The theory of market failure is a reproach to the free-market economy. Unless you have perfect competition, perfect information, perfect rationality, and no externalities, you can’t show that individual self-interest leads to social efficiency.* And this anti-market interpretation is largely apt. You can’t legitimately infer that markets are socially optimal merely because every market exchange is voluntary.
Contrary to popular belief, however, market failure theory is also a reproach to every existing government. How so? Because market failure theory recommends specific government policies – and actually-existing governments rarely adopt anything like them.
What do I have in mind?
1. When markets produce too much of something, market failure theory tells governments to impose corrective taxes that correspond to the severity of the excess – then let people do as they please. In the real world, in contrast, governments normally pass a phone book’s worth of regulations. They rarely consider the cost of the regulations, and almost never just let people bypass regulations by paying a high fee. Thus, you can’t buy your way out of an Environmental Impact Statement or heroin prohibition – and if the theory of market failure is right, this rigidity is deeply dysfunctional.
2. When markets produce too little of something, market failure theory tells governments to provide corrective subsidies that correspond to the severity of the shortfall – then let people do as they please. In the real world, in contrast, governments tend to directly run industries with alleged positive externalities. Public education and health care are the obvious example, but the same goes for national parks, government lands, etc. Furthermore, government firms routinely offer even rival products for gratis or next-to-gratis – even when the products have clear negative externalities such as road congestion and subsidized energy.
3. While the theory of market failure abhors monopoly, actually-existing governments do much to stifle competition. This is most grotesque for real estate and immigration, which most governments view with dire suspicion, but perhaps most blatant for occupational licensing. Again, if negative externalities were the real rationale for these restrictions, governments would just impose taxes – then let everyone build, move, and work as they please.
I could go on and on, but general point is that market failure theory does more than complain about markets; it also tells governments how to repair them. Any government that fails to comply with these impressively precise instructions ipso facto fails. Indeed, non-compliant governments are a textbook case of government failure. And while the severity of this government failure varies, every known government fails severely.
*Contrary to poorly proof-read textbooks, markets can yield social efficiency even if these assumptions are violated. A polluting monopoly is the classic example, but there are endless others. Standard assumptions are a sufficient, not necessary, condition for social efficiency.
READER COMMENTS
Mark Z
Jan 14 2019 at 7:53pm
Excellent post. I might add a couple more examples: asymmetric information can be remedied by mandating disclosure of relevant information, or perhaps by a state-sponsored rating agency; monopolies of course can be dealt with by anti-trust laws or just having commercial taxes increase with firm size. I doubt whether heavy-handed state take over of an industry is ever justified by a market failure. It seems fairly modest intervention is the optimal way to correct for even acute market failures.
With respect to many market failures of course, markets are pretty robust; competition probably almost never has to get close to being perfect for most of the benefit of competition to be captured; professional reputation and private rating systems likely mitigate most of the costs of information asymmetry. The Stliglitzian view of markets as fragile things that shatter to pieces from the slightest bump seems very unrealistic.
Matthias Goergens
Jan 15 2019 at 8:51am
Mandating disclosure is usually a better idea than a state sponsored rating agency.
The latter comes with an implicit government guarantee that if the rating says ‘good to go’, the product is actually good to go.
The proper market response to eg the market for lemons in used cars is interesting. There are multiple responses in the works. One of them is for a company to build a stellar reputation for good cars, so they can’t afford to trade in lemons.
Mark Z
Jan 17 2019 at 3:59am
I agree, but I think some would argue that for certain services, the average consumer won’t have the knowledge to make use of disclosed information (picking a good doctor, maybe even auto mechanic, etc.) and therefore depend on some general rating or reputation. Of course private markets develop for quality rating systems too, the used car market being a good example.
Thomas Knapp
Jan 15 2019 at 9:51am
“You can’t legitimately infer that markets are socially optimal merely because every market exchange is voluntary.”
Of course you can, in the same way that people infer the opposite — by defining “socially optimal” in whatever way one pleases.
Warren Platts
Jan 16 2019 at 3:41pm
Interesting. So Trump’s countervailing tariffs on Chinese dumped steel are apparently just what the doctor ordered?
Mark Z
Jan 17 2019 at 4:00am
Were Americans consuming too much steel in your opinion?
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