Market failures, government solutions, and moral perceptions.

• Author: Lee, Dwight R.
• Position: Essay

It should be obvious to even the casual observer that both markets and governments fail neither comes close to achieving perfection. Externalities, both positive and negative, are the most common explanation for market failures. The undersupply of public goods, for example, is seen as a market failure, and is the direct result of a positive externality being generated when a person contributes to a public good which, by definition, benefits others whether they contribute or not. Similarly, excess pollution is seen as a market failure resulting from the negative externality of people imposing uncompensated costs on others by emitting pollutants into the environment. But externalities are just as commonly the result of government activity as they are market activity. For example, many government transfers are best seen as negative externalities motivated by the desire of politically influential groups to benefit at the expense of others.

Yet when problems that capture public notice arise, the default response is almost always expanding government power to correct what are depicted as market failures. This is true even when the problem is largely caused by government policies (as in the case of the Great Recession) or entirely by government policies (as in the case of restricted competition in public education, K-12). Indeed, market failure is often used to justify government corrections when markets are working exactly as they should--for example, when government action is brought against a firm for expanding its market share at the expense of its competitors by providing better products or lower prices or both (antitrust). And market failure is often blamed for problems caused by the absence of markets (pollution problems) or when market arrangements have been greatly distorted by government interventions (medical care).

This is not an argument against an important role for government. Civil society and free market prosperity depend on government securing our liberty by protecting our persons and property against violence and theft, providing basic infrastructure and public goods unlikely to be privately provided, and enforcing the rules of private property and voluntary exchange that allow people to pursue their own objectives and solve most of their problems in productive cooperation with each other. But government's proper role is a limited one. Unfortunately, when people see problems as the result of market failures that require government corrections, the limits on government action quickly begin to erode. (1)

The tendency to favor government corrections to perceived market failures is not because people are unaware of government failures. Government failures in the form of poor outcomes and corruption are commonly reported in the news, possibly with as much frequency as market failures. The difference is that market failures are typically seen to be an inherent result of a process motivated by self-interest. On the other hand, there is a strong tendency for people to see political action as motivated primarily by concern for the public interest, with government failures more likely to be aberrations resulting from inevitable mistakes or, at worse, a few dishonest and venal politicians. Indeed, it is common for people to argue that electing more public-spirited and caring politicians would improve government, but one seldom hears anyone arguing that putting more public-spirited and caring CEOs in charge of our corporations would improve markets.

The Standard Public Choice Explanation

Economists explain the different performance of markets and governments in terms of the different incentives embodied in their underlying processes, not in terms of the public-spiritedness of the relevant decisionmakers. They also explain the choice between the two alternatives--market performance and government performance--in terms of the incentives people face to favor one over the other. Public choice economists have developed arguments to explain why those incentives are such that the alternative that creates the largest social value in a particular situation is not always the one seen as most appealing by political decisionmakers.

Consider the explanation for the appeal of government "solutions" to correct market "failures" based on standard public choice arguments. Government solutions are seen to address problems directly in ways that are easily seen, and to be structured so that much of the benefits are concentrated on members of organized interests who greatly appreciate them, while the costs are widely dispersed, and therefore largely unnoticed. So even when the benefits are less than the costs, as is often the case, the incentives to support government solutions are strong and the incentives to oppose them are weak. In contrast, market solutions address problems indirectly by imposing discipline on, and removing privileges from, politically influential groups. The benefits of ending a government subsidy, for example, are widely dispersed and therefore largely ignored, but the costs are highly visible and concentrated on a special interest group with whom the public may sympathize. Governments are then often seen to succeed even when they fail, and markets seen to fail even when they succeed.

There is obviously much to be said for the public choice explanation. But there are situations in which government solutions trump...