What Should Policy Maker’s Know When Economists Say “Market” Failure?

Justin M. Ross Assistant Professor School of Public & Environmental Affairs Indiana University Bloomington, IN 47403 [email protected]

December 5, 2008 Abstract I argue that framing the existence of externalities and public goods as “market” failures can be both misleading and confusing to policy makers. Voters and special interest groups have little reason to distinguish between pecuniary and technological externalities, so economists and other academics should be clear that the former is necessary for proper functioning of markets. Furthermore, both externalities and public goods are the result of institutional failures to assign property rights adequately. Since it took economists roughly 180 years to realize policy solutions in assigning property rights, they should not expect policy makers to immediately grasp this concept.

The phrase “market failure” has a tendency to be thrown around a lot in public policy discussions because it is a commonly agreed condition that can warrant government intervention (Pigou 1932). However, economists may often have a very different conceptual understanding from the policy makers they advise on matters of market policy (Hart and Zingales 2008). As a result, public policy makers may find it difficult to distinguish actual market failures from other social concerns and commercial failures (Holcombe and Sobel 2001). I wish to illuminate these areas in which the lexicon of economics may be problematic by distinguishing between what economists say and what they mean to say. Specifically, I ask economists and other academics to be careful with their language when discussing externalities and public goods with policy makers and the media. Hopefully, use of proper terminology will help avoid mental shortcuts that skip potentially viable policy solutions. To begin, it is helpful to think about what a market is and what it requires. A market is not just a collection of commercial transactions, but is more broadly thought of as decentralized individual decision making. When these individuals do engage in commercial transactions, the presence of competing buyers and sellers act on information pertaining to their own self-interest with the consequence of directing resources to their most valued use. When individual decision making is not realized in this manner an economist will commonly refer to the existence of a “market failure” in the process. The common sources of such failures can generally be classified into externalities, adequate provision of public goods, inadequate competition, and information problems.

However, communicating the concept of externalities and public goods can be

misleading and cause policy makers to lose sight of the problem when they are framed as “market” failures.

Externalities exist when a party engages in an activity without consideration of spillover benefits or costs it may incur on others, and can be classified into two categories: Technological and pecuniary externalities. Pecuniary externalities are spillover effects of individual decision making that occur through the price mechanism of the market, whereas a technological externality occurs through any channel other than price (Scitovsky 1954). When new college graduates enter the existing labor force, they impose a pecuniary externality of downward pressure on real earnings of the existing workers of similar pedigree. To the college graduates, the high earnings acted as a signal from the market that more workers of this caliber were needed and provided the incentive to act on this information. If a new production process results in a form of pollution that requires medical treatment, a technological externality, the costs effectively lower the real earnings of workers to the same extent as the effect of having new competing labor from college graduates. However, the consequences for economic efficiency are polar opposites. The negative technological externality of pollution resulted in too much of a certain type of production, whereas the negative pecuniary externality was a result of resources being redirected to a more efficient use and fulfilling a social need. Notice that the policy maker may hear complaints from constituents with the same bottom line, which is the experience of a decline in real earnings. Similarly, firms are just as likely to lobby for protection from foreign competition as they are from acid rain damage. What is important for economists and other academics is not to give credence to the pecuniary externality as if it were a failure of markets. The second difficulty of this lexicon is that the term “market failure” is a misnomer for what is actually an institutional failure to adequately assign property rights. A social, cultural, or legal institution may not be adequately assigning and protecting property rights for any variety of reasons. Perhaps the lack of assignment is not possible with current technology or it is just

prohibitively expensive. Coase (1960) articulated this point that technological externalities are a consequence of unassigned property rights. If a firm wishes to dump waste on private property, they must provide compensation on mutually agreeable terms or face legal consequences. If they drop waste in international waters or emit particulate matter into the air, it is unlikely any individual has the legal recourse necessary to negotiate compensation. Without property rights, there is no means for markets to function correctly when the true culprit is the failure of an institution to assign property rights. However, the label “market failure” can instill the idea that the only approach is to nudge market outcomes with taxes, subsidies, or regulation. These are potential solutions, but they are difficult to continuously monitor and implement effectively. How much should we tax an activity and subsidize another? How do we ensure that there is compliance? Can we find a way to tax the externality, but not the production? What are the unintended consequences created by these rules?

Also, these solutions share the burden with all taxpayers supporting the

administration of these functions, and are repeatedly exposed to the political process. The term “institutional failure” directs thinking towards the root of the problem, a lack of property rights, and simplifies the task before policy makers to determining who the rights should be assigned to and how to define them. For example, in the 1960s a rock lobster fishing community in Australia, Port Lincoln, was experiencing a special case of externalities popularly known as the commons problem. Since each fisherman had no incentive to return an undersized lobster, or restrain the number of catches they made, collectively the fishermen were destroying the very source of their livelihood. Fishery officials in Port Lincoln addressed this issue by essentially assigning property rights, not by granting a monopoly or taxing lobster, but by fixing the total number of boats by requiring each to purchase a license (Marks 2001). These licenses

represent the right to fish lobster and could be resold to others, giving the lobstermen the incentive to treat it like any other private resource to be conserved and protected. There is also a great self-monitoring feature, for if a rival fishing company or outsider were to infringe on the lobster population it would diminish the resale value of the other licenses. Furthermore, the fishermen work with scientists and collectively determine what self-controls are necessary for the sustainability of the lobster population. Public goods and services, those which are nonrival-in-consumption and have nonexcludable benefits, are another example of “market failure” that is in fact an institutional failure. Both of these features must be present to be considered a market failure (Sobel 2004). If households cannot be excluded from enjoying the benefits of such a good, it will be underprovided by the market because some households may “free-ride.” The extension of this train of thought is often behind the argument for taxpayer subsidization of professional sports stadiums (Johnson and Whitehead 2000). However, private property rights by definition include the right to exclusive use of the property (Gwartney et al. 2009, p. 33). Secondly, households often pay a price lower than the dollar value benefit they receive from a good, but by itself the existence of consumer surplus is an achievement rather than a failure of markets. Thinking about non-exclusivity as an institutional failure helps identify possible solutions beyond reaching into the public purse. Despite recognizing the existence of externalities and public goods at least since the days of Adam Smith, economists did not start to realize missing property rights as the root of the problem for about another 180 years. Policies for correcting market failures resulted in a focus on taxes, subsidies, and regulation for policy solutions. Framing these problems as the result of institutional failures to assign property rights to resources can help policy makers better

understand technological externalities and the exclusivity problem of public goods, and thus opening the door for more policy solutions. REFERENCES Coase, Ronald H. 1960. The Problem of Social Cost. Journal of Law and Economics 3: 1-44. Gwartney, James D., Richard L. Stroup, Russell S. Sobel, and David A. Macpherson. 2009. Macroeconomics: Private and Public Choice. Mason, Ohio: South-Western Cengage Learning. Hart, Oliver and Luigi Zingales. 2008. Economists Have Abandoned Principle. The Wall Street Journal, December 3, A17. Holcombe, Randall G. and Russell S. Sobel. 2001. Public Policy Toward Pecuniary Externalities. Public Finance Review 29(4): 304-25. Johnson, Bruce K. and John C. Whitehead. 2001. Value of Public Goods from Sports Stadiums: The CVM Approach. Contemporary Economic Policy 18(1): 45-58. Kathy, Marks. 2001. The Big Tuna. The Independent. April 20, Pigou, Arthur C. 1932. The Economics of Welfare. Library of Economics and Liberty. http://www.econlib.org/library/NPDBooks/Pigou/pgEW69.html. Scitovsky, Tibor. 1954. Two Concepts of External Economies. Journal of Political Economy 62(2): 143-51. Sobel, Russell S. 2004. Welfare Economics and Public Finance. In Handbook of Public Finance ed. by J. Backhaus and Richard E. Wagner, 19-51. Norwell, MA: Kluwer Academic Publishers