Market Failure and Government Failure

by Gil Guillory

A common rejoinder to the program of laissez-faire is that market failures require government intervention. Before such a proposition can be evaluated in general, or case-by-case, we must understand the terms. 

Government and Business Failure 

Failure, generally speaking, occurs when actions do not result in their intended consequence. A pole vaulter fails when he does not clear the bar. An engineer fails when his design is not sound. But, what of an institution? What does it mean for a government or business or market, to fail? 

Governments are organizations that have stated goals, such as establishing justice and insuring domestic tranquility. When, despite their actions, these organizations do not establish justice, or insure domestic tranquility, then they have failed. Governments both succeed and fail in their endeavors, as we would expect of an institution composed of humans. A business, considered as an economic institution, is that type of entity, whose primary goal is to make money. When a business, despite its efforts, does not turn a profit, it fails. 

Failure of an institution can be either intermittent or chronic. When a business fails chronically, its owners typically dissolve it. This dissolution is often called a “business failure”, even though it implies a whole string of failures. When a government chronically fails to meets stated goals, such a condition is properly termed “government failure”. 

Market Failure 

What is more problematic is the term “market failure”. A market, though a social institution, is not a consolidated phenomenon. The market has no written constitution, no membership list. It is, in Adam Smith’s memorable phrase, the simple system of natural liberty. What actors seek on a market varies from person to person. That a price seems high to a buyer, or seems low to a seller, is a subjective preference. A market, not being a monolithic institution, does not have a single set of goals against which one can compare its performance. We must dig deeper. 

The most interesting (and, alas, most common) use of the term “market failure” is in comparison to an impossible theoretical world. Market failure has been used to describe outcomes resulting from the fact that transmission of information is costly and imperfect; the fact that consumers do not always know whether or not a particular good or service will satisfy their desires; and the fact that there is fraud, default, and reneging among both buyers and sellers. These uses of the term “market failure” are misleading. While it is true that we do not live in a Garden of Eden, analysis should ultimately inform action. Market failure in this sense is necessary, but far from sufficient, to make the case for supplanting voluntary action with government action. So, this use of the term is to be avoided. 

The subjective nature of goods and the entrepreneurial nature of human action must inform our understanding of the term “market failure”. It will not do to claim that cars are generally not safe enough, or that the stock of Anthrax vaccines is too low. The appropriate level of safety for a car, and the cost-effectiveness of such safety features, is a subjective matter. Even if we could agree that the stock of Anthrax vaccines is too low, the decision to produce the vaccines took place in the past, when conditions were different. 

In sum, market failure, if the phrase means anything useful, must refer to fundamental defects in the nature of human ability to achieve certain goods through voluntary, as opposed to coercive, institutions. But, there are two major barriers that one must confront in making the case for market failure. 

The Monopoly Consideration 

First, governments are monopolies and (generally speaking) businesses are not. So, if the government chronically fails to reduce the number of people suffering in poverty or some other good, this is properly called government failure. However, if a particular business fails, this is not market failure. Even if a whole segment of businesses employing a particular business model fail, this is not market failure. In both cases, only the business model has been shown to fail. 

It has been said that the tragedy of science is “a beautiful hypothesis, slain by an ugly fact”. Many market failure arguments ignore this tragedy. Just because a particular business model will not be profitable in supplying a particular good, does not mean that such a business model cannot exist. If a single business model is proposed which has not been tried in the real world, especially if it can reasonably be shown to be sound, then the question of market failure remains open in a very real sense. 

There are two related logical misdemeanors committed by claimants for market failure. One is to blithely assume that any successful business model, were it to exist, would have been tried. The other is to assume that government action in the past was the best possible response to the problem at hand. Both of these errors are funny, because they both impute error-free action to entrepreneurs in the wide sense – a charge that is inaccurately leveled at the advocates of laissez-faire. 

Subjective Value 

Secondly, and more importantly, one must fully come to grips with the doctrine of subjective value. There is no general case to be made for preferring a certain quantity of one good over another. For the stock of vaccines to be higher, some other good must be sacrificed. Any suggested change in government policy that is contested (have you ever met one that wasn’t?) proves that preference orders vary. 

Institutional Considerations 

So, in making the case for market failure, one must show how incentive structures and constraints result in plainly worse outcomes in voluntary institutions of every conceivable stripe when compared to a highly specific coercive institution. 

But, even this does not go far enough. To fully make the case for market failure, one must examine the long run. One must demonstrate that the internal institutional structures of voluntary versus coercive systems will evolve over time to maintain the advantage for the latter. 

The foregoing should make it clear how hard it is honestly to make the case for market failure.

February 17, 2002  

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