Is Market Failure a Sufficient Condition for Government Intervention?
1. Introduction
We are unapologetic defenders of the economic way of thinking, not merely
because it helps us understand why—as economist Joseph
Schumpeter explained—capitalism
allows factory girls to buy more and better stockings for progressively
decreasing amounts of effort, but because with good economic analysis, some of
the great atrocities of human history could have been avoided. For example, the
Progressive eugenics movement of the early twentieth century was offensively
anti-economic, even though some who were called "economists"
encouraged it.1 As
Bryan Caplan has pointed out, the Holocaust found some of its roots in
Malthusianism, the idea that population growth would outstrip the growth of
agricultural output.2 The
disasters of central planning in the USSR, China, and elsewhere speak for
themselves. We don't exaggerate when we say that sound economic reasoning could
have saved tens, if not hundreds, of millions of lives.
But economic knowledge incompletely applied can be dangerous. In
introductory economics classes, students learn about several types of
"market failure," which occurs when some attributes of the market
prevent it from producing an efficient outcome. In the context of
twentieth-century neoclassical economics, these represent failures of the
actual market to reach the equilibrium of the perfectly competitive model. In
this framework, market failures are possible when there are externalities (uncompensated
costs or benefits that spill over onto people who are not party to a trade);
public goods (goods that are non-rival in consumption and for which it is
prohibitively costly to exclude non-payers); asymmetric information; and market
power like monopoly (when there is one seller of a good or service), monopsony
(when there is one buyer of a good or service), or natural monopoly (when the
cost structure of the industry makes it more efficient for a single firm to
produce the entire market's output).
Externalities, public goods, asymmetric information, and market power
provide necessary—but insufficient—conditions for intervention to be justified.
They certainly are not talismans that provide interventionists with carte
blanche to tinker with the members of a society as if they were pieces
on a chessboard. Too often, critics of markets think that merely invoking these
terms destroys the case for free markets.3 Unfortunately,
non-economists often do not understand these terms. Indeed, understanding these
terms clearly is only a first step toward a clear understanding of social
phenomena. Let's consider each of these concepts in turn.
2. Externalities
Critics of the market sometimes invoke externalities, which refer to costs
or benefits of economic activity that fall upon people not party to the actions
in question. A classic external cost (or "negative externality") is
pollution. Suppose that steel firms produce in a way that sends chemicals into
the air that dirty people's hanging laundry or cause them to feel ill, even
though they did not purchase the steel. If someone who purchases steel bears
these costs, we simply recognize it as part of what was purchased—i.e., the
cost is "internal" to the exchange. Another classic example is the
railroad that cuts through farmland and throws off sparks that occasionally
cause fires on the property of nearby farmers. A classic external benefit (or
"positive externality") is education. If we pay a university to
educate us, some of the benefits of that exchange accrue to the rest of society
by virtue of our higher productivity or more virtuous behavior.4 Just as the victim of
pollution has borne a cost without a benefit, the rest of society gets a
benefit from our education without bearing a cost.
In terms that are usually associated with Ronald
Coase, it looks as if markets
fail when the private costs or benefits of actions deviate from social costs or
benefits. In the case of negative externalities, economists have usually
suggested taxes on the externality-generating actions. So-called "Pigovian
taxes" (after economist A. C.
Pigou) would fix the market
failure. Market critics invoke precisely this sort of argument to explain why
government intervention is necessary.
However, the mere existence of a negative externality does not ipso
facto mean that government can improve on the market. Note that
externality problems are market "failures" only in comparison to the
perfectly competitive model's equilibrium. In other words, the "failure"
here is not that markets "do not work" in practice, but that they
fail to live up to a blackboard ideal. As it turns out, by that criterion, markets
"fail" all the time! No actual market is ever in perfectly
competitive equilibrium, not even the commodity markets we sometimes point to
in introductory courses.
In fact, negative externalities are omnipresent. We develop all kinds of
voluntary rules for dealing with them. The rules of etiquette, for example,
perform this function. When we all mind the rules of etiquette, we can both
avoid imposing external costs on others and have low-cost ways of dealing with
such negative externalities, all of which improve social interaction.
Understanding "market failure" and the omnipresence of negative
externalities can lead us to make the comparison that does matter.
Implicit in negative-externality arguments for intervention is the claim that
the political process will actually do what economists say it should do.
That is, politicians will impose the blackboard solution. However, the public
choice5 revolution that began in
the 1960s has challenged that assumption by showing how governments also fail.
Politicians' self-interest, combined with the limits to their knowledge, mean
that they likely will not and cannot produce the ideal
outcome. We are left to ponder which of two imperfect systems will serve us
better: the "failed" market or the "failed" political
process. We have many reasons to think that markets will outperform government
in this regard, even in less-than-perfect conditions. One approach sees every
"market failure" as an opportunity for entrepreneurs to solve a
problem and discover, through profit and loss, how well they have done.
Political processes do not have the requisite incentives and
knowledge-conveying processes to do as well.
Therefore, those who use "negative externalities" as a
justification for government action must show two things: first, that the
supposed market failure cannot be corrected either through entrepreneurship or
by changes in the rules of the game (e.g., more clearly defining property
rights to solve the negative externalities associated with a commons6); and second, that the
government-imposed solution is both consistent with political incentives and
superior to the imperfect market outcome. Unfortunately, people who argue for
government intervention to correct externalities rarely carry out this second
step. Even more unfortunately, economists rarely carry out this second step.
3. Public Goods
As economists are constantly pointing out, what makes something a
"public good" is not that the government produces
it, that it makes the public better off, or that it is conducive to the good of
society in some cosmic sense. Rather, something is a public good because is it
non-rival in consumption (which means that one person's consumption doesn't
leave less for others) and non-excludable (which means that it is prohibitively
costly to exclude people who don't pay for the good or service). An apple is a
rival good: If one person eats an apple, another person cannot. An economics
lecture is a non-rival good, up to a point: If you are sitting in a classroom
listening to your economics professor, you aren't reducing the amount of
economics lecture others can hear.
Excludability is more difficult. It is difficult to exclude someone from
being defended against a nuclear attack. If we pay to have our homes protected
from nuclear annihilation, we almost certainly will protect our neighbors'
homes, as well. Probably the best example of a pure public good is defense
against an asteroid that might destroy planet Earth—and this is used as an
example in chapter 18 of Tyler Cowen and Alex Tabarrok's Modern
Principles: Microeconomics textbook. But even then, there is a rival,
excludable, feasible-with-current-technology way to protect oneself from a
grisly, asteroid-related death, if the asteroid is small enough: build a
bunker. Goods that have both characteristics, goes the argument, are
under-produced by the market because many will benefit even if only a few pay.
People make some obvious mistakes when discussing public goods. The most
common one is to take the word "public" in "public good" to
mean "provided by government." But as we have noted, the word
"public" here refers to various features of the good and not to
whether the government currently provides it. Some claim that
higher education is a "public good," but we disagree. College is
excludable: Samford University and St. Lawrence University, where we teach, can
turn people away at the door. Contrary to popular belief, education is not a
public good by the economist's meaning of that term. History is filled with
examples of so-called "public goods" that were provided by market
mechanisms. To take just one example, economist Daniel D'Amico argues that law
enforcement, criminal law, and prisons can be provided privately. D'Amico
argues that government provision of prisons in ancient Greece originated not to
address market failures, but to benefit political elites.7
4. Asymmetric Information
Asymmetric information occurs when one party to an exchange has relevant
information that the other party does not. The market for health insurance
supposedly fails because of two phenomena: adverse selection and moral hazard.
In the case of adverse selection, due to an insurance company's inability to
distinguish between the sick and the healthy, only the sick will seek
insurance. In the case of moral hazard, someone who has insurance might change
his or her behavior and take greater risks because someone else (the insurance
company) will bear the costs.
Apparent failures in the market for medical insurance suggest a puzzle: Why
didn't Americans adopt some form of national health coverage during the
Progressive Era? There was a movement for it among reformers, but ordinary
Americans did not want it. Some historians claim that a combination of special
interests and American workers' ignorance explains why. But in his 2007 book Origins
of American Health Insurance: A History of Industrial Sickness Funds,
economic historian John E. Murray shows that American workers did not want
government-provided health coverage because they were satisfied with their
private solutions. Premiums were low, benefits were not lavish—it was insurance,
after all—and firms, funds, and workers devised a number of ways to address the
possibility of opportunistic behavior by fund participants. These funds were
not perfect; however, as Murray notes (p. 247), it was clear that they were not
"obviously worse than the state-led alternative."
When firms face the right incentives, they will create high-quality goods
and provide accurate information about them to consumers. In competitive
markets, reputation is a very strong mechanism that gives firms an incentive to
maintain certain standards of quality. Economic historian Sukkoo Kim notes8 that with urbanization
and the growth of markets, brand names and multiple locations operating under
the same banner (A&P back then, McDonald's today) became an important way
in which a firm could signal quality. Also, private certification firms and
organizations—such as the Underwriters' Laboratory, Good Housekeeping, the National
Institute for Automotive Service Excellence, and the Consumers' Union—test,
rate, and evaluate products. This is improving with mobile technology. If you
have ever visited a restaurant because of reviews you have read on yelp.com,
then you understand the power of a marketplace for information.
Here, too, simply claiming that there is "asymmetric information"
does not, on its own, make the case for government intervention being
preferable to the market. The existence of such problems has not prevented market
solutions in the past. Moreover, many current government interventions that
people use such arguments to justify were originally based on private,
self-serving interests and not on the public good. Consider the supposed
failure of the market for information in the medical field. As Milton
Friedman argued, medical
licensing raises the incomes of incumbent doctors at the expense of consumers.
Economist Morris Kleiner has shown that this is true for many licensed
occupations.9
5. Market Power
Monopoly is another market failure. A monopolist (a single seller of a good
or service) charges too much and produces too little output. In the early
twentieth century, several "trusts" were broken up by an activist
federal government. In his article "The Protectionist Roots of
Antitrust," economist Thomas J. DiLorenzo points out that many of the
firms and individuals persecuted as "monopolists" did not fit the
description. ALCOA, for example, was alleged to be a monopolist, not because it
raised the price of aluminum, but because itlowered the price.
Similarly with the so-called "robber barons."10 In a dynamic
marketplace, as Joseph Schumpeter noted in the middle of the twentieth century
and as economists Douglass C. North, John J. Wallis, and Barry Weingast argued
in their 2009 book Violence and Social Orders, the way to get rich
is to innovate: to come up with better mousetraps and let the world beat a path
to your door.
"Natural monopoly" sightings are almost as rare as Bigfoot
sightings. Although some public utilities may be natural monopolies, many
so-called "natural monopolies" are not. Even with public utilities,
we can see that changes in technology can undermine what appears to be a
natural monopoly—e.g., the development of using microwave technology to
transmit phone calls, followed by cellular technology. Of course, AT&T's
long-standing monopoly over phone service was the result of its effective
lobbying of the government in the 1910s, a time when it was the largest of over
20,000 separate phone companies. This slowed innovation: Absent the grant of
monopoly to AT&T, the United States would likely have had more advances
more quickly. Moreover, the Federal Communications Commission slowed the
introduction of cellular phones by more than a decade and at a cost to
Americans comparable to that of the infamous savings and loan bailout.11
A quick search shows that a lot of people think that Google is a natural
monopoly in the search world (proof by contradiction that it isn't: Art did the
search using Bing); that Facebook is a natural monopoly in social media (proof
by contradiction that it isn't: Art has LinkedIn, Google+, and Twitter
accounts); and that Twitter is a natural monopoly in whatever Twitter does,
exactly (proof by contradiction that it isn't: we both do similar things with
other social media sites). A few years ago, people were claiming that Microsoft
is a natural monopoly (proof by contradiction that it isn't: Apple), and today
some people are claiming that Apple is a natural monopoly (proof by
contradiction that it isn't: Microsoft). Just a few years ago, you could read
that MySpace is a natural monopoly. As with our other examples, simply pointing
to large firms and claiming "market power" or "natural
monopoly" does not magically end the debate; rather, it is the start of
what should be a much more interesting conversation about markets and
governments.
6. Conclusions
Market failure is a tricky topic even for professional economists. And when
non-economists raise the examples of market failure that we discussed here,
matters become even trickier. Not only do all of these terms have technical
meanings that often do not match what the non-economist thinks the terms mean,
but most non-economists also are unaware of the various criticisms that have
been raised in the literature on these topics. Most important, non-economist
critics of the market are frequently unaware of the comparative institutional
analysis that public choice theory has made a necessary part of thinking about
the role of government in the economy. Pointing out imperfections in the market
does not ipso facto justify government intervention, and the
only certain way that market "failures" are "failures" is
by comparison to an unreachable theoretical idea. Market imperfections are not
magic wands that make market solutions and government imperfections disappear.
Real understanding of comparative political economy begins rather than ends
with the recognition that markets are not always perfect.
Footnotes
1. See Carden, Art and Steven Horwitz. "Eugenics: Progressivism's Ultimate Social
Engineering." The
Freeman, September 21, 2011.
3. One extreme recent example is a critic's recommendation
that the government nationalize Facebook. See Philip N. Howard, "Let's Nationalize Facebook,"Slate, August 16, 2012.
4. If the student captures all of the increased productivity
in his or her wage, then there is no positive externality involved.
5. For more on public choice, See William F. Shughart, II, "Public
Choice," in David R. Henderson,
ed. The Concise Encyclopedia of Economics, 2nd ed., Liberty
Fund, 2008.
6. For more on the commons, see Garrett Hardin, "Tragedy of the Commons," in David R. Henderson, ed. The Concise Encyclopedia of
Economics, 2nd ed., Liberty Fund, 2008.
7. D'Amico, Daniel. 2010. "The prison in economics:
private and public incarceration in Ancient Greece." Public Choice 145(3-4):
461-482.
8. Sukkoo Kim, "Markets
and Multiunit Firms from an American Historical Perspective," December 14, 2000. PDF file.
9. Friedman, Milton. 1962 [2002]. Capitalism and
Freedom. Chicago: University of Chicago Press. Kleiner, Morris. 2006. Licensing
Occupations: Ensuring Quality or Restricting Competition? Kalamazoo,
MI: Upjohn Institute for Employment Research.
10. See David R. Henderson, "The Robber Barons: Neither Robbers Nor
Barons," Econlib, March 4, 2013,
11. See John Haring, "Telecommunications," in David R. Henderson, ed. The Concise Encyclopedia of
Economics, 2nd ed., Liberty Fund, 2008.
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