If somebody were to start an engineering textbook by saying that the maximum theoretical speed of a perfect car was the speed of light and that a car that travelled at any speed lower than that was a ‘failed car’ or suffered from ‘car failure’, you would probably think that it was an unhelpful way of presenting the topic - and you would be right.
Yet, a common approach in economics teaching is to lay out the preconditions of a so-called perfect market (full information, no transactions costs, no externalities and so on) and then look at how markets, in practice, deviate from that textbook model. We then call those deviations ‘market failures’ because they imply that all opportunities for welfare maximisation have not been taken. This is despite the fact that it is impossible to have a perfect market, just as it is impossible to have a ‘perfect car’.
Because markets are deemed to fail according to the textbook model, the concept is then used to justify different forms of government intervention. For example, consider this statement by the former regulatory body for financial markets, the Financial Services Authority (the body that presided over financial regulation at the time of the financial crash) made in 2003:
‘In meeting our objectives in a manner consistent with the principles of good regulation, we have adopted a regulatory approach based on correcting market failure…There are, however, numerous cases where unregulated financial markets will not achieve the best outcome due to some form of market failure, making action on our part necessary.’
The word ‘necessary’ is especially interesting in this statement because all markets suffer from the problem of market failure as defined in the textbooks – just as all cars travel at less than the speed of light - and thus there would appear to be no limit on the extent of regulatory intervention that the FSA believed it needed to use to try to perfect the market. The market failure doctrine is not simply a problem in economics textbooks, it is used to determine public policy.
In some A-level syllabuses, the concept of market failure is balanced by that of ‘government failure’ – the idea that, for various reasons, the government might not be able to perfect markets through regulatory intervention. However, though this provides balance, it is not a helpful phrase to use. We cannot expect governments to perfect markets – it is simply beyond their capacity. As such, governments do not fail if they do not perfect markets. The lessons of public choice economics tell us that regulators may act in their own interests, or may get ‘captured’ by the industries that they are trying to regulate so that the actions of regulators do not contribute to increasing overall welfare and improving market outcomes. Regulators might be risk averse and over-regulate markets or they may have cognitive biases that lead them to regulate markets through ‘rule writing’ which simply raises costs without improving outcomes. Furthermore, Austrian economics suggests that, if a market is ‘imperfect’ in some way, governments and regulatory bureaus simply cannot know what the outcome of a perfect market would have been had it existed.
For these reasons and others, governments cannot perfect markets and the concept of ‘government failure’ is just as unreasonable as that of ‘market failure’.
Achieving better outcomes, not perfect outcomes
The obsession with the market failure approach to policy analysis is relatively new and can probably be ascribed to Pigou. The obvious example is the idea of the optimal tax to deal with pollution. If a factory owned by one individual pollutes the air or land of other individuals, the argument goes that the problem can be solved with an optimal tax on the factory’s activities to bring marginal social costs into line with marginal social benefits. Again, this is reflected in A-level and undergraduate economics syllabuses.
However, we do not know what that tax should be. How can a government minister know the social cost caused by a pollutant? People’s preferences for different economic goods are only revealed by the prices they pay in market transactions. Different people will have different preferences. Some people might have a strong preference for clean air; others might prefer dirty air if allowing more pollution allows them to be a little bit more wealthy in other ways. The government could only have the information to work out the optimal tax if it had all information about the costs and benefits of all potential uses of economic resources. If it had that information, then centrally planning the economy more generally would work. And yet we know that central planning is a catastrophe.
There is a better way of dealing with these problems. Instead of focusing on market imperfections and government regulation and taxation to correct those imperfections we might think about which set of institutions and policies generally produces the best result – not a perfect result but the best result. In the case of externalities we might want to consider the set of policies that will lead to the parties causing harm and the parties who are harmed coming to an agreement that leads to better outcomes.
Let us take land-use planning as an example. At the moment, people in the South East of England tend to oppose more development because it reduces their environmental amenities, leads to more road congestion and so on. On the other hand, people regard new houses in the South East as incredibly valuable compared with other uses for the same land such as farming. Land with planning permission for building is worth about 100 times land with planning permission only for agriculture. So there is a conflict: builders want to build and existing residents want to prevent building. There is a social cost from building more houses but a huge potential welfare gain too.
Since 1948 we have resolved this conflict by giving powers to regulators in local government to take decisions about development using a bureaucratic process that is influenced by interest groups. This leads to some perverse outcomes, one of which is that houses that might have a minor impact (minor social cost) on nearby villages do not get built even though the private gains might be huge. If only those who gained could compensate those who lost, there could be much better outcomes.
Instead of this process of regulators trying to dictate who should and should not have permission to build, what if we were to bring those parties that gain together with potential parties who might lose? Builders, who gain hugely from turning agricultural land into building land, reflecting the value their customers put on new houses, could use some of that gain to directly compensate those who lost their environmental amenities. This could be done at a very local level as the number of people affected by housing developments is normally quite small. Localities that valued their environmental amenities highly might refuse compensation, and the builder can build near people who value their environmental amenities less.
Good, better, best – but not perfect
There are many more examples of how we might improve economic outcomes by looking at the institutional framework rather than looking to regulators to pull levers, but what is the general approach that should be taken?
We should do two things. Instead of saying: ‘this is a market failure, we should give power to a regulator to pull the lever marked "X" to perfect the market’ we should look to improve institutions, to extend markets so that economic agents have a good chance of taking into account the costs and benefits of different courses of action. As in the planning example, this might involve better definition of existing property rights so that parties can work out a solution in a way that best takes account of costs and benefits. The outcome may not be perfect, but it will be better.
Secondly, so-called market failures are not generally failures of markets. They normally involve incomplete markets. In the planning example, under current law, there is no market in environmental amenities. If I get some benefit from the farmland at the back of my house, is that a property right of mine or not? Under our current land-use planning regime, it is in a kind of limbo. On the one hand the farmer cannot simply build on his field without permission. On the other hand, he cannot be stopped from building once he has permission. In lots of areas (for example, land-use planning, fishing rights, environmental pollution) the problem is that property rights do not exist in the relevant resource so nobody has an incentive to use the resource efficiently or come to agreements with others to compensate them for the ‘social costs’ of their actions.
Failure to treat this subject properly is a major impediment to economics being useful in solving public policy problems.
This article will be published in the October 2014 edition of EA Magazine.