Unit 10 Market successes and failures: The societal effects of private decisions

10.11 The limits of markets

Markets might seem to be everywhere in the economy, but this is not the case. Herbert Simon (Section 6.1) described how a visiting Martian would view the economy. The Martian mainly sees green areas, which are firms. They are connected by red lines representing buying and selling in markets, but many resource allocation decisions are made within the firms. Families, similarly, do not allocate resources among parents and children by buying and selling. Governments use a political process rather than market competition to determine where, and by whom, schools will be built and roads maintained.

People disagree about the boundaries of the market system. Why are some goods and services allocated by firms, families, and governments, rather than markets? This is an old question, and there are two basic answers.

First, some kinds of activities are better carried out within families, some by governments, some within firms, and some by markets. It is hard to consider, for example, how conceiving and raising children could be effectively carried out by firms or markets. A combination of families and governments (schooling) does the job in most societies.

Ronald Coase provided an explanation of the relative importance of firms and markets. Firms exist because for some things, ‘in-house’ production is more profitable than acquiring the same thing by purchase. The extent of the market is determined by the firm’s decisions about which components of a product to produce in-house, and which ones to buy. Coase explained that the boundaries of this divide between the firm and the market are set by the relative costs of the ‘make it’ and ‘buy it’ options.

Coase’s explanation underlines an important fact that is often lost in sometimes heated debates about the merits of decentralized systems of organization—like markets—as opposed to more centralized ones, like governments or large firms. He showed there are some things that centralized organizations are better at, and others that are better handled by the market. And the beauty of this demonstration is that it is not a judgement by some possibly biased observer: it is the verdict of the market itself. Competition among firms ultimately punishes firms that overdo the ‘make it’ option by overextending the boundaries of the centralized system through internal expansion. And market competition equally punishes the firms that fail to take advantage of centralized decision-making by overly opting for the ‘buy it’ option.

The second answer to the question about why some goods are not allocated in markets is quite different from Coase’s analysis of the boundaries of the firm. Most people think that there are some things that should not be allocated through market transactions—although they may disagree about which ones.

Two arguments are often made for limiting the extent of the market:

  • Repugnant markets: Marketing some goods and services—vital organs, or human beings—violates an ethical norm, or undermines the dignity of those involved.
  • Merit goods: It is widely held that some goods and services (called merit goods) should be available to people independently of their ability or willingness to pay.

Repugnant markets

In most countries, there are well-established institutions that allow parents to voluntarily give up a baby for adoption. But laws typically prevent parents from selling their infants.

Why do most countries ban the buying and selling of babies? Wouldn’t a market for infants provide parents wishing to sell and would-be parent wishing to buy with opportunities for mutual gains from exchange?

Virtually all countries ban the sale of human organs for transplant. Commercial surrogacy—a woman becoming pregnant and giving birth to a baby for another couple for pay—is not legal in most countries (although it is legal in some states in the US, Thailand, and Russia). But if applied to these cases, economic reasoning would hold that it is wrong to prevent these transactions if both parties enter into them voluntarily in the anticipation of mutual gain.

But simple economic reasoning cannot be applied to just any exchange. One reason we might object is that the sale may not be truly voluntary, because poverty might force people to enter into a transaction they might later regret. A second reason would be a belief that putting a price on a baby, or a body part, violates a principle of human dignity. It corrupts our attitudes towards others.

In our video, Al Roth, who won a Nobel prize for his work, explains why he calls these repugnant transactions.1

The philosophers Michael Walzer and Michael Sandel have discussed what we call the moral limits of markets. Some market transactions conflict with the way we value humanity, such as buying and selling people as slaves; others with principles of democracy, such as allowing people to sell their votes. We have analysed some of the advantages of allocating resources using markets and the price system. In that analysis, we implicitly assumed that exchanging the good for money did not affect its intrinsic value to the buyer and seller.2 3

But voters’ appreciation of their democratic rights and parents’ attitudes to babies might both be altered if they were bought and sold. When we consider whether it would be beneficial to introduce a new market, or monetary incentives, we should think about whether this might crowd out other social norms or ethical preferences.

Michael Sandel investigates the moral limits of his audience in his TED Talk ‘Why we shouldn’t trust markets with our civic life’.

Merit goods

merit good
A good or service that should be available to everyone on moral grounds, irresprective of their ability to pay.

There are some goods and services that are considered special in that they should be made available to all people, free of charge. These are called merit goods, and they are provided by governments rather than allocated by a market governed by the willingness to pay.

In most countries, primary education is provided free to all children and financed by taxation. Basic healthcare—at least emergency care—is also often available to all, irrespective of the ability to pay. The same holds in many countries for legal representation at trial: a person unable to pay for a lawyer should be assigned legal representation without charge. Personal security—protection from criminal assault or home fires, for example—is typically ensured in part by publicly provided police protection and firefighting services.

People of limited income do not have access to a great many things. They typically live in substandard and often unhealthy housing, and have very limited opportunities for recreational travel. Why are basic healthcare and schooling, legal representation, and police and fire protection different? Why should any particular type of good be provided free to everyone? According to the idea of merit goods, having access to some types of good is a matter of right—like the right to vote—and not the ability to pay. What rights should be guaranteed differs from country to country and has changed over time (including the right to vote, that was not even close to universal in most countries until early in the last century.) But broadly, the answer is that as a society, we make judgements that some goods and services are so important—in particular, because they have serious implications for an individual’s future life—that they should be considered the right of every citizen.

Exercise 10.13 Capitalism among consenting adults

What are the limits of economic reasoning? Should all voluntary contractual exchanges be allowed among consenting adults?

State what you think about the following (hypothetical) exchanges. You may assume in each case that the people involved are sane, rational adults who have thought about the alternatives and consequences of what they are doing. In each case, decide whether you approve, and if you do not approve, whether or not you think the transaction should be prohibited. In each case explain why the transaction described produces mutual benefits (that is, it is a Pareto improvement over not allowing the exchange).

  1. A complicated medical procedure has been discovered that cures a rare form of cancer in patients who would otherwise certainly die. Staff shortages make it impossible to treat all those who would benefit, and the hospital has established a policy of first come, first served. Sarah, a wealthy patient who is at the bottom of the list, offers to pay Ben, a poor person on the top of the list, $1 million to exchange places. If Ben agrees with the switch and later dies (which is very likely), then his children will inherit the money. Ben agrees.
  2. You are waiting in line to buy tickets for a movie that is almost sold out. Someone from the back of the line approaches the woman in front of you and offers her $25 to exchange positions in the line (he takes her position in front of you and she takes his position at the back of the line).
  3. A politically apathetic person, who never votes, agrees to vote in an election for the candidate who pays him the highest amount.
  4. William and Elizabeth are a wealthy couple who give birth to a baby with a minor birth defect. They sell this baby to their (equally wealthy) neighbours and buy a child without any birth defects from a family who needs the money.
  5. An individual with an adequate income decides that he would like to sell himself to be enslaved by another person. He finds a buyer willing to pay his asking price. The aspiring slave will use the money to further his children’s education.
  1. Alvin E. Roth. 2007. ‘Repugnance as a Constraint on Markets’. Journal of Economic Perspectives 21 (3): pp. 37–58. 

  2. Michael Sandel. 2009. Justice. London: Penguin. 

  3. Michael Walzer. 1983. Spheres of Justice: A Defense of Pluralism and Equality. New York, NY: Basic Books.