A topic that gets a lot of play in most undergraduate microeconomics courses is the issue of market failure. Unfortunately, while the concept is sound, many people and even many economists err in one of three ways. First, they often attribute problems to market failure that are actually the result of government intervention. Second, economists often fall into the trap of doing “armchair economics” and fail to look at the real world where some of the things they call market failures are often market successes. Third, although non-economists and economists can sometimes point to examples where markets fail to achieve the economist’s ideal and to the fact that no apparent government intervention causes it, they often conclude, without examining how government works, that the government will do better.
This is the opening paragraph of David R. Henderson, “A Skeptical Look at Market Failure,” Defining Ideas, July 14, 2023.
Under the second item, I discuss lighthouses and contracts between bee owners and orchard owners. I also quote one of my favorite lines from Ronald Coase, which, it turns out, was not original with Coase.
Under the third item, I discuss Demsetz’s distinction between the “Nirvana approach” and his preferred “comparative institutions approach.”
Read the whole thing.
The picture above is of Harold Demsetz.
READER COMMENTS
Dylan
Jul 13 2023 at 10:27am
Overall a good piece, and I agree that it is frustrating when things are called market failure that are really caused by government interference in the market. That being said, I wanted to draw attention to this example, since I think there are a few things wrong with it.
First, I’m not familiar with any research towards using felbamate in stroke patients intravenously. A quick Google Scholar search didn’t find much, but I didn’t dig too deep. So, everything I’m going to say is more general.
Steiner says that it could reduce damage from stroke by half, but without a clinical trial that is just informed speculation, and most of the time that speculation is wrong.
I did find a paper that said that an IV formulation wasn’t developed for felbamate due to solubility issues – those could possibly be avoided with a novel formulation, which leads to point 3
The initial patents on felbamate are expired, but that doesn’t mean you can’t get new patents on formulation and for a new indication. A patent for a new indication by itself can be kind of weak, but combined with a formulation patent for IV administration, this should be almost as strong as the original patent and give another 20 years of protection. You’d have to run trials before you take it to the market, but trials are typically shorter if you’re not dealing with a NCE (new chemical entity), so you might even get more market exclusivity than the original innovator did.
The patent system itself is of course a form of government interference in the markets. One of your co-bloggers recently wrote a piece advocating for abolishing the system, but I believe that most economists favor some form of IP protection as correcting for what would otherwise be a “market failure” of an under investment in innovation.
Dylan
Jul 13 2023 at 10:28am
Frustrating that a numbered list gets automatically created when writing a post and formatted well, and then disappears into a single paragraph once you post
steve
Jul 13 2023 at 2:09pm
Something seems to be wrong with this claim. Drug companies commonly apply for formulation patents on older drugs that have been available for a while. They do get abused a bit but this would seem to be a near perfect fit for this kind of adaptation. Description at link.
https://www.obrienpatents.com/types-pharmaceutical-patents/
Steve
Jon Murphy
Jul 13 2023 at 10:51am
Good stuff here. I would like to point out that Rosen & Gayer also make a “lighthouse” mistake. Some financial planning firms (like Northwest Mutual) do offer what is essentially “poverty insurance.” It acts like unemployment insurance: if you are laid off, they pay you your salary for a certain period of time.
robc
Jul 13 2023 at 2:48pm
My info may be out of date, but the last time I looked at it, both companies offering private unemployment insurance were not accepting new clients.
Jon Murphy
Jul 13 2023 at 4:08pm
That could be. I have one such policy still. Maybe I am just grandfathered in.
Monte
Jul 13 2023 at 12:47pm
Up until the last few years, most economists might have agreed with you. The patent system was/is intended as a collaborative effort between private enterprise and the government to promote entrepreneurship and innovation. However, recent judicial reforms to the system (abstract idea doctrine, creation of the PTAB, venue reform) have had a crippling effect on the market for ideas and their patent applications. Rather than correcting for any perceived market failure, the current system can more accurately be described as both a government intervention and a government failure.
Jose Pablo
Jul 17 2023 at 2:42pm
both a government intervention and a government failure.
Aren’t these two the same thing?
vince
Jul 13 2023 at 1:53pm
If private interests lobby for their own favorable market failure, who should be blamed, the private sector or the public sector? It’s too simple to call it just market failure or government failure.
Jon Murphy
Jul 13 2023 at 2:41pm
Public sector. They’re the ones handing out favors.
vince
Jul 13 2023 at 3:43pm
But they don’t hand it out for free …
Jon Murphy
Jul 13 2023 at 4:08pm
True but irrelevant.
Michael Sandifer
Jul 13 2023 at 5:52pm
If I’m not mistaken, the best establiished market failure empirically involves sticky wages. It is not obvious to me that government controlling the money supply has been the best solution to this problem.
nobody.really
Jul 14 2023 at 6:26pm
What conclusion are we supposed to draw based on the Coase article?
First, yes, Coase notes the role of private initiative in building lighthouses. But he also cites a Report of the Select Committee of the House of Commons noting that lighthouses “have been left to spring up, as it were by slow degrees, as the local wants required, often after disastrous losses at sea….” That doesn’t strike me as a ringing endorsement of the efficacy of private initiative.
In short, even if we conclude that private initiative was sufficient to generate SOME lighthouses, I find nothing suggesting that it generated anything like an optimal level. Indeed, arguably the greatest need for a lighthouse is along remote, rocky shoreline far from any port. How were such lighthouses built and financed? Maybe I just missed it, or maybe they weren’t.
Second, and more importantly, the idea that lighthouses are “privately provided” strains the meaning of the term. Yes, lighthouse owners charged ships at ports. But why would ships pay? If a given dock required such a fee, why not simply unload at the dock 10o feet down the shoreline? Coase explains why: The lighthouse owners had received GOVERNMENT AUTHORIZATION TO TAX. (For example, “Two men, Lovett and Rudyerd, decided to build another lighthouse. Trinity House agreed to apply for an Act of Parliament authorizing the rebuilding and the imposition of tolls and to lease their right to the new builders.”)
Granting private parties the power to impose arbitrary taxes backed by government authority—what could possibly go wrong? Coase is happy to tell us, quoting the Select Committee of the House of Commons of 1834:
What grounds was there to think that the lighthouse operators were charging more than necessary? ‘Cuz they don’t deny it; instead, they seek Parliament’s sympathy on the grounds that they use some of their profits to support a charity. Awww….
So, yes, it appears that in the United Kingdom, lighthouses were financed through government-enforced user fees rather than from the nation’s general fund. This entailed some individual initiative, but that initiative involved securing government authorization for a local monopoly without the benefit of rate regulation. And ultimately Parliament overturned this system out of concern that arbitrary taxation was an impediment to commerce. True, Parliament had to buy out the tax-collecting concession it had granted to the private parties, and so was unable to impose a general reduction in lighthouse taxes until this debt was paid off. Coase acknowledges that these fees in fact decreased thereafter, but expresses remorse for the charity’s losses.
So what does all this tell us about market failure?
David Seltzer
Jul 14 2023 at 6:49pm
Nobody, trenchant as always. Nobody said, “Granting private parties the power to impose arbitrary taxes backed by government authority—what could possibly go wrong?” Is this market failure or another example of regulatory capture? It seems market failures in the absence of government intervention, are more quickly self-correcting than government failure.
Jon Murphy
Jul 15 2023 at 11:05am
That public goods don’t need to be publically provided.
nobody.really
Jul 15 2023 at 1:46pm
What does “publicly provided” mean, if not provided on the basis of taxation?
David Seltzer
Jul 15 2023 at 3:29pm
Private highway builders erect tollbooths at entrances and exits and charge for use of their roads. Hayek talked about banks using private currency. He called it Free banking. I suspect there are other examples of public goods not provided by taxation.
nobody.really
Jul 15 2023 at 3:52pm
Great. To this list we could add intellectual property rights: Giving someone a monopoly (copyright, patent) on some intellectual property for a period to provide an incentive to produce intellectual property.
But none of these examples relies on taxation–whereas the lighthouse example apparently did. After all, I’m free to evade paying a road toll by driving on some parallel roads to get to the same destination—but it’s unclear whether shippers could evade the light tax by using a parallel dock; the lighthouse authorities apparently had received permission to impose a tax on all shippers at a given port, regardless.
Jon Murphy
Jul 15 2023 at 5:53pm
Provided by the government.
nobody.really
Jul 19 2023 at 2:53pm
Ah. So the moral is that we don’t need the government to provide public goods so long as we can rely on private parties wielding government-granted taxing powers. I’m glad we’ve clarified that crucial distinction.
In the absence of such arrangements, nothing in the Coase article dissuades me of the merits of government intervention to provide public goods. Indeed, Coase documented that even in the presence of such arrangements, letting government run the lighthouses resulted in the same services delivered at lower cost.
David Henderson
Jul 15 2023 at 10:27pm
Your comment deserves a response. I’m on vacation, which is why I haven’t done so yet. But I’ll reread Coase’s article and respond tomorrow.
David Henderson
Jul 16 2023 at 7:12pm
I’ve now reread Coase’s article.
Here are my responses.
You write:
Hmmm. Interesting perspective. It does strike me as a ringing endorsement of the efficacy of private initiative. A problem happens. People come up with a way of dealing with it. I bet that fire insurance on houses didn’t come about until after actual houses burned down.
You write:
I think you fell victim to the Nirvana approach. I don’t know what the optimal level is but this statement from Coase on page 364 is quite revealing:
Whatever the optimal level, some is more than none.
Also, Coase does give an example of a lighthouse built privately 14 miles offshore. That strikes me as an example of a lighthouse “far from any port.”
On the rest of your comment, you’re right that this is not a clean case of private provision with coercion. But it’s fairly limited. The people coerced were those for whom there was a prima facie case that they benefited from the lighthouse.
Ken Costello
Jul 15 2023 at 10:03am
Many physical projects and new technologies with long lives have high initial costs that could discourage investors who require a quick payback. Whether barriers to particular investment warrant third-party (namely, government) support in response to alleged market failure to alleviate them is a policy question that often results in government failure. A strong argument against intervention is that some barriers are normal market features best addressed, over time, by buyers and sellers of new technologies. For example, the advancement of certain technologies that would lower capital costs reflects an expected market response to boosting their economics.
Another point is that the hesitancy of firms to invest in ostensible cost-effective investments might reflect uncertainty of the future rather than irrational behavior or, again, a market failure. Often in other contexts the unwillingness of market participants to take actions that on the surface appear to be in their self-interest presumes a flawed market. Inertia, instead, may simply reflect the reluctance of prospective investors to commit funds because of uncertain outcomes that could make them worse off. It may also reflect, say, high transaction cost of switching to a new technology. Mitigating or eliminating some barriers like inertia when in fact they reflect rational behavior is ill-advised: they are simply not cost-beneficial. Spending taxpayers’ monies to alleviate this “problem” in most instances would constitute bad policy.
nobody.really
Jul 17 2023 at 6:14pm
1: David Henderson has a knack for understatement. This ranks along with “Accounts of my death have been greatly exaggerated” (a delightful line which, as with so many delightful lines, Mark Twain never quite got around to saying).
To my mind, the relevant questions are A: Do the aggregate benefits of a lighthouse exceed its costs? and B: Would people have built the lighthouse in the absence of the ability to coerce payments from shippers? If the answers are A: yes and B: no, then this looks like market failure to me, justifying government intervention–at least, the intervention of granting a monopoly.
At best, it appears that port owners might have had a local natural monopoly in “porting” services, and used their monopoly to extort shippers into paying for “lighthousing” services as well. (In antitrust parlance, they refused to “unbundle” their monopoly services from their non-monopoly services.) But it also appears that the port owner’s monopoly may not have been all that natural, but was instead granted by the state.
(That said, would state involvement make any difference? If a private party with a monopoly to a given location imposes conditions on your accessing that location, does that differ in any meaningful way from a state-imposed condition?)
2: Consider the case of Charles River Bridge v. Warren Bridge, 36 U.S. (11 Pet.) 420 (1837). Massachusetts “granted a charter” to the Charles River Bridge Co. to build a bridge over the river and to collect tolls for a term of years. Thereafter Massachusetts granted a charter to the Warren Bridge Co. to build a second bridge nearby–a bridge that would charge tolls for six years and then become free.
The Charles River Bridge Co. sued for breach of contract, arguing that its investors made their investment solely on the implied term that they’d have a monopoly. Investors make investments by assessing supply, demand, and normal business risk; if the state can arbitrarily change these variables, the plaintiffs argued, then no one’s investments are safe.
In deciding whether government action constituted a “taking of property for a public purpose” in violation of the 5th Amendment, SCOTUS would ask if that action “interfered with distinct investment-backed expectations….” But the Court articulated that standard in 1978. In 1837, in contrast, the Court concluded that the state’s power to promote the public welfare trumped whatever ambiguous claim the Charles River Bridge Co. had. Unlike the case of the lighthouses, no compensation was given to the Charles River Bridge Co., which had apparently been driven out of business before SCOTUS had issued its decision.
3: Or consider slavery–an institution that induced free people to invest in slaves by granting a state-enforced monopoly on the proceeds from an enslaved person’s labor. When the state subsequently abolished slavery, many slave owners complained that this constituted taking of private property for a public purpose without just compensation. But in DC, slaveowners were paid to surrender their slaves. Note, however, that this compensation policy was enacted before the end of the Civil War, when the future of slavery was very much a live issue. This is a relevant practical fact, although it’s not clear how the state of the Civil War influences the issue of government takings.
4: These cases pose challenges for libertarians: Should they celebrate the rejection of state-imposed monopolies? Or should they defend private property/contract rights from state encroachment, especially when the state was explicitly or implicitly party to initially granting the property/contract right?
In fairness, I guess we can wait until David Henderson returns from his NEXT vacation to address all of this….
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