Milton & Rose Friedman on Market Failure and Government Failure

From Free to Choose. Chapter 1 "The Power of the Market." Excerpt:

"A more subtle example involves effects on "third parties," people who are not parties to the particular exchange—the classic"smoke nuisance" case. Your furnace pours forth sooty smoke that dirties a third party's shirt collar. You have unintentionally imposed costs on a third party. He would be willing to let you dirty his collar for a price—but it is simply not feasible for you to identify all of the people whom you affect or for them to dis-cover who has dirtied their collars and to require you to indemnify them individually or reach individual agreements with them.

The effect of your actions on third parties may be to confer benefits rather than impose costs. You landscape your house beautifully, and all passersby enjoy the sight. They would be willing to pay something for the privilege but it is not feasible to charge them for looking at your lovely flowers.

To lapse into technical jargon, there is a "market failure" be-cause of "external" or "neighborhood" effects for which it is not feasible (i.e.,would cost too much) to compensate or charge the people affected; third parties have had involuntary exchanges imposed on them.

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 leas 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 alternatively, 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 by standers. 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 important to justify government action. The lesson to be drawn from the misuse of Smith's third duty is not that government intervention 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 interventions 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 terminated. 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."