When an industry in the private sector is not performing efficiently or effectively, there is said to be “market failure”. The recommendation by economists and others typically is then for government actions to combat such failure, such as taxes to help reduce pollution. The diagnosis of market failure may be accurate, but the call for government involvement may be naïve and inappropriate.
The reason is that actual governments do not necessarily do what economists and others want them to do because there is “government failure” as well as market failure. Before recommending government actions to correct market failures, one should consider whether actual government policies would worsen rather than improve private sector outcomes. Since many factors often make for considerable government failure, considering such failure is crucial and not just a theoretical fine point.
Consider, for example, that consumers are sometimes ignorant of the qualities and other aspects of the products they buy. However, before advocating various forms of government protection of consumers, we should recognize that voters are far more ignorant of political candidates then consumers are of what they buy. The reason is that consumers directly suffer if they make bad choices out of ignorance, while individual voters have negligible influence over political outcomes. Hence voters have little incentive to be informed about different candidates and their positions, and the consequences of the mistakes they make are largely borne by others.
Monopolies do arise in the private sector, as when Microsoft had monopoly power over personal computer operating systems, when IBM still earlier had monopoly power over computers, or when manufacturers form cartels to raise their prices by restricting production. Yet, monopoly also occurs in the political sector, and it is far more pervasive there. An industry that contains only two firms is considered a duopoly that is presumed to raise prices above competitive levels, but the political process is dominated in democratic countries by duopolies, such as the Democratic and Republican parties. In addition, when government companies receive monopoly positions, such as the US Postal Service or national oil companies in many countries, they generally succeed in either keeping out or greatly delaying the entrance of private competitors. By contrast, private monopolistic positions are usually temporary, as seen in the eroding over time of IBM’s and Microsoft’s dominant positions in the computer industry.
Government actions sometimes not only fail to overcome market failure but rather worsen the failure. Fannie Mae and Freddie Mac were formed as quasi-governmental institutions to help encourage mortgages in the residential housing market because of a belief that the private sector was not providing enough mortgages, especially to lower income families. Yet, as documented in detail in Reckless Endangerment by Gretchen Morgenson and Joshua Rosner, these two companies used their privileged positions to take excessive risks, and to insure large numbers of mortgage loans that should never have been made.
European regulators have attacked Microsoft, Google, General Electric, Intel, and other (mainly American) companies because of various alleged anti-competitive policies. In these cases, and in many antitrust cases brought by American regulators, such as the recent objection to the merger of AT&T and T-Mobile, the motivation seems to be to protect the competitors of these companies or to protect jobs rather than to improve outcomes to consumers.
Many countries subsidize various alternative forms of energy, such as wind, solar, biofuels, and electric batteries, because of the substantial pollution from using coal, oil, and other fossil fuels. Often, however, the choices of what to heavily subsidize are made on political rather than economic criteria. For example, for years hydrogen cars were politically the most promising substitute for gasoline driven cars; then hydrogen fell out of favor and electric cars became the political darlings. Since governments have seldom succeeded in picking technological winners, I suspect they will be wrong again in these attempts to steer the development of cost-effective alternatives to the internal combustion gasoline engine. Another example is the scandal about the heavy American government financial support to the solar panel company Solyndra that recently failed.
How does one approach policy once it is recognized that government failure is substantial, and often much worse than market failure? As a general rule I believe the presumption should be in favor of government actions only when market failures are quite large and persistent. So clearly governments should have the dominant role in the military and police areas, in the judiciary, in protecting against massive pollution, and in providing a safety net for its least fortunate members (private charities are important but do not do enough). On the other hand, when market failures are relatively small and likely to be temporary, as in monopoly situations or in exploiting consumer ignorance, government involvement should be minimal, as in minimalist anti-trust policies, and in allowing consumers generally to make their own decisions.
The intermediate cases are the most difficult: when market failures may be significant, and yet government alternatives are not attractive. This may be decided on a case-by-case basis, but I believe the usual rule should then be to let the market operate. This belief is based on the conclusion that, on the whole, government failure is far more pervasive, damaging, and less self-correcting, than is market failure. Others may reach different conclusions, but these are the problems that a relevant welfare analysis should focus on. Simply concluding that in particular instances markets are not working perfectly is a misleading and incorrect basis for supporting active and sizable government involvement.
I would like to add that one of the major reasons for government failure in attempts to correct alleged market failures is the "know-it-all" attitude that is pervasive amongst those who find government interventions highly appealing. Those who believe that they know much more than everyone else (and much more than the market) are disproportionately attracted to greater government intervention especially when it means that they will be the ones dictating policy; when it comes to economic regulation, they support enlightened despotism because they believe themselves to be enlightened.
Consider the case of Energy Secretary Steven Chu. His department has actively promoted the subsidizing of various alternative energy sources that have not panned out, insisted on maintaining a ban on incandescent light bulbs, and even suggested a policy of painting white on pavement and the roofs of buildings to combat global warming.
If only these "experts" had more power! They could make global communism work by setting MR equal to MC!
Posted by: Mitchell K. | 09/18/2011 at 08:34 PM
Great post. I wish everyone could read this very carefully and with an open mind. This post doesn't even mention the capture theory of regulation, the idea that regulators are captured by industry.
Posted by: Cyril Morong | 09/18/2011 at 08:42 PM
Amazing post, professor Becker. Milton Friedman once said, "the government solution to a problem is usually as bad as the problem." This couldn't be more true. The Interstate Commerce Commission, the Civil Aeronautics Board, the Food and Drug Administration, the National Labor Relations Board are prime examples. Governments usually exacerbate the problem. The political theorist Rudolph Rummel calculated that in the past century alone, some 262 million people have died as a result of state-imposed externalities. This doesn't include combat deaths and executions. Rummel calls this phenomenon of government failure, "democide." George Stigler would have had lots to say about government failures had he lived today. You could have mentioned "regulatory capture," classic patent law, occupational licensing, price floors and ceilings, rent controls, drug lag, and tariffs and quotas to elaborate on government failures.
Posted by: neoclassical_libertarian | 09/18/2011 at 08:46 PM
Professor Becker, I find it necessary to bring up Friedrich Von Hayek's epistemological argument against government planning. He argued that the information required to effectively organize all capital and resources is decentralized and dispersed across the population and is not available to a single group of central planners. I think the regulators are in a similar position. They do not have the information to effectively regulate the market activity of millions of people, analyze all unintended consequences, and solve the problem of externalities.
Posted by: neoclassical_libertarian | 09/18/2011 at 08:53 PM
Although governmental market intervention haven't had a corrective effect or have even worsened the situation, we have to look at future interventions and how to make these interventions more effective. Today, the multinationals are critically big (in every industry, look at Nestle, Pfizer, Google etc.) where they are quasi monopolies. These multinationals should be "forced (reducing the profit maximization notion)" by the governments to start planning and budgeting sustainably. There is much more to gain, if governments and multinational start to work together, that's also a way to reduce unintended consequences, put efficient and effective regulations in place and hence reduce the problem of externalities.
Posted by: universalism | 09/18/2011 at 09:48 PM
Warmed over Chicago pro-market nostrums again. To top it off, this post does not really have any clear train of thought.
So now we can excuse market failures because there are as many and worse government failures? How does it follow? If Microsoft had a monopoly, why does it matter if Republicans and Democrats have a duopoly on the political process? The argument to break up Microsoft's monopoly is completely unaffected by that. If anything, the fact that the political process is a duopoly means that companies can capture government easier and fight against true competition. This means the courts should all things equal favor challenges to monopolies, since in all liklihood, if they are brought, it is more likely that it is true that they are a more obvious monopoly.
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Posted by: prada | 09/19/2011 at 01:45 AM
If there is market failure then we can get the substitute for a product or service from different sources.But if Govt. fail to handle the Market failure and the different surroundings problems then the public will be in danger.So while taking decision Govt. should consider all the pros and cons for the particular action against for controlling the market failure.
Posted by: Brian@Legal Letters | 09/19/2011 at 04:28 AM
Seems to me that one should ask why government fails.
Most always it is because the rich use lobbyists to gut effective legislation or to refuse to fund a program or they get thugs to be judges (e.g., Central Bank of Denver)
Now, for example, when we most need a robust SEC because only transparency will ever restore trust in the equity and bond markets, surprise, the Republicans are gutting the SEC budget (which is not even paid for with taxes)
The perceptive reader will understand that Becker is just a PR flack for the wealthy and powerful, who stand to become even richer under his approach.
Posted by: an observer | 09/19/2011 at 05:45 AM
It seems to me if we want government to keep its hands off then don't expect bail outs. Why is it bad to regulate the financial industry but good to give bail out money?
It appears it is good to have two parties...bull....the Media has decided on that and so has the big money. Large is bad for the economy but it appears our great minds have gone another direction. Government fails because the heads have their own agenda and don't care about the country as a whole. They care about their own industry and more so their own pocket book.....Greed is good.....What would Jesus do?
Posted by: SID | 09/19/2011 at 11:37 AM
Market Failure or Government Failure? Both are bad. When trying to balance the Economic Scales, in the interests of all (that is why Society exists is it not?), mistakes and errors can and will occur (humans or computers aren't perfect) and so dislocations and various problems will arise while trying to balance that Economic Scale. The solution to the problem is to recognize that the Scale is out of balance and to take the necessary action to bring the Scale back into balance so that all benefit. Not just a select few.
Posted by: NEH | 09/19/2011 at 11:56 AM
Becker sez: "Since governments have seldom succeeded in picking technological winners, I suspect they will be wrong again in these attempts to steer the development of cost-effective alternatives to the internal combustion gasoline engine."
........... You have me reflecting on the tentative recovery of our still delicate economy having been flattened again by soaring oil prices. As we all know gasoline prices are highly inelastic -- double the price? we still have to pick up the kids and go to the job, and the job itself may be energy intensive. Little choice in the short run but to pay and pay and pay. And.......... not "go shopping".
I conclude incentives for ANY alternative would have a good effect. Consider Brazil where motorists have a choice of NG, gasoline, or ethanol competitively produced from cane; while in the US we've no choice at all but to "get mad and stay home" or ride a bicycle, IF there are safe lanes and trails upon which to ride them.
As for the "current fad" of electric propulsion, could electricity possibly be more wrong than internal combustion that has the near monopolistic advantage of 100 years of momentum? Can the seemingly super-rational move to natural gas as, first, truck fuel, then passenger car fuel be achieved w/o the government leadership we're seeing in a few states? Who solves these "chicken before egg" problems of the car being unsalable before the fueling stations are developed and vice versa?
As for the "failure" example of hydrogen, it seems premature to claim it as a failure. The two obvious sources for hydrogen would seem to be stripping it from NG, and using "surplus" or stranded wind energy to "crack" water.
In a nation such as ours that is so dependent on LOTS of energy (twice as much per GDP dollar as many of our competitor nations) it is beyond foolish to be SO heavily dependent on costly, and increasingly imported, NON-renewables as we have become.
Cost? To stay with oil........ the cost is up to a seemingly rigged "world market" beyond our control while many of our electrical generation facilities are regulated utilities that CAN switch between oil, NG, coal or nuclear power, hydro, and increasingly, wind. Consider: A fleet of electric cars can and is "shopping" for the most efficient, and/or least costly fuel as the utility makes their choices, while the oil burner has ONLY the "company store" of CFTC? OPEC?
If America were a company and a competent CEO were found to run it, or at least it's energy department, I'm sure the first thing the CEO would do is try to diversify our energy supply. IF he/she lunched with National Security folks, I'm more than sure they would applaud the diversification efforts.
And today how to really figure "costs?" Brazil has a natural advantage in being a large cane producer. We have a natural advantage in wind. Suppose that new wind generation "costs more" in the short or even intermediate range than imported oil. We with a HIGH rate of unemployment in the construction sector have a choice of putting our people to work on "more costly wind" or letting them sit at home on some form of welfare or another while we continue to build the impressive skylines of the OPEC nations. Brilliant?
I'd agree with Becker that the fed government is the wrong place to try to out guess "the market" in fast moving small sectors, but in a broad scope of deciding we ought to diversify our energy sources, and find ways to re-employ our construction people, many of whom will NEVER work in housing or light commercial again.
Our founders in mandating that we develop our national resources for the general welfare of our people would likely agree that a functioning democracy OUGHT to be able to make some of the big, long term decisions. I'd agree.
Posted by: Jack | 09/19/2011 at 08:02 PM
Mitch! Ha! I'm one of those you lament! What could be more of a win-win-win than the government leading the way to recoat every flat black roof top in America over the coming decade? WHY did we not do so years ago? White commercial rooftops would substantially reduce cooling energy wastage -- and of concern this year, would have the effect of "strengthening" our electrical grid. Also, consider that most often the air conditioning unit is right there on the roof operating in a much hotter atmosphere than need be. And, finally, white roof tops expand and contract less, leading to a longer roof life.
Making streets a lighter color? Spending time in OK it doesn't take long to notice that black asphalt is too hot to walk on barefoot while the surrounding greenery stays relatively cool. Cement, used for most of the driveway aprons is far cooler, but a poor choice for residential streets as it cracks and looks terrible with asphalt "patches". But note that every time cool greenery is dug up and replaced with black asphalt the whole neighborhood and city become even hotter than before.
Is it the "American way" to, dumbly, keep dumping black asphalt on the ground that will be there for many decades? One quick google trip shows that there are light colored emulsions and reflective material that can be added to asphalt. In addition to being cooler wouldn't the lighter color be safer with head lights reaching further with humans showing up better against the lighter backdrop?
Chances of subdividers with a TON of concerns already on their plate doing this on their own? Z e r o.
Posted by: Jack | 09/19/2011 at 08:21 PM
Jack provides compelling anecdotal evidence that "we have a natural advantage in wind."
Posted by: TANSTAAFL | 09/19/2011 at 08:32 PM
The market is unable to make collective directed long-term decisions about the future of a society, but it is exactly such long term planning that is necessary for the continuance of society, especially in the face of the kinds of environmental challenges that we face (and none too few of them a result of "the market").
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Posted by: Used IBM Computers | 09/20/2011 at 05:10 AM
Tans: Here, read up on our wind source a bit. Then you can take out the "anecdotal".
http://awea.org/
Annnnnnnnnnd! Most of the world has a natural advantage in solar. It IS the future, might be good to get started soon. Mebbe bring the lagging, sun belt states, they of the economic miracle of low paid jobs hard beside the road of the wage race to the bottom, up the the levels achieved by CA?
Turtle! Yes! It is the job of business to sniff around looking for profits on the existing playing field. It's the task of a functioning democracy to design the field, set the long term goals, REGULATE the game and hire good umpires!
BTW one of the top Chinese officials was on Cspn recently lining our their long term goals replete with percentage targets for lifting the living stds of their populace. They may fail due to too much micro-managing, but at least have stated national goals. Us? Where "The Market" and Rent-seeking "businessmen" takes us.
Posted by: Jack | 09/20/2011 at 01:55 PM
An observer notes: "The perceptive reader will understand that Becker is just a PR flack for the wealthy and powerful, who stand to become even richer under his approach."
By the same token, Obama is just a PR flack for Marxists who prefer redistribution of wealth via governmental coercion over the economic liberty our Constitution guarantees.
But the comparison is inapt. Becker earned his Nobel Prize.
H.L. Mencken put it well when he observed that the New Deal created two classes of citizens: those who work for a living and those who vote for a living. It's not hard to figure out which category most of the commenters above dwell in.
Posted by: TANSTAAFL | 09/20/2011 at 08:30 PM
Tans-- Give us a break! Or......... show us an instance where the President "flacked" for "Marxists". The issue of the day, is, again, as in the 30's to reform capitalism before the whole thing goes down again.
As for the "redistribution of wealth???" I've posted these graphs a number of times but "some" seem not to have become aware that the "class warfare" took place over the last three decades. Working folk lost. Big time.
http://lanekenworthy.net/2008/03/09/the-best-inequality-graph/
.......... and here we are as a nation "discussing" whether to continue to help those who won with more unaffordable tax breaks and whether the Buffet Rule (haha! I think we'll hear that one all during the coming election season!) of million buck earners and the 400 wealthiest families kicking in at least the percentage paid by "Buffet's secretary" and most who are still working.
I really don't think the ALL FOR THE RICH "trickle down someday" bit has legs to get through another election year. Mebbe Repubs could find something that by some considerable stretch could be seen as beneficial to working folk?
Posted by: Jack | 09/20/2011 at 09:01 PM
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Posted by: huaiyiting | 09/21/2011 at 07:01 AM
"Many countries subsidize various alternative forms of energy, such as wind, solar, biofuels, and electric batteries, because of the substantial pollution from using coal, oil, and other fossil fuels. Often, however, the choices of what to heavily subsidize are made on political rather than economic criteria. For example, for years hydrogen cars were politically the most promising substitute for gasoline driven cars; then hydrogen fell out of favor and electric cars became the political darlings. Since governments have seldom succeeded in picking technological winners".
This touches on an issue that I would very much like Professor Becker and Judge Posner to address in a future column. The idea expressed in the above quote is not particularly controversial, particularly among "conservative" economists. The idea is this: the government is not very good at allocating capital or picking winners or losers and therefore it should not be in the business of granting subsidies, either outright or through the tax code. In other words, the government should not go around handing out carrots to further objectives or industries it favors.
On the other hand, most economists, including many conservative ones, seem to agree that "Pigovian taxes" constitute a legitimate and useful means of reducing things that government does *not* want. In other words, it's ok to use the stick, but not the carrot. This puzzles me because it seems that the approach to this type of government interference should normally be symmetrical.
The only rationale I can come up with, and perhaps our hosts will confirm it, is that government is better at identifying things that are bad (because such bad things already exist) than it is at predicting those things that might be good, if only they were to exist through government encouragement.
Posted by: Vivian Darkbloom | 09/22/2011 at 07:59 AM
Another great post by Becker.
I also contend that an industry's failure is not necessarily a market failure (although it could be), but to the contrary a symptom of market efficiency as the market pursuits greater production possibilities.
For example, left alone by the government the automobile industry would likely fail or at least decline to an optimal scale, which would allow the reallocation of resources that it consumes to more productive industries. This would ulitmately benefit the whole economy in the long run if not sooner. Markets are typically far more effective at this than governments.
Posted by: David | 09/22/2011 at 10:27 AM
A few days ago Charles Moore, an ultraconservative british author of the biography of M. Thatcher, wrote that he thinks, the "left side" is absolutely right. That's impressive if you read the whole article dealing with capitalism and banking failures.
Posted by: wiesbadenzahnarzt.de | 09/22/2011 at 12:32 PM
Folks, the Dow fell 391 today, continuing the decline in investor confidence in reaction to Obama's latest plan to reallocate assets from private industry to government control. While not conclusive, this circumstance supports Becker's viewpoint.
Consider a hypothetical. What if a creative financier set up a mutual fund indexed to Obama's performance on managing the economy? Who would invest in such a fund? Other than short sellers, that is.
Posted by: TANSTAAFL | 09/22/2011 at 06:09 PM
David -- what are the "more productive industries?" And would auto resources and employees be better suited at them than the several trillion of idle capital on the side just know and the pool of 15,000,000 under and UNemployed? If you've got some good ideas you should be able to broker some billion buck deals and earn a substantial commission!
Posted by: Jack | 09/22/2011 at 08:18 PM