Thoughts on economics and liberty

History of market failure – José Luis Gómez-Barroso

I liked this history, sharing it on my blog (from an encyclopedia), with coloured annotations.


Economic literature usually awards Bator (1958) the merit of having coined (or of at least having used it for the first time in a publication) the term “market failure,” defined as the failure of a more or less idealized system of price-market institutions to sustain “desirable” activities or to estop [sic] “undesirable” activities.

However, the existence of market failures appears to be explicitly or implicitly linked to any opinion on the role reserved for the State in the economy. This means, in practice, that one way or another, the notion of market failure (though not necessarily the term) can be traced back throughout all contributions made to economic science. And although the work of Adam Smith, and his “invisible hand,” would seem to mark, in the opinion of many, a starting point in the construction of a system capable of suitably assessing the question of efficiency in markets, what is true is that reasonings in one or another sense, with varying degrees of rigor, can be found in any chapter of the history of economic thought.

It can be generically stated that all schools prior to Smith had doubts about whether private activity (the markets) managed to reconcile individual and social welfare. The ancient Greek thinkers, who did not conceive of the economy as an autonomous discipline, saw in its fellow citizens’ pursuit of wealth a danger for the harmony of social order. Consequently, both Aristotle and Plato invoked strict control of economic activity by the State. In Politics, Aristotle proposed a superintendency whose main functions were to see that everyone involved in transactions was honest and holds to their agreements and contracts and that orderliness was maintained; some authors have even suggested that Aristotle’s idea was that these supervisors could set prices (Mayhew 1993).

With all the considerations derived from some very different context and motivation, these ideas were taken up again in the Middle Ages by scholastics to reach some similar conclusions: the sinning nature of man means that, against the will of God, his love for himself comes before his love for others and, therefore, the result of unregulated individual activity (ergo the market) does not agree with divine dictates. The intervention of the authority to ensure the harmony of socioeconomic order is, once more, the corollary of this reasoning.

For mercantilists, in the sixteenth and seventeenth centuries, it was not the precepts of justice, be it divine or not, but national interest that was discredited when self-interest was pursued. And given that the first representation of this national interest is the accumulation of precious metals, commercial activity is the sector where control of private initiative should be directed at in the first place.

As a reaction to mercantilism, in the eighteenth century, the physiocrats postulated the abolition of obstacles to trade. Even though their thinking often appears to be associated with the phrase laissez-faire, laissez-passer, the pursuit of self-interest, derived from an excessive demand for manufactured and luxury goods, continued to be  part of the problem that had to be resolved (Medema 2009). In fact, François Quesnay, one of the greatest representatives of this school, advocated control of the markets, especially of agrarian markets, given their special transcendence due to agriculture being the source of the produit net.

What distinguishes Adam Smith from his predecessors is the assessment of the result that the sum of individual actions produces: even if individuals do not consider in their actions anything similar to the common good, but rather the strictly personal, the most beneficial outcome for society is derived from the sum of all these actions. It is important to stress the idea of “sum,” since Smith in Wealth of Nations gives some 60 examples in which the pursuit of self-interest causes harmful consequences for social good (Kennedy 2009). Moreover, the idea of an invisible hand infallibly guiding the markets is more a modern interpretation of his thinking than the foundation of his work, in which he only uses the expression incidentally and in the religious and cultural context of his time (among many others Harrison 2011; Kennedy 2009). Whatever interpretation is given to the metaphor of the invisible hand, what Smith is clear about is that public interference could not improve the result of private activity. Again, here it is possible to make a (important) qualification, since the three functions assigned to the sovereign in the system of “natural freedom” described in Book IV of Wealth of Nations are defense, justice, and “the duty of erecting and maintaining certain public works and certain public institutions, which it can never be for the interest of any individual, or small number of individuals, to erect and maintain,” an exception that has even led to calling him “cautious interventionist” (Reisman 1998).

In spite of all the detailed statements that can be made on what Smith wrote, it is at least unambiguous that the market should be much less guided by governments or religions in his system of natural freedom than in all contributions that had been made up to then. His vision was shared, and refined, by the classical economists of the nineteenth century. Without being too ardent in their defense of laissez-faire, as they are often represented, for them the pursuit of self-interest, duly channeled through the activity of the markets, produces results that, on most occasions, are better than any other that could be obtained by government policy. The assessment of those results and, therefore, the conclusion they reach incorporate ideas developed by Jeremy Bentham and his utilitarianism ethic.

By the middle of the century, some nuances on firmly held concepts began to be introduced. The first to do so was John Stuart Mill, who in his “harm principle” puts as a limit to individual activity the cases in which said activity negatively affected the interests of others, which in modern terminology would be called the presence of negative externalities. As with so many theorists, his thinking is more complex than what is often presented: the circumstances in which public intervention could be admissible include situations in which individuals are not able to judge the result of their own actions (e.g., with regard to education). The above notwithstanding, Mill shares his reservations regarding public intervention with classical economists (there is a clear rule for not interfering, but none for interfering), though these reservations come more from his misgivings regarding the competence of governors than from some solid theoretical principles. Henry Sidgwick extended even further the catalogue of situations in which the principle of laissez-faire did not maximize common welfare. Examples are the overexploitation of natural resources, the occasions on which companies do not offer sufficient quantities of goods or services because they cannot recoup their investment or the cases in which there is not enough information on the effects of a certain product or action. For Sidgwick, a direct need for public intervention did not, however, come about in these situations. His answer to the question follows the rules of utilitarianism to their extreme and is, therefore, much more pragmatic than that of Mill: the cost of potential intervention (that includes aspects that already concerned many of his predecessors, such as corruption and the possibility that certain groups are intentionally favored) should also be valued and then confronted with the potential benefit obtained.

At the dawn of a new century, economists from the Cambridge School applied the tools of marginalism to the problem of market limits. Alfred Marshall, by means of the consumer surplus calculation, identified situations in which public activity could increase welfare. Arthur Cecil Pigou, comparing social and private net marginal product, gave much more concrete form to what we today call the theory of externalities. His book The Economics of Welfare (Pigou 1920) became an obligatory support or criticism in any subsequent contribution to the debate. The role reserved for the State was, according to Caldari and Masini (2011) and despite what is usually argued, more important for Marshall (for whom the market should be substituted in questions of social relevance) than for Pigou (for whom it should merely be complemented). All this in theoretical terms, since in practice (normative economics against positive economics) both authors, especially Marshall, did not openly commit to intervention given the limitations and inefficiencies that both pointed out in the political processes (Backhouse and Medema 2012).

In the following decades, these misgivings disappeared to the extent that economists who extended the work of Pigou not only kept enhancing and shaping the theory of externalities but made progress in the mathematical demonstration of the benefit generated by public intervention (therefore necessary) in these situations (Meade 1952; Scitovsky 1954; Buchanan and Stubblebine 1962). Also, by the middle of the century, further progress in the categorization of public goods was made; the work of Samuelson (1954), where the characteristics of “collective consumption” goods are described, and that of Buchanan (1965), on impure public goods, merit to be highlighted.

But at the same time as this current was developing, other economists were challenging their conclusions: the critical work of Coase marks an inflection point accompanied in time by the theory of Government failures.

Though sketched in other previous works, it was in The Problem of Social Cost (Coase 1960) that Ronald Coase structured his arguments. For him, when an activity is restricted due to the presence of negative externalities, there is also a cost associated with the restriction of such activity that is not taken into account in the calculations of social and private welfare. Which of the two “damages” is permitted is a question of assigning property rights. That assignation, though, does not necessarily lead to an efficient outcome. Ideally, it is not public intervention, but rather negotiation (the market) that could lead to an optimal (efficient) situation if the rights were well defined and there were no transaction costs. When this is not fulfilled, other options are possible. Regulation is one of them. However, if the costs associated with regulation exceed those it aims to prevent, it would leave not doing anything as the only solution; thus, the importance of having an appropriate institutional structure.

It was also in the second half of the century that a theory that did not strictly refer to market failures, but which should compulsorily be mentioned, was formulated: it is the parallel theory of Government failures. The precedents of the school of public or collective choice, as they are known, can be traced in the work of the Italian school of scienza delle finanze and of Knut Wicksell, who had incorporated public decision processes into theoretical analyses, thereby turning them into a factor that also determines what should be the nature and extension of the functions of the State (see Medema 2009), and further on in the work of Kenneth Arrow (most especially in Arrow 1951). With this foundation, some economists from the universities of Virginia and Chicago in the early 1960s developed a theory whose maxim was that individuals who choose between alternatives are guided by an actual rationality, both when they do so in the public function as when they choose it for themselves: they always tend to maximize self-interest.

Further on in the second half of the twentieth century, some developments came about in the theory of market failures, very linked overall to the exploration of the consequences of the asymmetries of information, which includes concepts such as adverse selection (the famous market for “lemons” described in Akerlof 1970), the moral hazard, or the lock-in effects. There has also been abundant literature theoretically or  empirically resisting these advances: a dozen studies are compiled in Cowen and Crampton (2002).

At this point, it is apparent that some important schools have been left out of this historical summary. Though they have not directly referred to market failures or even to self-interest, their concept of the role of the State enables us to infer what their position is in this regard. Here we consider three that are basic for understanding modern economic thought: Marxism, the Austrian School, and Keynesianism.

For Marxism, the market always generates undesired results and, therefore, does not consider perfect markets (in which there is also capitalist exploitation and economic crises) as a desirable or reasonable end. Therefore, market failures are an irrelevant argument or, from another perspective, all markets are pure failure.

The spontaneous order advocated by the Austrian School generates a more efficient allocation of society’s resources than that which any design can achieve. There are, therefore, no market failures, or rather it would be impossible to know whether the market is failing. To do so it would be necessary to carry out an impossible assessment, since they deny the neoclassical concept of efficiency that is substituted by the non-hindrance of the actions of individuals. In this respect, any market failures would come from public action.

Finally, Keynesianism places the emphasis on the stickiness of prices and (especially) of wages in the short run, a circumstance that makes markets with no intervention generally not able to generate efficient outcomes.

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Sanjeev Sabhlok

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