A popular academic rationalization for having government forcibly override people's economic decisions is the theory of market failure. Advocates of the free market have long emphasized that the countless self-regarding actions individuals perform daily in the marketplace generate a larger complex spontaneous, or undesigned, order — that is, a high degree of interpersonal coordination that is remarkably pleasing to consumers. This is the social cooperation Ludwig von Mises placed at the center of his description of the market process.
Critics of the market realize this is a powerfully appealing feature of the economists' case for what these critics deride as the unfettered marketplace. (On the contrary, the free market, when permitted to work, is rather severely fettered by free consumer choice.) So this feature has been among the prime targets of those who would straitjacket or even abolish the market. Hence the attraction of market-failure theory.
The critics counter the coordination argument by claiming that market behavior can lead to less-than-favorable phenomena, such as free-riders (public goods) and prisoner's dilemmas. In theory these have the following characteristic: rational individual behavior brings about an overall result that the individuals themselves dislike.
In the case of free-riders, providers of certain jointly consumed services have no practical way to charge consumers who don't volunteer to pay; therefore, the services are underproduced or not produced at all. This is also called the public-goods problem. Lighthouses and national defense are alleged to be examples. Prisoner's dilemmas, an idea from game theory, describe situations in which people who cannot communicate with each other act in their apparent best interest only to find that they could have made better choices had they known what others were doing. Somehow this is seen as relevant to the marketplace.
Market advocates have often pointed out that the market itself — if allowed to work — contains fixes for these alleged failures, but an equally important point has gotten less attention. Accepting the critics' argument for the moment, it is fallacy to assert that any time the market is expected to generate suboptimal results, government should step in. Why is that a fallacy?
Because it assumes that the results of government preemption would be superior to whatever results the market would have produced. But that cannot be assumed. It has to be proved. And it has not been. Market critics have had enough time to bring forth the arguments. Where are they?
Mises and F. A. Hayek left behind a voluminous literature explaining that calculation and knowledge problems assure that government-generated outcomes will be inferior to market-generated outcomes. Israel Kirzner has specifically shown that these problems plague not only full-out central planning, but the regulatory state as well.
David Friedman has elaborated another argument against government inference. Market failure, Friedman writes, applies to government itself in a more egregious form than it applies to the marketplace. And while the market has built-in corrective features, government does not.
In a December 2005 Liberty magazine article, Do We Need Government? Friedman wrote, In order for government intervention to improve on the market outcome, it is not enough that there is something government could do that would give a better outcome. There must also be a reason to expect government to do it. …[T]he incentives of the relevant political actors have to be such that it is in their best interest to act in way that result in the improved outcome.
Have we any grounds to assume that those incentives exist? Friedman thinks not. Representative democracy, he says, has a perverse incentive — a free-rider problem — right at its core: the voting system. In order to figure out both what a politician is doing and whether he should be doing it, the voter must spend substantial amounts of time and effort studying the issues and the politician's voting behavior. In doing so, he is producing a public good — better laws — for a very large public. He himself collects only a tiny fraction of any benefit. Seen from the other side, he is bearing a large cost for a trivial gain — an increase of perhaps one chance in a million in the probability that the right politician will get elected.
Thus even a voter who understands some economics and who would favor a reduction in government interference with the market has little incentive to exert much effort. (Bryan Caplan points out that most voters don't understand economics and are blinded by antimarket biases. The public goods problem Friedman describes gives them no incentive to examine and discard those biases.)
Friedman generalizes to this conclusion: [T]here is no reason to expect individual rationality in that [political] market to lead to group rationality. In private markets, most of the time, an individual who makes a decision bears most, although not all, of the resulting costs, and receives most of the resulting benefits. In political markets that is rarely true. So we should expect that the market failure that results from A taking an action most whose costs or benefits are born by B, C, and D should be the exception in the private market, the rule in the political market. It follows that shifting control over human activities from the private market to the political market is likely to increase the problems associated with market failure, not decrease them (emphasis added).
So market failures, Friedman recaps, are the exception in real markets and the rule in democratic political systems. He takes this a step further and points out that a market failure is also a profit opportunity. A profit opportunity — in a genuinely free market void of privilege — indicates that consumers are underserved; that is, scarce resources are not being used in ways consumers would most prefer if they knew what they were missing. The entrepreneur rights things in this regard. Profit is his reward. The lure of profit is the incentive to discover how to better serve consumers. Friedman writes, If the result of individuals acting rationally in their own interest is to make them worse off than if they acted in some other way, it follows that an entrepreneur who could somehow move them to the better outcome would produce a net benefit — some of which, with luck, he could pocket. Hence in a market society there is an incentive for private parties to find ways around the inefficiencies caused by market failure.
The problem for the economic market, in other words, is overestimated.
What about political market failure? It also creates incentives, Friedman says. When the incentives generated by the political marketplace are sufficiently perverse, illegal market transactions may be the best way of dealing with the problem.
Note the difference. The economic market holds the means of correcting itself: entrepreneurship. But to get relief from failures in the political market, people have to go into the economic market (the black market). The political market can't correct itself.
Friedman cautions his readers against thinking that government can be restricted to intervening only where the private market fails badly. Implementing such a rule would necessarily leave it to politicians to define fails badly. Would they use a narrow or broad standard?
A final note: I'm uneasy with this problem being referred to as market failure even when it applies to politics. As Caplan says, we should drop specious analogies between markets and politics, between shopping and voting. Markets — when they are allowed to work — are based on consent. Politics is based on force. Using the same term — market — to describe both is confusing and unnecessary. The sort of failure Friedman discusses obviously is not exclusive to the economy, since it occurs in the political realm also. Thus it is imprecise to call it market failure. Maybe it's simply a social failure. Whatever we call it, let's avoid the qualifier market, for it only prejudices the case and lends an illusion of credibility to the statists' arguments.