Thursday, 3 November 2011

Goff fails my intermediate micro exam

Every year, I work to beat into my Econ & Current Policy Issues students what things get to count as market failures and what things don't. So I could ask on an exam something like:
After the earthquake, many houses became uninhabitable; the price of remaining houses went up as supply remained relatively inelastic. Explain whether this is a market failure. If it is, what kind of market failure is it? If it isn't, explain why.
The very best answer - the kind that goes a bit beyond what's asked without getting much wrong - would say:
That prices increase consequent to changes in supply and demand is not a market failure; it represents the normal functioning of markets after an increase in relative scarcity. No part of the First Fundamental Theorem of Welfare Economics has been violated. At best, there is a pecuniary externality benefiting those whose homes have been less damaged. If we worry about the inequities that result from the lottery-assignment of property destruction or property price increases, that is better addressed by insurance or other transfers to those adversely affected than by intervening in property markets to cap prices.
The government may wish to reconsider the optimality of zoning regulations that limited the supply of land for housing on the Christchurch suburbs however; even in the case that those restrictions were optimal prior to the earthquake, the very large negative supply shock likely changes things.
Now, here's Phil Goff in last night's Leaders' Debate.
At times you have to intervene. The market is a good system. But there's a thing called market failure. And when you've got 10,000 people chasing sections all at the same time, that's not the normal functioning of the market. And if there isn't the supply to meet that, then your property prices are going to be inflated.
Sorry, Phil, that gets you a C- at best. Yes, if there's a shock to demand for standing houses and supply is relatively inelastic, property prices go up. But you've bollocksed the part on market failure by taking the populist understanding of the term instead of the economic one. More on that later.

Goff goes on to recommend that the government buy up a pile of sections and sell them on at cost to folks whose houses have been destroyed. Unless that's coupled with easing up the supply restrictions on the edges of town, that does nothing to reduce the run-up in house prices. And if it is coupled with easing supply restrictions, all the work's done by that easing; the government intermediation of sales is superfluous.

Key replies to Goff that central government came in to release more sections for development. It took central government far too long to do this, but moving more quickly to kick Christchurch Council around might not have been well received.

I really hate how politicians use the term market failure to refer to any market outcome of which they disapprove. They couldn't do it, though, if the public didn't share that view of market failure. And we, as a profession, do harm in our introductory-level teaching of economics. If a student comes away from Principles with a better grasp of that government can improve outcomes in case of market failure than of the strict conditions under which this may be true, we've set the stage for later policy harm.


  1. It is truly baffling trying to understand what Labour is proposing with this one.

    I can only imagine they are going to buy non-residential zoned farmland, and re-zone themselves to capture the value increase associated with the zoning and then sell them on at cost.

    I would term it - Taking the implicit nationalisation of property rights through zoning, and making it explicit.

  2. Could we get every journalist in the country to read this simple and clear post?
    Jeff W

  3. See the problem is you are not using the political definition of market failure. In the politicial world a market failure is anything that you don't like that you would happily intervene in to make it how you think it should be. This rule is especially relevant in election years or if any market does something that might make you less electable.