaal University of Technol... 7 PUBLICATIONS 1 CITATION

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Pretoria, 2011

Mesopartner Monograph 4 Edition 1, July 2011 Pretoria, South Africa Front cover illustration by Lina Stamer

Understanding market failures in an economic development context

Dr Shawn Cunningham

Foreword by the author

This publication is the completion of a process that I started with the late Dr J?rg Meyer-Stamer in 2008. Sadly, J?rg passed away in May 2009 before we could do much work on this specific publication. We agreed to hold back this project so that I could finish the research for my PhD that looked into market failures.

One of my and J?rg's favourite topics for discussion was market failures. We both brought very different experiences and perspectives to this debate, and my academic research benefited greatly from the debates and coaching from J?rg. We frequently presented sessions together at training events which were important opportunities for us to further refine and synchronise our thinking. In many parts of this publication I have used some of the texts that we developed together, but in the interim I have also gained some additional insights.

The completion of this publication is one small task on a to-do list which I started in 2005. Future publications will revisit the use of the Systemic Competitiveness framework to diagnose and address market failures. This publication is targeted at practitioners who are working in and around the field of market development. It should not be seen as an introduction, but more as a technical publication directed at people who are trying to solve problems in a practical way based on a deeper understanding of market system. In many instances I have decided to cite only references to the many gurus who have done so much work on this topic before me. After the last chapter I have provided a list of popular books that readers can consult if they wish to read more about the phenomenon of markets and their role in societies.

Dr Shawn Cunningham

Contents

Chapter 1 Introduction ............................................................. 1

Chapter 2 What are markets? ................................................... 4 Chapter 3 Requirements for a market to function ..................... 8 Chapter 4 When markets fail .................................................. 13

4.1 SOME COMMON TYPES OF MARKET FAILURE.................................15 4.1.1 Natural monopoly ....................................................... 15 4.1.2 External effects ........................................................... 15 4.1.3 Indivisibilities or economies of scale .......................... 16 4.1.4 Asymmetric information ............................................. 18 4.1.5 Public goods ................................................................ 19 4.1.6 Incomplete or non-existent property rights ...............20 4.1.7 Sub-optimal market structures: monopolies and oligopolies ................................................................... 22

4.2 SUMMARISING THE CONSEQUENCES OF MARKET FAILURE ............... 26 Chapter 5 Markets and other modes of coordination .............. 31

Chapter 6 The relationship between market failure, government failure and network failure...................................... 36

Chapter 7 Addressing market failure ....................................... 38

7.1 ADDRESSING MARKET FAILURE AT THE LOCAL OR REGIONAL LEVEL....39 7.2 IMPORTANT CONSIDERATIONS WHEN ADDRESSING MARKET FAILURES ......................................................................................... 43

7.2.1 Who should lead? .......................................................43 7.2.2 The appropriate role of government in addressing

market failure .............................................................44 7.2.3 The problem could be in the system of institutions ... 45 7.2.4 Designing completely new markets............................45 7.2.5 International pressure to reform markets..................46 7.2.6 Sometimes it takes some evolution............................46

7.2.7 7.2.8

Technology can sometimes overcome market failures .................................................................................... 47 Sometimes just start with improving the flow of information................................................................. 48

Chapter 8 Conclusion ..............................................................49

Recommended reading ...............................................................52

Case study 1: Understanding and Addressing Market Failure: .....53

Case study 2: Market, Hierarchy and Network forms of allocation ........................................................................56

Source list ...................................................................................59

List of Tables

Table 3.1: Comparison of McMillan's five elements with Rodrik's non-market institutions...................................................... 11

Table 4.1: Common market failures and their consequences applied to rural farmers ..................................................... 26

Table 5.1: Stylised comparison of forms of economic organisation........................................................................ 32

Chapter 1 Introduction

In development cooperation, the topic of markets has received a great deal of attention over the past 20 years. The main purpose of the structural adjustment programmes that were launched from the 1980s onwards was to remove distortions that stood in the way of the emergence of functional markets in developing countries. In the 1990s, the promotion of small business went through a paradigm change with the evolution of the BDS (business development services) approach which emphasised the development of BDS markets rather than the substitution or crowding-out of markets through government interventions. Although many people associated this change mainly with donors, there was a global trend towards a more liberal approach to government interventions. In the early 2000s, some donor organisations introduced the Making market systems work for the poor approach, expanding the scope of the developing markets approach from BDS to the wider compass of markets and later to economic sub-systems.

Many scholars have argued that markets remain the most efficient way to coordinate transactions in societies simply because of their decentralised nature and the self-interest of the actors involved. One of our favourite authors on the topics, John McMillan, once said that markets are so easy to create that they emerge spontaneously everywhere ? even within humanitarian camps or prison cells. In the last few years a whole series of books have been published that have shed more light on market systems (see Recommended Reading at the end of this publication).

If markets can emerge so spontaneously, and if they are so good at allocation of resources, then why are we treating them as if they

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