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 ([1776] 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...