Notes: Market Failure: An argument both for and against government (David Friedman)

I just attended the Young American’s for Liberty state convention yesterday in order to hear the venerable David Friedman speak. Below are my notes highlighting the main points of the talk. You may recognize some examples and positions if you’ve been following his work.

Economists studying market failure make legitimate arguments against laisse-faire, but those arguments make a stronger case against government. Let’s define market failure as those circumstances in which individual rationality doesn’t lead to global rationality. For example, suppose we were part of an army standing on the battle field. I think, there’s only a minuscule chance that it affects the battle if I defect, and I will almost surely live as the others delay the opposition by fighting. All of us execute that logic, we all run, and the opposition kills us. To take another example, I am warmed greatly by burning coal and only make a minuscule contribution to the London fog. But, it’s possible (though not always), to engineer around the failure with a change of the rules. For example, the arab’s deadlocked in the open desert making no progress to the nearby oasis as they insist on winning the “who’s got the slowest camel” competition. Economists largely assume that people act in their own rational self-interest and that’s generally the case.

But what about Public Goods? (aside: The government often produces private goods, such as the post, while many public goods are produced privately, such as education and libraries.) Let’s define a public good as one that’s open to consumption, where the producer cannot capture payment from the consumer. For example, the beauty of the Sears Tower, listening to an unencrytped radio broadcast, or watching a TV program. For some cases, the market arrived at a clever solution: couple the public good (radio program) with a public bad (advertisement) and let the baddies subsidize the good for the enjoyment of all.

There are often externalities, in both directions. Some the costs outweigh the benefit and others where the cost is less than the benefit but the producer can’t collect enough to make it worth the effort. For example, take a resturant, a movie theater, and a store. It might not be worth running any individual enterprise, as they impose foot traffic on neighbors (negative externality). But if they occur together, say in a mall, then the traffic is mutually beneficial to all stores (externality becomes positive) and the rent for a shopwindow captures some of that.

Not all problems are solveable with laisse-faire and the market result is often less than ideal (comparison to the ideal is how the market ‘failed’ even when the outcome was considered ‘good enough’ by the people). With perfect information, you might be able to obtain the ideal, but we are in very short supply of good dictators.

Democracy also has its failure modes. For example, voters should be knowledgeable and informed when they cast their ballots. But proposals are seldom transparent. For example, the Farm Bill is never advertised as a money transfer program. Plus, in a representative system, the voter has a double-indirection problem. First they must know how good/bad each bill is and then they have to know how the candidates voted. Often that’s unknown, because the candidate is new (actually, all upcoming bills are unknown). Given that the chances of changing the election are slim, how much should a voter invest in becoming informed? Not much, they should be rationally ignorant, with two exceptions. One, the think politics is fun and do it out of intrinsic interest and two, they have influence or represent a special interest and have a high stake in the result. In this market, we see concentrated special interests winning benefits over dispersed victims.

What about long term planning? In the market, why should I plant black walnut trees which won’t bear nuts until I’m long dead? Well, ten years from now I can sell them! to a person that doesn’t want to wait as long. In turn, they could sell years later to a still more impatient person. But the transfer needs strong and secure property right. I must expect that the field is still mine to sell after ten years. Politicians, in contrast, have very insecure property rights. They will often be out of office before the benefits of a bill become evident, and it might be the other party is in office at that time and claims all credit! So they have a strong aversion to paying large amounts now when the benefits are far away in the future. You can see that their rhetoric does not reflect their actual behavior, because they often promise without making delivery in that uncertain future.

So politicians tend to 1. Promote policies that sound good on the surface (easy to advertise), 2. enact bills that benefit special, concentrated interests at the expense of dispersed victims, and 3. take short-term actions. Finally, and what’s worse, they make decisions that have very widespread effects (externalities) without knowing the outcome. For example, a panel of judges making a decision about a vaccination program (for polio?) treated an annual recurring cost as a one-time payment, mis-pricing the program by a factor of 40, negatively affecting thousands of people.

We must conclude then, that Market Failure is structurally endemic to Politics and the theory of market failure is a better predictor of government behavior than it is of free market behavior.

The conclusion generalizes to everyday life. For example, for those with a spouse, who does dishes after dinner? There are two options: 1. one cooks, the other cleans, and 2. the same person cooks and cleans. Everyone chooses option 2, because then the cooker controls how much cleaning takes place (makes a meal with fewer dishes). Also, this is why we tell children to clean up their own mess, rather than the messes of others.

There’s also the silent student problem. When the instructor asks “does every one get it?” they never get a response. Mostly, because the cost of asking is to look dumb in front of everyone (but, rationally, in a large classroom, there must be others who didn’t understand), but also because the benefits of asking will be dispersed to everyone present (they might do better on the exam). One solution is to use a button on the floor, which can be inconspicuously pressed, activating a signal at the back of the class visible to the teacher, but not the students.

Or economics and law. Suppose a proposal that makes armed robbery a capital crime, assuming murder is already a capital crime. Many people might be for it, as “being tough” and providing a strong dis-incentive for armed robbery. But the economist will ask: Do you really want all armed robbers to murder their victims? Because if the cost of robbery is the same as robbery + murder, then I, as a robber, will surely kill my victims for the punishment (cost) is no different and there is a benefit that the dead won’t identify me to the police.


What should we do? Given that rationally ignorant voters make decisions on freely available information, politicians complicate the issue by advertising bills with plausible deniability. For example, the auto tariff is about protecting jobs and hurting foreigners. The auto-workers union doesn’t ask for a bill that’s a direct transfer payment. How should we respond? One: change the body of free information. Spread more accurate information and ideas. Two: create alternatives. Run a business that competes, showing that the government-provided solution isn’t any good (quality or quantity).

What about replacing the government entirely? Dealt with this in 3rd part of Machinery of Freedom, discussing private security insurance firms that operate under the discipline of repeated interaction. Customers have their choice of firm.

With increasing productivity, what about ensuring work/jobs? First, we should think of jobs and workers as two distinct numbers, and then notice they are always very close to each other. Sometimes apart (depression era) sometimes close, but very strongly correlated (both increased over the last century). This implies they are in an equilibrium situation, so we should not worry too much. Also, look at the fixes: the racism inherent in the minimum wage (historical union). And be careful: if you give the government power to do XYZ, how will they *actually* use that power?

What about education? School voucher program implies that most schools would be comparable in quality. That’s not really different from being centrally managed. Instead, if we value diversity, we should remove single organizational administration and control, we should decentralize.

What about Rothbard and 100% reserves? It’s actually not desirable for a bank to have 100% backing, especially if it has other liquidate-able reserves. It could then, when faced with a run, sell the other assets in exchange for the backing material (e.g. gold or silver) and make good on the original agreement. Personally, would prefer some electronic, anonymous, cash-like system.

What about the incentives to incarcerate faced by private prison operators? Well, those same incentives are faced by state-run prisons. It sounds good to be “tough on crime” and the taxpayers foot the bill. Refer to David Skarbek’s book, The Social Order of the Underworld: How Prison Gangs Govern the American Penal System, to see how even outlaws have created an ordered society. Also, read Poul Anderson The Margin of Profit for an answer on “how to get people to stop doing bad things” (answ: make it unprofitable), and my book Law’s Order: What Economics Has To Do With Law and Why It Matters for an examination on the costs and benefits of a property system.