Why Market Failure Fails

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The market failure flood

One of the prevalent arguments against free markets is that free markets fail, or that there is market failure. Failure in what sense? Wikipedia explains the term nicely. Economists define market failures as markets that do not produce or allocate goods efficiently, which has a technical or mathematical definition in neoclassical models.

Technical or not, market failure is a loaded and value-laden term. Do we ever hear about market success from those who stress the failures? Do we hear about market success in the proportion it holds to market failure, which is a vast number approaching infinity? Economists who stress market failure are hardly being value-free. And they usually segue from market failure to its supposed solution, government action. Textbooks on policy analysis, welfare economics, and cost-benefit analysis are rife with instances of market failure waiting to be molded into efficient shapes by the beneficent and omniscient hands of government legislators and bureaucrats. Whole units of universities are dedicated to the pseudo-science of market failure and policy analysis.

Market failure is very big business — people are pulling down big bucks in and out of government based on this one concept. Because of all this, we the people end up paying and losing from government meddling. One tiny example from today’s headlines will suffice. The European Union proposes a one-way air passenger tax of $37, the idea being to lower the environmental impact of aviation on the environment. This is an anti-global warming measure, and it is based squarely on the notion that free markets are damaging the atmosphere. With the costs of this measure being quite definite and the benefits unidentifiable or even negative, is there much doubt that such a measure is a sure loser? But, as we proceed, you shall see that I do not intend to argue against market failure on the basis of utilitarian arguments over particular measures. There are general arguments that undercut the whole rationale that is called market failure.

Government officials are even less constrained than economists by the unenforced customs or canons of a value-free science. One encounters all sorts of government studies and policies, often written by economists, that build upon the foundation of market failure. For example, the following justification for government is extracted from a report to the European Commission: "A higher, all-enveloping level — such as the State — should carry out activities that cannot be performed efficiently by the market, or that should not be performed by it because of the nature of these activities. In other words public authorities are to take action when market failures arise. Markets fail to achieve an efficient outcome when competition is imperfect, when information is incomplete, when there are public goods to be produced, when production induces externalities, or when the markets face uncertainty. Equity considerations can also call for government intervention."

Or see here for a United Nations report with prominent sections on market failure. Or read this apology for government intervention in China written by a Yale political scientist. It is no exaggeration to say that a large part of the world of 2006 is immersed in socialist justifications for socialism that stem, not from Karl Marx, but from modern-day notions developed by economists, one of these being the doctrine of market failure.

It is very important to point out and explain the fallacies and failures of the market failure argument in some depth and from many angles because this argument is so prevalent and ultimately so damaging to human welfare. By no means do I cover all the possible grounds for rejecting market failure arguments here. There are far too many for one article, and each argument should be made in detail because of the subject’s importance. My goal is the modest one of making several rather general and possibly novel arguments in the rest of this article.

Standard of value

To make a judgment of market failure requires an external standard of value that is supposed to lie above the standards of value used by the individuals who are freely transacting in the market. That standard is supposedly "efficiency." It is virtually self-evident that it is impossible to justify such an external value over the values of free choices and exchanges made by individuals in a market. If individuals make all the exchanges that they find to be worthwhile, while respecting property rights of others, how can any outside authority justify invoking a higher standard of value that interferes and overrules individual choices? And if no external standard can be justified, then a fortiori it is impossible to justify government as a means of imposing such an external value. For these basic reasons, market failure can be indicted as a justification of government. The burden of proof strongly falls upon those who propose to impose government measures. It does not fall upon those falsely accused of failing to live up to a concocted standard.

And what are these standards anyway? Critics of the market set themselves up as demi-Gods who provide the rest of us with standards for what a market should be or do. Most of the time the standard is nothing more than a mathematical condition in an economic model! It is sometimes a claim that under certain abstract mathematical conditions a price does not equal a marginal cost. Perhaps it is a claim that there is an externality that is being under-produced or over-produced. This too will be "shown" mathematically or at least its proponents believe so. Perhaps it is a claim that a market doesn’t have enough producers to satisfy the critics. In the case of Microsoft, the regulators are dissatisfied with the very product being produced. This is a complaint in many other instances too. In general, there is a whole lot of second-guessing going on. That’s all it amounts to, and it therefore has no claim to be enforced by the heavy-handed power of the State just because it is dressed up in the pompous language of market failure.

Unanimity as a criterion

In a Cato article about the end (or failure) of market failure, Zerbe and McCurdy tell us that "the proper role of government in the marketplace" is a vexing issue. They tell us that "In the search for objective standards by which [government] decisions can be made, public officials have increasingly turned to the concept of market failure." How true. To a critic of government, such an adherence to the concept is enough to raise doubts that market failure is a valid idea. But for serious criticism, we have to ask the question: "What makes the market failure concept invalid?"

I’ve just argued that there is no possible objective standard that justifies market failure arguments for government interference in free markets. Now I will approach the issue from the other end, namely, the search for objective standards that tell us what government’s role should be and what the role of free markets should be. I will argue that there is an objective standard that delineates the size of the government’s proper role versus that of free markets, and that standard implies that the government has no role. In this I disagree with Zerbe and McCurdy who believe that "the issue of government intervention is largely empirical rather than theoretical." I disagree with Nelson whom they quote as saying: "There is no satisfactory normative theory regarding the appropriate roles of government in a mixed economy." I next develop a logical case for what that standard is.

Like Socrates, I say that government can have no proper purpose other than to do good. What is that good? Whatever it might be, it has to consist in individuals being able to achieve some benefits with government in place that they could not achieve without its existence. Moreover, since government involves a monopoly of violence and forced taxation to fund its activities, these benefits have to be such that individuals not only could not achieve them without government but would not. They must be forced into actions that they would otherwise not select on their own while acting as individuals.

But since government consists of a subset of all individuals, these government souls cannot properly impose or force themselves or their values on the remaining persons not in government with a notion of making the underlings or subjects better off. Why not? In a utilitarian framework, such a course at the very least requires invalid interpersonal utility comparisons and it requires data on costs and benefits that simply can’t be obtained by the individuals composing a government. In a natural rights framework, there also can be no validation of such an aggressive course since it violates individual rights. I conclude that any proper government has to be established by the unanimous consent of the governed at some stage, either by consent to a voting rule or by consent to the government itself. This is the objective standard that provides the appropriate size of the government’s proper role versus free markets: unanimous consent.

In reality, this is a standard that States do not ordinarily attain. If there are any that are founded on unanimous consent, they are surely exceptional. For simplicity, barring unanimous consent by its subjects, I say simply that no State can be said to have a valid warrant to interfere in free markets because none bases its measures on unanimous consent at any stage of its formation or continuation, neither in the foundational choice of social rules nor in their application.

From this it follows that it is erroneous to assume that there is some optimal positive degree of government interference in free markets. And then to attempt to find what it is by some social science or by some concept such as market failure is a futile, empty, and meaningless endeavor. It cannot be done. It cannot accomplish what it sets out to do.

Social contract theory to the rescue?

A theorist might try to rescue the State, that is, validate it by some sort of theory of social contract. This I will argue is well-nigh impossible. Suppose we try. The subjects have to unanimously agree to be ruled on a set of policy matters that I call P’s. They agree on which matters these are. At the same time, they do not agree unanimously on each of the policy matters taken singly. Otherwise they would not want or need a government. They must therefore know that they will be made to do some things against their will. They expect, however, on net to be better off, so they agree to the compact unanimously. So far, so good.

Next, they must disagree on more than one policy matter. If there were only one, they would not set up a government. There must be at least two such issues. If there are, why don’t the individuals bargain among themselves to reach agreement on the package? Why create a government to settle the matters? For example, there are 3 people, A, B and C. A and B want P1 and C wants P2. A and C want P3 and B wants P4. They bargain and agree on P1 and P3. A gets P1 and P3. B gets P1 but reluctantly accepts P3. C reluctantly accepts P1 and gets P3. No government is needed. Now if the numbers of issues and people are small, perhaps no government is needed as in this example. On the other hand, given many people, many issues, and many intensities of preferences on these issues, bargaining like this becomes more difficult. Some might now argue that this justifies or explains government. This conclusion is false. It doesn’t justify government unless there is unanimous consent for it. But this has almost no chance of happening because each individual can’t predict whether he will be worse off or better off. He doesn’t know the preferences of others, their intensities, or how the votes will turn out. No one can rationally support government under these conditions. On the other hand, the complexities of bargaining involve possible profits if entrepreneurs can devise solutions. There may be many, many creative local solutions even if global ones are hard to attain. This situation is tailor-made for free-market solutions. And who knows, local solutions can be aggregated into associations that produce highly satisfactory global solutions.

Now if a government came into being somehow, it also can’t be counted on to do any better than markets in resolving these issues. How can a few people know everyone’s preferences and their intensities and thus what to choose that somehow satisfies all the rest? In fact, how can the government even know what the set of policy issues contains? The fact that government struggles with finding objective standards to make policy decisions is a sign that it faces heavy obstacles in doing so. The standard of profit and loss that entrepreneurs face who attempt to satisfy market preferences and thereby overcome market problems is the opposite, very objective.

There are other problems with a social contract theory. There are many risks associated with the creation of a government, even one that is freely created. They include that the government will accrete power, or start to rule on a set of issues that many people did not agree on. This risk also counts against people unanimously voting for the government, especially if its powers are to be great and hard to control. Furthermore, social contract theory suggests that new votes on the compact are logical as people change and new issues arise. This doesn’t happen or happen very often. Thus, even if a government could be justified in 1865 for a set of people facing a set of policy issues for which they desire government, a continuation of that government or its laws in 1906 or 1946 or 2006 is not justifiable. The contrast with how individuals continually "vote" in markets with their purchases could not be greater.

Social contract ideas have something of an unreal quality about them. Nevertheless, social contract is a prevalent idea with a long history that needs to be understood in order to be discarded as a justification for government. Social contract theory, in my view, is an incorrect guide to what government is, what it does, what its defects are, and what to do about it.

Transactions costs to the rescue?

The Cato article by Zerbe and McCurdy tries to save the market failure concept from one of its many defects, its faulty treatment of transactions costs. This is a blanket term for a panoply of costs that individuals face in a variety of market situations. Their argument is that market failures seem to crop up in such great abundance because analysts ignore transactions costs. This may be so, but their criterion for government action does not help very much. It goes like this: "Coercive rules have benefits if they reduce transactions costs for individuals, as in expenditures on self-protection. If the government did not have coercive laws against theft, people would spend more money protecting themselves from thieves. They might hire security guards or buy more deadbolts and alarm systems. Aggregate expenditures on self-protection would be much higher if legislatures did not enact laws against theft and establish mechanisms to enforce them. However, a coercive rule is not efficient just because it reduces the resources people spend. To be efficient, the reduction in cost must be greater than the transactions costs of enforcing the rule."

The fact is that people spend more on security and obtain less of it with government than without, but here that is not my main concern about their argument. In their efficient world, the government is redirected but still conceived of as a coercive mechanism that locates spots of intervention that people are supposedly happy to have them locate. People are happy to pay the taxes to support these interventions. What’s wrong with this picture? The arguments made earlier apply. (1) An external standard of value is being promoted that overrules the values that individuals reveal by their actions. As I have argued elsewhere, there can be no valid justification for imposing aggressively forceful measures on individuals. (2) A government is being endorsed that does not have the unanimous consent of those it rules. (3) These externally imposed rules to lower transactions costs can’t be justified on utilitarian grounds. The government can’t know what these costs are since costs are subjective and it can’t compare costs across different individuals. Taxes lower utility and even if some security measures increase the utility of some, there is no known method to aggregate utility across individuals. (4) These rules clearly violate individual rights simply by being imposed on individuals.

There are many other problems with arguing in favor of government interventions to correct so-called market failures. The assumption is that the government is able to locate the appropriate markets in which to intervene and not intervene in others. There is no basis for this assumption because the government actually cannot measure the costs and benefits that individuals experience. It surely cannot measure the costs and benefits that individuals expect to experience, and what people foresee is the basis of their optimizing actions.

The assumption is that the subjects of intervention will be able to control the government once it is given the power to intervene. History does not look kindly on this assumption. We observe all sorts of interventions in a wide variety of markets, and we observe growth in the interventions.

The assumption is that government intervention will not disturb or discourage other activities currently in progress or being contemplated. This is certainly untrue in many areas of the economy such as telecommunications, auto manufacturing, and oil exploration, refining, and production. Telecommunications is a nightmare of arbitrary regulations whose reasons have long since been buried in squabbling. The State should abandon its welter of rules and regulations that now control the entire complex of telephone, cable, satellite, internet, broadcasting, and entertainment. The same is true of industry after industry.

Government is not limited to a known set of policy issues or areas that everyone agrees on. This means that there are not effective ways to control the controllers or those who influence the controllers. The very existence of a government encourages the population to devise purported market failures and remedies that benefit them at the expense of others. The shameful spectacle of outcompeted computer companies such as Sun Microsystems running to Washington to impose antitrust maneuvers on the industry winners is a sorry chapter in recent American history.

Conclusion

Whatever success America has had owes in large part to market success. Now to lambaste markets for their supposed failures is a pernicious and harmful doctrine. I emphasize two arguments against market failure here. There is no objective standard by which government is justified in intruding on the decisions of sovereign individuals making their own decisions in free markets. There is a logical standard for the proper amount of government interference. That standard is none, no interference whatsoever.

Michael S. Rozeff [send him mail] is the Louis M. Jacobs Professor of Finance at University at Buffalo.

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