Free markets are not perfect. In fact, they are anything but (a topic I have spilled lots of digital ink in discussing, for example here). Markets may end up in inefficient allocation of resources, may give rise to monopolies, or any number of other non-perfect competition outcomes. However, the fact markets aren’t perfect, that people make mistakes, is a feature, not a bug, of markets.
When a market imperfection (or “market failure”) arises, it indicates that there is some “surplus” (that is, welfare) not being captured. It’s being lost. This signals a profit can be made for anyone willing to exploit this failure and correct it. If, for example, the price of Good X is “too high” because of monopoly power, it encourages people to look for ways to enter the market to capture some of that profit. This, in turn, brings more of Good X to the market which helps lower the price of Good X.* The market mechanism helps fix the misallocation.
Of course, enticing others into production is not the only way the market can “heal” itself. Relatively high prices also cause people to search or create substitutes. A good example of this is what Mark Perry highlights at Carpe Diem: synthetic diamonds created to combat the cartel power of diamond miners. In fact, the failure or missteps of markets is a major driver of innovation!
However, the profit motive is itself not perfect. When dealing with public goods or poorly defined property rights, the profit motive may break down. There is a lot of discussion to be had on that topic, and thus I will avoid it for now. Rather, I want to focus on the larger message: markets stumble, but they also have mechanisms built in to correct those stumbles.**
The market has failed. Long live the market.
*This example assumes no government barriers protecting the monopoly. Other barriers, such as geographical or technological, that help create a monopoly can be broken down eventually. Government barriers, not so much.
**I’m hesitant to use this language as it may cause the reader to conclude, incorrectly, that markets are machines that can be designed. I hope readers know markets are organic and not mechanical.