Thursday, 4 July 2013

Is Market Failure a Sufficient Condition for Government Intervention?

By Art Carden and Steve Horwitz

We are unapologetic defenders of the economic way of thinking, not merely because it helps us understand why—as economist Joseph Schumpeter explained—capitalism allows factory girls to buy more and better stockings for progressively decreasing amounts of effort, but because with good economic analysis, some of the great atrocities of human history could have been avoided. For example, the Progressive eugenics movement of the early twentieth century was offensively anti-economic, even though some who were called "economists" encouraged it. As Bryan Caplan has pointed out, the Holocaust found some of its roots in Malthusianism, the idea that population growth would outstrip the growth of agricultural output. The disasters of central planning in the USSR, China, and elsewhere speak for themselves. We don't exaggerate when we say that sound economic reasoning could have saved tens, if not hundreds, of millions of lives.

But economic knowledge incompletely applied can be dangerous. In introductory economics classes, students learn about several types of "market failure," which occurs when some attributes of the market prevent it from producing an efficient outcome. In the context of twentieth-century neoclassical economics, these represent failures of the actual market to reach the equilibrium of the perfectly competitive model. In this framework, market failures are possible when there are externalities (uncompensated costs or benefits that spill over onto people who are not party to a trade); public goods (goods that are non-rival in consumption and for which it is prohibitively costly to exclude non-payers); asymmetric information; and market power like monopoly (when there is one seller of a good or service), monopsony (when there is one buyer of a good or service), or natural monopoly (when the cost structure of the industry makes it more efficient for a single firm to produce the entire market's output).

Externalities, public goods, asymmetric information, and market power provide necessary—but insufficient—conditions for intervention to be justified. They certainly are not talismans that provide interventionists with carte blanche to tinker with the members of a society as if they were pieces on a chessboard. Too often, critics of markets think that merely invoking these terms destroys the case for free markets. Unfortunately, non-economists often do not understand these terms. Indeed, understanding these terms clearly is only a first step toward a clear understanding of social phenomena. Let's consider each of these concepts in turn.

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