Market Failure and Resource Use: Economic Incentives to Use Different Payment Instruments

Abstract

Market failure occurs when there is a divergence between a product’s private cost, the price faced by a purchaser, and its social cost, the value of real resources that are consumed when the product is produced. This holds even if private costs reflect efficient or minimum cost production. For institutional and legal reasons rooted in history, there is a substantial degree of market failure in the U.S. payment system. The use of some important payment instruments are in effect subsidized or taxed because of the divergence between their private and social costs. While there can be situations where such a divergence is in the public interest, this is not the case for the U.S. payment system. Here the subsidies and taxes distort incentives and misallocate resources, so that from a social viewpoint some payment instruments are underused and others are overused. The market failure in the U.S. payment system is the central focus of this chapter.