When an industry in the private sector is not performing efficiently or effectively, there is said to be “market failure”. The recommendation by economists and others typically is then for government actions to combat such failure, such as taxes to help reduce pollution. The diagnosis of market failure may be accurate, but the call for government involvement may be naïve and inappropriate.
The reason is that actual governments do not necessarily do what economists and others want them to do because there is “government failure” as well as market failure. Before recommending government actions to correct market failures, one should consider whether actual government policies would worsen rather than improve private sector outcomes. Since many factors often make for considerable government failure, considering such failure is crucial and not just a theoretical fine point.
Consider, for example, that consumers are sometimes ignorant of the qualities and other aspects of the products they buy. However, before advocating various forms of government protection of consumers, we should recognize that voters are far more ignorant of political candidates then consumers are of what they buy. The reason is that consumers directly suffer if they make bad choices out of ignorance, while individual voters have negligible influence over political outcomes. Hence voters have little incentive to be informed about different candidates and their positions, and the consequences of the mistakes they make are largely borne by others.
Monopolies do arise in the private sector, as when Microsoft had monopoly power over personal computer operating systems, when IBM still earlier had monopoly power over computers, or when manufacturers form cartels to raise their prices by restricting production. Yet, monopoly also occurs in the political sector, and it is far more pervasive there. An industry that contains only two firms is considered a duopoly that is presumed to raise prices above competitive levels, but the political process is dominated in democratic countries by duopolies, such as the Democratic and Republican parties. In addition, when government companies receive monopoly positions, such as the US Postal Service or national oil companies in many countries, they generally succeed in either keeping out or greatly delaying the entrance of private competitors. By contrast, private monopolistic positions are usually temporary, as seen in the eroding over time of IBM’s and Microsoft’s dominant positions in the computer industry.
Government actions sometimes not only fail to overcome market failure but rather worsen the failure. Fannie Mae and Freddie Mac were formed as quasi-governmental institutions to help encourage mortgages in the residential housing market because of a belief that the private sector was not providing enough mortgages, especially to lower income families. Yet, as documented in detail in Reckless Endangerment by Gretchen Morgenson and Joshua Rosner, these two companies used their privileged positions to take excessive risks, and to insure large numbers of mortgage loans that should never have been made.
European regulators have attacked Microsoft, Google, General Electric, Intel, and other (mainly American) companies because of various alleged anti-competitive policies. In these cases, and in many antitrust cases brought by American regulators, such as the recent objection to the merger of AT&T and T-Mobile, the motivation seems to be to protect the competitors of these companies or to protect jobs rather than to improve outcomes to consumers.
Many countries subsidize various alternative forms of energy, such as wind, solar, biofuels, and electric batteries, because of the substantial pollution from using coal, oil, and other fossil fuels. Often, however, the choices of what to heavily subsidize are made on political rather than economic criteria. For example, for years hydrogen cars were politically the most promising substitute for gasoline driven cars; then hydrogen fell out of favor and electric cars became the political darlings. Since governments have seldom succeeded in picking technological winners, I suspect they will be wrong again in these attempts to steer the development of cost-effective alternatives to the internal combustion gasoline engine. Another example is the scandal about the heavy American government financial support to the solar panel company Solyndra that recently failed.
How does one approach policy once it is recognized that government failure is substantial, and often much worse than market failure? As a general rule I believe the presumption should be in favor of government actions only when market failures are quite large and persistent. So clearly governments should have the dominant role in the military and police areas, in the judiciary, in protecting against massive pollution, and in providing a safety net for its least fortunate members (private charities are important but do not do enough). On the other hand, when market failures are relatively small and likely to be temporary, as in monopoly situations or in exploiting consumer ignorance, government involvement should be minimal, as in minimalist anti-trust policies, and in allowing consumers generally to make their own decisions.
The intermediate cases are the most difficult: when market failures may be significant, and yet government alternatives are not attractive. This may be decided on a case-by-case basis, but I believe the usual rule should then be to let the market operate. This belief is based on the conclusion that, on the whole, government failure is far more pervasive, damaging, and less self-correcting, than is market failure. Others may reach different conclusions, but these are the problems that a relevant welfare analysis should focus on. Simply concluding that in particular instances markets are not working perfectly is a misleading and incorrect basis for supporting active and sizable government involvement.