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Public Policy and Market Failure

The views expressed are those of the author and do not necessarily reflect the views of ASPA as an organization. 

By Ben Tafoya
June 23, 2017

Government intervention in the economy recognizes there are often issues with allocating certain goods and services using market mechanisms. For example, there is little debate about the efficiency of the market pricing mechanism making five-star restaurant meals out of the reach of the vast majority of families in our society. This is fine according to most ideological or ethical codes. The price system helps us manage scarcity but society takes action when it is not appropriate for some items given certain circumstances, because the goods or services are deemed critical to a basic standard of living. So, we do recognize every family needs a certain level of sustenance from food and we have non-market arrangements such as SNAP (food stamps) and school based nutrition programs to fill gaps. We make sure the poor and vulnerable (particularly children) have lunch and breakfast because their income levels do not allow for the expenditure of money to properly supply all items such as shelter, food and medical care, which we deem as necessities.

These types of social service interventions exist either because of a failure in the economy (such as cyclical or structural unemployment) or a personal issue such as a disability or skills/educational deficiency, which makes it difficult to impossible for the individual or family to engage in a standard of living society deems as the minimum. In the Great Depression era, the US government recognized the lack of support for retirement income for seniors and brought about Social Security. We collectively intervene in labor markets to restrict working hours and prop up wages. Without these protections employers with excessive market power would take advantage of workers by scheduling them for excessive hours and not compensating them for the additional time. This is a failure of markets in that they do not naturally provide the outcomes we desire as a society because markets operate on different motivators.

At a recent meeting, I witnessed a debate over the concept of whether building more “market rate housing” would help lessen the housing crisis in Eastern Massachusetts. The theory is that by building more housing for the higher than average income ranges will drive down prices due to chin111314seaportview_art5oversupply. This implies that the market works according to the laws of supply and demand. That means as demand increases faster than supply then prices will rise. Once they get to a point above equilibrium then demand will fall. With falling demand comes lower prices as landlords and developers and homeowners lower prices to bring the market back into equilibrium. This theory depends on the fundamental principles of the market being present; many buyers, many sellers and perfect information to make decisions. Even with the deep differentiation among suppliers of housing there are some assumptions that must be present for the market to work.

In the real world, it is difficult to see one housing market. It is useful for the purposes of comparisons over time to use aggregate depictions of the housing market such as the Case-Shiller Index from Standard and Poors. They track housing prices over time and show the ups and downs of values in major metropolitan areas. But within a metro area there are many different housing markets. They are segregated by rent versus buy, geography, price, property taxes and much more. Locally, the market for a one bedroom condo in Boston is much different than that of a three bedroom near schools and parks in the suburbs north of the city. Despite the differentiation, can increased supply drive down prices?

The challenge and reality of market failure comes from the fundamental principle of supply. Actors in markets are trying to maximize profit. Developers in the hot markets like Boston, Seattle, Washington DC, San Francisco and Seattle have been building “luxury” units rather than homes for young families. This actually drives up pricing and makes housing less affordable in the near term. The market failure comes from the lack of units affordable to families in the range of incomes under and above the median. The presence of government intervention for other purposes such as zoning restrictions on building density, setbacks and the like are to protect the scale of a neighborhood and the livability for its current residents, can exacerbate the problem of “supply.” Yet watching the current market in “hot” communities the highest buildings with the biggest densities are the least affordable units.

Given this challenge, if not market rate units, then what? Housing challenges in the nation’s metropolitan areas require the active presence of government to build and support affordable units. Housing policy must address the wide range of needs of working families. The current fiscal climate of austerity might make such a commitment difficult to imagine from a political perspective. However, if the market is not meeting the needs of consumers and the lack of housing affordability threaten the economic prospects of our great urban centers then it falls to government to craft a solution that fixes this particular market failure.

Author: Dr. Ben Tafoya is the Director of the Division of Local Mandates for the Office of the Massachusetts State Auditor. He has served as a local elected official in Massachusetts for nine years and is still active in governmental affairs. Ben has his Doctorate in Law and Policy (DLP) from Northeastern University and a BA in Economics from Georgetown University. He is a contributing faculty member at Walden University. He can be reached at [email protected] .

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