Market Failure, Regulation, and Invisible Gorillas

• Author: John Hasnas
• Position: J.D., Ph.D., LL.M., Professor of Business at Georgetown's McDonough School of Business and Professor of Law (by courtesy) at Georgetown University Law Center
• Pages: 813-840

Market Failure, Regulation, and Invisible Gorillas

JOHN HASNAS*

ABSTRACT

The market failure argument is one of the conventional arguments for gov-

ernment regulation of the market. It holds that private transactions can gener-

ate negative externalities–costs to third parties that the transacting parties do

not take into account. As a result, the government must regulate the market to

prevent transactions where such costs to third parties are great enough to

render the transaction socially detrimental. This article argues that this argu-

ment is flawed to the extent that it ignores the regulatory effect of civil liability,

and must be revised to take this effect into account.

TABLE OF CONTENTS

I. A STORY ABOUT MARKET FAILURE AND INVISIBLE GORILLAS 814

II. THE DUAL NATURE OF ANGLO-AMERICAN LAW . . . . . . . . . . . . . . 817

A. The Characteristics of the Common Law 818

B. The Characteristics of Legislation . . . . . . . . . . . . . . . . . . . . 819

III. THE MARKET . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 822

IV. THE RELATIONSHIP BETWEEN LAW AND THE MARKET REVISITED . 824

V. THE MARKET FAILURE ARGUMENT REVISITED . . . . . . . . . . . . . . . 825

VI. THE MARKET FAILURE ARGUMENT REVISED 828

VII. THE COMPARATIVE ASSESSMENT . . . . . . . . . . . . . . . . . . . . . . . . . 829

A. General Considerations 829

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* J.D., Ph.D., LL.M., Professor of Business at Georgetown’s McDonough School of Business and

Professor of Law (by courtesy) at Georgetown University Law Center. Professor Hasnas wishes to thank

the participants in both the Georgetown Institute for the Study of Markets and Ethics fall ethics

workshop, his fellow symposiasts, and Ann C. Tunstall of Remedy Pharmaceuticals, Inc. and Annette

Hasnas of Georgetown University for valuable comments on a draft of this article. He would also like to

thank Augustin Horner and Anna Colby for their invaluable research help, and Annette Hasnas of

Georgetown University and Ava Hasnas of the New School of Northern Virginia for first-hand

experience with the ways efforts to regulate human behavior can fail. © 2021, John Hasnas.

813

B. Specific Examples 833

1. McDonald’s Coffee 833

2. The BP Oil Spill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 834

CONCLUSION 839

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I. A STORY ABOUT MARKET FAILURE AND INVISIBLE GORILLAS

Many years ago, when I completed my graduate study in law and philosophy, I

accepted a position as an assistant professor at Georgetown’s business school.

Not being trained as an economist, this was somewhat intimidating. During my

first few faculty workshops, I noticed that my colleagues—social scientists and

economists all—frequently talked about the need to remedy “market failure”

when advocating for government regulation. Eventually, overcoming my embar-

rassment at not understanding the reference, I asked one of my colleagues what

precisely it meant. With good-humored amusement at the naivete of the new guy,

he provided the following explanation.

In general, markets are good because they make everyone better off. When two

parties engage in market exchange, each receives something that he or she values

more than the thing he or she gives to the other party. After the exchange, both

parties consider themselves better off. Both have gained from the trade, and the

wealth (store of value) of society has increased. This is the case as long as the

transaction imposes no costs on anyone else—as long as the contracting parties

who receive 100% of the benefits of the transaction also bear 100% of its costs.

The problem is that there are cases in which the transacting parties do not bear all

the costs of the exchange. In some cases, the exchange imposes costs on others who

are not themselves parties to the transaction. These costs, which are external to the

transaction—or in economic terminology, are negative externalities—are the social

costs of private market activity. When the external or social costs are great enough

to outweigh the private benefits received by the transacting parties, the transaction is

detrimental to society as a whole. However, because the private benefits received by

transacting parties exceed their private costs, they will proceed with the transaction.

As my more sophisticated colleague explained, in such cases, markets fail to deliver

the socially optimal outcome. Therefore, government intervention is necessary to cor-

rect the market’s failure to consider the social costs of private transactions or, again in

economic terminology, to internalize unacceptable negative externalities.

1

This is the

market failure argument for government regulation of the free market.

2

1. For a more precise account of the market failure argument, see Tyler Cowen, Public Goods and

Externalities: Old and New Perspectives, in THE THEORY OF MARKET FAILURE: A CRITICAL

EXAMINATION 1, 1–3 (Tyler Cowen ed., 1988) and MILTON FREIDMAN, CAPITALISM AND FREEDOM 30–

32 (1962).

2. Please note that despite my use of the definite article, the argument described is not “the” market

failure argument but one among a family of “market failure” arguments that identify ways in which

814 THE GEORGETOWN JOURNAL OF LAW & PUBLIC POLICY [Vol. 19:813