Monday, July 31, 2017

Milton & Rose Friedman On Externalities, Market Failure And Government Failure

Excerpt from Free to Choose:

 "Almost everything we do has some third-party effects, how-
ever small and however remote. In consequence, Adam Smith's
third duty may at first blush appear to justify almost any proposed
government measure. But there is a fallacy. Government measures
also have third-party effects. "Government failure" no less than
"market failure" arises from "external" or "neighborhood" effects.
And if such effects are important for a market transaction, they
are likely also to be important for government measures intended
to correct the "market failure." The primary source of significant
third-party effects of private actions is the difficulty of identifying
the external costs or benefits. When it is easy to identify who is
hurt or who is benefited, and by how much, it is fairly straight-
forward to replace involuntary by voluntary exchange, or at least
to require individual compensation. If your car hits someone
else's because of your negligence, you can be made to pay him
for damages even though the exchange was involuntary. If it
were easy to know whose collars were going to be dirtied, it would
be possible for you to compensate the people affected, or alterna-
tively, for them to pay you to pour out less smoke.

If it is difficult for private parties to identify who imposes costs
or benefits on whom, it is difficult for government to do so. As a
result a government attempt to rectify the situation may very
well end up making matters worse rather than better—imposing
costs on innocent third parties or conferring benefits on lucky
bystanders. To finance its activities it must collect taxes, which
themselves affect what the taxpayers do—still another third-
party effect. In addition, every accretion of government power for
whatever purpose increases the danger that government, instead
of serving the great majority of its citizens, will become a means
whereby some of its citizens can take advantage of others. Every
government measure bears, as it were, a smokestack on its back.

Voluntary arrangements can allow for third-party effects to a
much greater extent than may at first appear. To take a trivial
example, tipping at restaurants is a social custom that leads you
to assure better service for people you may not know or ever
meet and, in return, be assured better service by the actions of
still another group of anonymous third parties. Nonetheless, third-
party effects of private actions do occur that are sufficiently im-
portant to justify government action. The lesson to be drawn from
the misuse of Smith's third duty is not that government interven-
tion is never justified, but rather that the burden of proof should
be on its proponents. We should develop the practice of examining
both the benefits and the costs of proposed government interven-
tions and require a very clear balance of benefits over costs be-
fore adopting them. This course of action is recommended not
only by the difficulty of assessing the hidden costs of government
intervention but also by another consideration. Experience shows
that once government undertakes an activity, it is seldom ter-
minated. The activity may not live up to expectation but that is
more likely to lead to its expansion, to its being granted a larger
budget, than to its curtailment or abolition."

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