See Carden, Art and Steven Horwitz. "Eugenics: Progressivism's Ultimate Social Engineering."The Freeman, September 21, 2011.
FEATURED ARTICLE | APRIL 1, 2013
Is Market Failure a Sufficient Condition for Government Intervention?
"You keep using that word. I do not think it means what you think it means."
—Mandy Patinkin playing Inigo Montoya in The Princess Bride
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.
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.
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
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
For more on these topics, see the EconTalk podcasts Winston on Market Failure and Government Failure and Boudreaux on Market Failure, Government Failure and the Economics of Antitrust Regulation.
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 it lowered 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.
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.
See Carden, Art and Steven Horwitz. "Eugenics: Progressivism's Ultimate Social Engineering."The Freeman, September 21, 2011.
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.
If the student captures all of the increased productivity in his or her wage, then there is no positive externality involved.
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.
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.
D'Amico, Daniel. 2010. "The prison in economics: private and public incarceration in Ancient Greece." Public Choice 145(3-4): 461-482.
Sukkoo Kim, "Markets and Multiunit Firms from an American Historical Perspective," December 14, 2000. PDF file.
Friedman, Milton. 1962 . 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.
See David R. Henderson, "The Robber Barons: Neither Robbers Nor Barons," Econlib, March 4, 2013,