Book Review: The Theory Of Market Failure Edited by Tyler Cowen

The theory of market failure, it seems, has always been with us, but it wasn’t until the 1950s that Keynesian economist Paul A. Samuelson, along with other elaborators, defined and formalized it. The argument they gave sounded compelling at the surface, but many scholars later showed it to be, in many respects, fallacious.

“Externalities” are a key part of the theory. They occur when an economic exchange affects someone not party to the original exchange. These can be positive or negative effects. For example, factory pollution creates a “negative ex-ternality,” but when a neighbor improves his land and your property value goes up, you get a “positive externality.”

Not all externalities are cause for worry, however: only those that create a large “divergence between private and social cost” which diminishes, in some mechanistic sense, social welfare at large. The free market can’t solve this divergency, some economists say, because the “transactions costs” are too high. The factory, for example, cannot work out a satisfactory deal with every person in a city to correct the negative ex-ternality because of the costs involved in contracting, bargaining, and enforcing agreements. Government is therefore needed to correct the problem.

Similarly, the existence of transactions costs also plays a part in creating what economists call public goods, that is, those goods (or services) that everyone wants, but that the market “fails” to provide, because of the good’s “special characteristics.” Some traditional examples are national defense, fire departments, roads, and schools.

The lighthouse is a common example of a good that supposedly embodies all the problems asso-rated with public goods. The lighthouse service can’t be restricted to paying customers since when the beam is on, every ship in the harbor can see it. This is the condition of “non-excludability”; non-subscribing boaters receive the benefits of the lighthouse (a “positive externality”) courtesy of the subscribing boaters. If the service is provided to one boat, it becomes useful to all. This creates what is called “non-rivalrous consumption,” which in turn leads to the problems of shirking and flee-riding.

Why should some lighthouse customers pay, while others receive a light they are not paying for, that is, when they can free-ride? And as long as there is the chance for free-riding, why shouldn’t everyone try to shirk in hopes that someone else will pay for the service? Faced with these problems, say some economists, the market won’t provide lighthouses. The only alternative, it appears, is to have the government provide the lighthouse and charge everyone equally for the service through taxation.

Fortunately not all economists accepted the theory of market failure at face value. The classical liberals had long provided critiques of the logic underlying market failure. But the newly formalized neo-classical theory of market failure called forth a formal response. Starting in the mid-1970s, and continuing to the present, a string of brilliant scholars have taken the model apart piece by piece. As a result, this once invincible case for government interference has severely malfunctioned. Some say the theory now stands on the verge of intellectual collapse.

In The Theory of Market Failure, Tyler Cowen has collected primary critiques of market-failure theory, most of which appeared in economics journals during the last 30 years, and organized them into an accessible volume. He also includes some previously unpublished essays that are especially notable. Cowen’s excellent introduction details the important points of each article, explains the contribution each makes to the literature, and makes suggestions for further research. Contributors include Robert Axelrod, James M. Buchanan, Earl R. Brubaker, Steven N. S. Cheung, Ronald H. Come, Harold Demsetz, Jerome Ellig, Kenneth D. Goldin, Jack High, Robert W. Poole, Jr., and Robert J. Smith.

As the contributors demonstrate, the market has an array of ways to overcome its alleged failures. The “special characteristics” of public goods turn out to be not so special, as Goldin points out, since most if not all goods can be supplied with either “restrictive access” or “equal access,” which brings into question the inherent “publicness” of some goods over others. Dem-setz shows that when “non-excludability” is not in question, as in a movie theater or park, entrepreneurs can charge consumers different prices based on differing consumer values. This allows public goods to be supplied privately. Similarly, Buchanan explains in a now-classic article how private clubs and social groups can provide public goods in ways never imagined by the mar-ket-failure economists.

But what about cases where the service of the public good cannot be excluded from nonpaying consumers? As a private solution, these goods can be connected, through tie-in arrangements, to other goods that are excludable.

For example, the lighthouse beam is not excludable but space in the harbor is. Harbor owners can charge a fee to boats entering the private port which can pay for the lighthouse. In fact, Coase shows that contrary to the assertions of economists, prior to 1842 British lighthouse services were provided privately through a port-en-try charge. Coase concludes that “economists wishing to point to a service which is best provided by the government should use an example which has a more solid backing.”

Another example of market failure debunked in these pages is that of the beekeepers and the apple-growers, whose services create externalities for each other (bees both eat and fertilize the apples). Economists use this example to illustrate how taxation and subsidies are the only way to correct some externalities. Cheung, however, demonstrates that beekeepers and apple growers have been arranging private contracts with each other for many years, with no apparent failures in the market.

The same is true for education, another alleged public good that government must provide. High and Ellig show how before the advent of government schools, in both Britain and the U.S., private enterprise did a fine job of providing education, even to the poor. Of special note, their article describes how the government used public schools to crowd out competitive private ones. The contributions of Poole and Smith show how the “market failures” of fire protection, public parks, and nature conservation also have been privately provided.

As a caveat, most of the contributors to this volume are neo-classical economists and therefore assume the postulates of “perfect competition” and utility scales that are interpersonally measurable, both of which are untenable in a world of action. For a more fundamental critique of market failure, one that takes into account the insights of subjectivism, readers must look toward economists writing within the tradition of Austrian economics.

Cowen’s volume is nonetheless an outstanding research tool. Many economists will continue attempting to justify government intervention by pointing to “market failures.” But this collection puts them on the defensive. Their claims will not be regarded as self-evidently true, as they were only a few years ago.
Mr. Tucker is a fellow of the Ludwig von Mises Institute.