Turning Market Failure on Its Head

I’ve finally returned from two weeks of seminars, sponsored by the Institute for Humane Studies, for college-age students interested in classical liberal (i.e., libertarian) ideas. These events are always exhilarating because they rekindle my interest in topics that might seem old hat to me, but that are often new and exciting to the uninitiated.

One topic that came up with some frequency was the notion of “market failure.” Economics textbooks almost always use this term as the category heading for such potential sources of inefficiency as positive externalities, negative externalities, and public goods. But the more I think about it, the more I realize this is something of a misnomer. Externality and public good problems are hardly unique to markets; they occur in virtually all institutional settings, particularly legislatures and bureaucracies. Labeling them “market failures” sends the erroneous message that markets are especially or even exclusively susceptible to these sorts of problems, whereas the truth is almost precisely the opposite. Instead of calling these problems “market failures,” we ought to simply call them “failures,” or, if you feel the need for an adjective, “institutional failures.”

I’m not just making the hackneyed (though correct) claim that textbook discussions of “market failure” ought to be balanced with discussions of “government failure.” The best textbooks do, in fact, include at least some material on the failings of governmental institutions. My point is that the *same problems* afflict both markets and governments. In governmental institutions, any action (a legislative vote, support for a new administrative rule, etc.) that is beneficial automatically creates positive externalities, and any action that is damaging automatically creates negative externalities. Governmental actors rarely, if ever, bear the full benefits and costs of their actions, but instead are shielded by the bundling of issues in political discourse, the dilution of their individual impact in the context of large-group decisions, and the rational ignorance of voters (among other things). The reason large encompassing-interest groups like taxpayers and consumers cannot organize effectively for political action, whereas special-interest groups like steel workers and farmers can, is that the former face massive public-good/free-rider problems that the latter do not.

I’m making an argument for symmetry here: externality and public goods problems afflict both markets and government, and therefore should not be classified under the misleading title “market failures.” But actually, there is a good case to be made for reversal rather than symmetry: market institutions tend to solve externality and public good problems, whereas governmental institutions tend to create them. Private property, for instance, internalizes the positive externalities associated with improving land or using it for a productive purpose. (E.g., if someone drains a swamp in a commons area, he creates benefits for everyone who might potentially use the area; private property concentrates those benefits on the owner.) Indeed, I would be willing to argue that market institutions evolved, and outstripped other forms of social organization, precisely because of their tendency to solve the kinds of problems usually labeled “market failures.”

It is true, of course, that numerous externality and public good problems persist even in market systems. But blaming the market for the existence of those problems is not unlike blaming traffic lights for impeding traffic, or blaming language for breeding miscommunication. This is glass-half-empty thinking at its worst, because it damns the solutions for the problems they emerged to solve.