The Roots of Government Failure
By Randy T. Simmons
The Independent Institute Copyright © 2011 The Independent Institute
All rights reserved.
Market Failure and Government Intervention
The View from Welfare Economics
EVEN THE MOST elementary of modern economics texts routinely inform the reader that markets suffer from serious and inherent imperfections. We are told of undersupplied public goods, exorbitant and ubiquitous social costs of private actions, inevitable business cycles, unprotected consumers, and unfairly distributed wealth and income.
Concerns about markets are widespread among economists. The Wall Street Journal (Sept 3, 2004) asked several Nobel economists, "In what sphere of life, if any, do you think it most important to limit the influence of market forces?" Most replied with the standard arguments of welfare economists about supposed market failures. One did not, however. Vernon Smith, who shared the Nobel Prize in 2002, answered:
None, because "markets" are about recognizing that information is dispersed in all social systems, and that the problem of society is to find, devise and discover institutions that incentivize and enable people to make the right decisions without anyone having to tell them what to do. The idea that market forces should be limited stems from a fundamental error in beliefs about markets. This is the wrong question.
The other Nobel economists' worries about market failure have a powerful impact because such worries are intuitively appealing and understandable to the general public and especially to idealistic students. And when these worries about markets lead to proposed solutions, most people ignore Professor Vernon Smith's concerns about wrong questions because the causes of failure are seemingly clear and the solution readily at hand. When markets fail, this argument goes, we must resort to and can rely on politics and governmental administration. Resources will be allocated efficiently and wealth and income will be fairly distributed, that is, more equally divided. Furthermore, political activity ennobles individual citizens while the unseemly, raucous, and self-interested competition in the market debases them.
Many economists now agree that models of market failure need to be coupled with models of government failure. Yet, even the Nobel economists interviewed by the Wall Street Journal quickly slip into worries about market failures. Moreover, non-economist social scientists and the general public are even more inclined to take a jaundiced view of the workings of a market economy. For them any activity motivated by self-interest is at best suspect and at worst contaminated. Adam Smith's unseen hand is widely regarded as a contradiction in terms; public benefits cannot emerge from competition and self-interest. In contrast, since political man is considered selfless and well informed, the public interest can be readily and accurately divined; since the political process is considered costless, the public interest is easily achieved. And political conflict debases no one.
I reject this simplistic political view and contend that market failure is seriously misunderstood. Further, I maintain that normal political responses to alleged market failures usually make things worse and that our chief problems stem not from market difficulties but from political intervention in otherwise robust markets. To set the stage for my arguments, I begin by exploring how markets work and discuss how mid-20th century critics — led by welfare economists — criticized them and justified the government intervention so prominent today.
The Market Process
"The market" is an abstract concept referring to the arrangements people have for exchanging with one another in all aspects of economic life. Thus, it is a process rather than a clearly defined place or a thing that we can observe easily, although some markets are in particular places. Markets can be as formal and well organized as the stock market and as informal and unorganized as Saturday garage sales or even singles bars.
Markets coordinate human activity by taking advantage of self-interest, as Adam Smith ( 1981) famously pointed out. In the "bartering and trucking" of the market, a person is "led by an invisible hand to promote an end which has no part of his intention" (IV.ii.9). In one of Smith's most famous passages, he asserted:
It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves not to their humanity, but to their self-love, and never talk to them of our own necessities but of their advantages (I.ii.2).
Notice that Adam Smith's example shows how markets use self-interest to cause people to act as if they care about others. We get what we want from the butcher, brewer, and baker by making them better off. Conversely, they improve their own wealth by making us better off and they seek to do so, not because we necessarily like each other (although brotherly love is not precluded) but because they do "well" in markets by doing "good" for others. The chief characteristic of markets, then, is cooperation with others.
All of the cooperation between buyers and sellers and competition for products and for buyers means that no one is in direct charge of markets — no one declares how much of a product will be produced, by whom, in what quantities, and what will be the price. There is no one in charge of the market for shirts or coffee or pens or shoes, or bread or the myriads of other products we buy and sell every day. They are all produced and their prices are set spontaneously, without central direction and central planning. Individual companies and entrepreneurs, however, do a great deal of planning while coordinating their activities across time and space with little or no knowledge of each other.
Not only is no one in charge of markets, no one knows how to produce the vast majority of products sold in markets. The classic essay explaining how decentralized knowledge is coordinated spontaneously is "I Pencil: My Family Tree as told to Leonard R. Reed (1958)." In the essay the pencil makes a startling statement: "... not a single person on the face of this earth knows how to make me." He means that although billions of pencils are made each year no single person knows how to do all the steps in the process — creating saws, cutting trees, building trucks to haul logs, mine and smelt ore, and on and on. "I Pencil" has been updated by Matt Ridley in his book The Rational Optimist: How Prosperity Evolves (2010). "No single person," Ridley writes, "knows how to make a computer mouse." Many people know how to assemble a computer mouse, yet they know nothing of the processes of producing plastic from oil, drilling for the oil, or creating the materials needed for circuit boards. Ridley describes the computer mouse as "a complex confection of many substances with intricate internal design reflecting multiple strands of knowledge."
Markets develop and expand by relying on voluntary exchange as a way for people to obtain what they want. Markets promote exchange by providing information about the qualities of a particular product, especially compared with the qualities and costs of competing products, and the cost of agreeing on a price. When the costs of making decisions and trades are reduced, new opportunities can be exploited, and as the new opportunities are exploited wealth increases and economic growth occurs. More opportunities mean more wealth.
A simple classroom experiment illustrates the power of exchange in making people better off. As students enter the room they receive a plastic sandwich bag containing different combinations of candy. Each student identifies the value of his or her bag and the individual values are totaled. Then, students are allowed to exchange any of their candy with other students. After exchanges are made the students place a monetary value on their bags and those values are totaled. The bags are now worth more to them than they were before trading. That is, the trades produced more wealth even though the total amount of candy did not change.
Markets provide information, in part, by generating prices. Each price is a piece of potentially valuable information about available opportunities. The more prices there are and the more widely they are known, the wider the range of opportunities available and the more wealth that is generated. The prices consumers are willing to pay at a particular time and place indicate the relative value the consumers place on goods and services. As prices become known, individual suppliers send goods and furnish services where they are wanted most; that is, where they bring the highest price.
Because prices indicate the relative values other people place on goods, prices discourage wasteful use of scarce resources. The fact that something is expensive is an indication that others value it highly and that it is costly to replace. The fact that something is inexpensive or even free for the taking — if it has a zero price — indicates that it has little value to others and can be replaced easily. Low prices encourage consumption. High prices discourage it.
Markets, then, are decentralized processes for directing human activity. No central committee or decision-maker determines how or when resources will be used. Instead, values are expressed by monetary bids, and self-interest is usually the dominant motive for participation. When such a process produces outcomes that seem unacceptable or less than what is believed possible, many people — economists and non-economists — tend to support attempts to impose the visible hand of government on the invisible hand of the market.
Markets function best within a stable legal structure containing a set of welldefined rights. These rights include the freedom to contract with one another, the right to property, and the right to have contracts enforced. Protecting rights and contracts against fraud, deceit, destruction and theft is a necessary part of such a legal structure. Without these minimal activities by government, markets could exist only with great difficulty.
Legal systems establish frameworks for exchange — they set the rules of the game. Establishing this framework does not require that government officials or agencies intervene into the people's voluntary exchanges. It means there is a power to which people may appeal if contracts are breached, if fraud occurs, or private property is taken.
Establishing a stable legal structure while protecting rights and enforcing contracts is a widely recognized and accepted role for government. Some forms of government are, obviously, better at fulfilling those functions than others. Justifications for other appropriate functions for government are based on claims that markets, although useful for directing some human choices and behavior, are ill suited for directing others. Put bluntly, the claim is that markets fail and that failure justifies government action.
Market Failure as Justification for Restraining the Invisible Hand
Students of market failure begin their investigations of markets and market activity by postulating a perfect market; that is, one in which all opportunities for mutually advantageous exchange are being exploited. Under a set of rigorous assumptions about preferences, motivations, and technology, they show that markets will reach a point at which no one can be made better off without making anyone else worse off. Market failure simply means real-world markets failing to achieve the standards of the imaginary, perfect market.
Those economists most active in developing theories of market failure are welfare economists, one of whom was A.C. Pigou. In The Economics of Welfare (1932), which built on earlier work by Sidgwick (1883) and Marshall (1920), Pigou showed that the performance of markets in supplying social amenities is likely to be unsatisfactory. By 1952, the arguments were well enough developed for William Baumol to bring them together in his book, Welfare Economics and the Theory of the State. Baumol's work became the economic profession's standard for the study of market failures and provided an intellectual foundation on which to base proposals for government programs designed to improve on markets.
Baumol's work on the theory of market failures was followed by many of the other leading economists of his time. One notable contribution was made by Francis Bator (1958) whose essay, "The Anatomy of Market Failure," summarized what was developing into a large body of literature as well as analytical consensus.
Bator and others identified a set of market failures that eventually became central to modern economic analysis. Specifically, they clarified the characteristics of "public goods" and the reasons why markets are expected to underproduce them. They explained the nature and reasons for overproduction of negative externalities. They identified market power, lack of information, and market instabilities as having ruinous effects on the efficient operation of the private economy.
In the following pages, I briefly discuss the most commonly accepted forms of market failure developed in the welfare economics literature. I also identify the orthodox policy solutions. As later chapters make clear, I seldom agree with the diagnoses of market failure or with prescriptions for cure.
One seemingly pervasive market failure results from "spillover" or "external" costs of a private action. That is, one or more person's activities may create costs for a second person without the second person's permission or, sometimes, knowledge.
Private costs are the portion of the costs paid by the individual taking action. The spillover costs of an action are that portion of the total costs passed on to others. For example, if you neglect to change the oil in your automobile and the engine is damaged, you must have it repaired. Your negligence has produced private costs. If, however, your negligence causes the engine to emit noxious fumes, some of the costs of your failure to keep your car in good repair will spill over to all those who breathe the air contaminated by the fumes.
People generally undertake only those activities for which they expect the additional personal costs will be less than the additional personal benefits. When there are no costs created for others, an individual comparing costs and benefits avoids waste and searches for efficiency. But if some of the costs of your action spill over to others while you capture the benefits, then comparing private costs and benefits will lead to actions that are costly to society.
Let's return to the example of your automobile. If all of your auto's exhaust fumes were pumped into the interior of your car so that you were the only one to breathe them, you would drive very little if at all or you would find a means of making the emissions breathable. But if you are able to vent your exhaust fumes into the atmosphere, where others will breathe them, you are not likely to reduce your emissions voluntarily because your cost of reducing emissions outweighs your benefits. That is, since other people, plants, and animals who use the air share the cost of your pollution, you get a net benefit from polluting. Furthermore, your emissions by themselves will have a negligible effect on air quality regardless of whether others use the air as a waste repository or not.
Spillover costs are also known as negative externalities. When costs can be socialized — externalized, as in the automobile example — the individual weighs the total benefits against only a portion of the costs (the ones he or she bears) and improves his or her own position at the expense of others. Socialized costs and privatized benefits mean that people get a "free ride" at others' expense.
Where such spillovers do occur, most economists assume the market will respond imperfectly, if at all, to the desires of the public. The belief in the pervasiveness of negative externalities and the dangers they pose, as well as the implied need for government action, is demonstrated by a June 2010 Google search of the Internet for "ubiquitous externalities." The search yielded scholarly articles on electrical transmission, urbanization, water quality and quantity, political and economic interdependence, arms control, biodiversity, ecosystem management, waste disposal, and on and on. Apparently, those who seek for externalities find them everywhere.
Proponents of governments acting to control externalities commonly advocate four broad categories of policy instruments. The first three aim at influencing the behavior of the externality producer: regulation through direct controls, regulation that relies on market incentives, and persuasion. The fourth is direct government expenditures, generally for large construction projects such as sewage treatment plants to correct the externality at taxpayer expense. (Continues...)
Excerpted from Beyond Politics by Randy T. Simmons. Copyright © 2011 The Independent Institute. Excerpted by permission of The Independent Institute.
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