A Skeptical Look at “Market Failure”

Government intervention is often the cause of such failures, not the remedy for them

By David R. Henderson. 

"A topic that gets a lot of play in most undergraduate microeconomics courses is the issue of market failure. Unfortunately, while the concept is sound, many people and even many economists err in one of three ways. First, they often attribute problems to market failure that are actually the result of government intervention. Second, economists often fall into the trap of doing “armchair economics” and fail to look at the real world where some of the things they call market failures are often market successes. Third, although non-economists and economists can sometimes point to examples where markets fail to achieve the economist’s ideal and to the fact that no apparent government intervention causes it, they often conclude, without examining how government works, that the government will do better.

Failures Resulting from Government Intervention

First, often what are called market failures are not, but are, in fact, the result of prior government intervention. I’ll give three examples.

Consider the current difficulty many people in California have finding home or auto insurance. That’s not a market failure; it’s a government failure. It results from price controls. California has an insurance commissioner, Ricardo Lara, who has the power to say no to insurance companies that want to raise their prices.

In a long news story in the June 20 San Francisco Chronicle, reporter Claire Hao wrote:

“Never in my career have I heard from so many insurance agency owners and consumers, desperate to buy auto or home insurance, yet unable to purchase it due to lack of availability,” he [Mike D’Arelli, executive director of American Agents Alliance] continued.

Last month, State Farm announced it would stop writing new homeowner’s policies in California, setting off worries of shrinking insurance availability in the state, particularly in high-risk wildfire areas. The Chronicle also confirmed that Allstate quietly stopped writing new homeowner, condo, and commercial policies last year.

Why did this happen? Price controls. Hao wrote:

Lara didn’t approve any rate increases for auto insurers from May 2020 to October 2022—which Progressive’s CEO cited in an earnings call last year as an explanation for slowing business in California. 

Another example is housing. Increasingly in American cities and Canadian cities, people have trouble finding housing at what they regard as affordable prices. We see this in San Francisco, Los Angeles, New York, Vancouver, and Toronto, to name five examples.

Does that happen because the market has failed to provide cheaper housing? No, it’s because developers have not been allowed to build housing. Restrictions on building over decades in places like San Francisco and Los Angeles have put housing more and more out of reach of even middle-class families. Getting rid of the restrictions would make housing more affordable for tens of millions of Americans and Canadians.

Here’s a final example. A drug called felbamate is used to treat epilepsy but has been approved only for oral use, not intravenous use. According to Sol Steiner, a long-time drug expert with whom I spoke, there are “eight golden hours” after a stroke during which the stroke victim can be effectively treated. Steiner says that if felbamate were injected intravenously during that time, about half of the damage from a stroke could be avoided.

So the fact that no drug company has come forward and produced an intravenous form of felbamate is a market failure, right? Wrong. A drug company that applied to the Food and Drug Administration for permission to produce intravenous felbamate might have to spend hundreds of millions of dollars to establish efficacy. But the patent on felbamate has expired. That means that if a drug company did bear the cost of showing efficacy, other drug companies could compete with generic felbamate. So, the drug company that bore the cost of getting approval would not be able to charge a premium price. Every drug company, looking at these facts, decides not to undertake the process. Result: no intravenous felbamate and more people being unnecessarily damaged by strokes. That’s not a market failure. That’s government preventing a valuable drug from being on the market.

Armchair Economics

Economists often fall into the trap of doing armchair economics, sometimes called “blackboard economics,” and fail to look at the real world where some of the things they call market failures are often market successes.

One of the strongest critics of blackboard economics was the late British economist Ronald Coase of the University of Chicago, who won the Nobel Prize in economics in 1991. In explaining what was wrong with blackboard economics, Coase quoted a fellow British economist named Ely Devons, who wrote, “If economists wished to study the horse, they wouldn’t go and look at horses. They’d sit in their studies and say to themselves, ‘What would I do if I were a horse?’ ” 

In his own work, Coase actually presented one of the most famous examples of blackboard economics being refuted by evidence. In both the nineteenth and twentieth centuries, economists argued that there could not be for-profit lighthouses and that, therefore, governments needed to tax people to build and operate lighthouses. Did these economists actually go out and check whether such lighthouses existed? No. They couldn’t conceive of how a private company could profitably provide lighthouse services. They argued that lighthouse companies would not be able to charge for their services because many ships would “free ride,” taking advantage of the lighthouse but never paying.

Their argument, on a blackboard, seemed cogent. But wouldn’t an economist who made such a claim want to check the evidence? Apparently not, but Coase did. In a famous 1974 article in the Journal of Law and Economics titled “The Lighthouse in Economics,” Coase showed that lighthouses in nineteenth-century Britain were privately provided and that ships were charged for their use when they came into port. There must have been free riders—there I go, doing armchair economics—but enough ships paid that the enterprise was successful.

Another example of using evidence to refute armchair assertions of market failure is what Steven Cheung, then a University of Washington economist, called “The Fable of the Bees.” In a 1973 article by that title, he quoted James Meade, a British economist who shared the 1977 Nobel Prize, arguing that apple orchards provide gains to bee owners and bees produce gains to apple orchards, but these gains are not taken account of because there are no contracts between orchard owners and bee owners. Hence, argued Meade, the market had failed. By examining data from Washington state, Cheung showed that “contractual arrangements between farmers and beekeepers have long been routine.” Hence, the market had succeeded.

The Real and the Hypothetical

Although economists can point to examples where markets fail to achieve the economist’s ideal and there is no apparent government intervention causing it, that doesn’t mean that the government will do better. The mistake that many economists make is in comparing actual markets with ideal government intervention. The late Harold Demsetz, who, by the way, was the main person who persuaded me to become an economist, called this way of thinking the “Nirvana approach.” When you compare actual markets to ideal government, it’s not surprising that ideal government often wins.

Demsetz argued that the “comparative institutions approach” is the correct way to proceed: we should compare actual markets with actual government. In laying this out in his famous 1969 article “Information and Efficiency: Another Viewpoint,” Demsetz pointed to three fallacies that, singly or together, are part of the Nirvana approach. They are (1) the “grass is always greener” fallacy; (2) the free-lunch fallacy; and (3) the “people could be different” fallacy.

Consider each fallacy.

With the fallacy labeled “the grass is always greener,” the economist sees what looks like a failure in the free market and concludes that the government intervention would improve things without actually considering how government intervention would work. What if someone who was asked to judge a contest between two figure skaters judged only the first skater and on that basis awarded the prize to the unevaluated second skater? We would all see the problem with that. But that, in essence, is what many economists do in awarding the “prize” to government intervention.

Economists commit the free-lunch fallacy when, to reach the conclusion that the market fails to provide certain goods or services, they ignore the fact that various costs make it not worth providing. Although Demsetz’s insights have made a splash, and even Wikipedia has an entry on what economists now call the “Nirvana fallacy,” other economists, even good ones, still fall prey to the free-lunch fallacy. In the ninth edition of their textbook, Public Finance, authors Harvey S. Rosen and Ted Gayer write:

In reality, markets for certain commodities may fail to emerge. Consider, for instance, insurance, a very important commodity in a world of uncertainty. Despite the existence of firms such as Aetna and Allstate, there are certain events for which insurance simply cannot be purchased on the private market. For example, suppose you want to purchase insurance against the possibility of becoming poor. Would a firm in a competitive market ever find it profitable to supply “poverty insurance”? The answer is no, because if you purchased such insurance, you might decide not to work very hard. To discourage such behavior, the insurance firm would have to monitor your behavior to determine whether your low income was due to bad luck or goofing off. However, to perform such monitoring would be very difficult or impossible. Hence, there is no market for poverty insurance—it simply cannot be purchased.

But if high costs cause the market for poverty insurance not to exist, that should be chalked up as a market success, not a market failure. When not subsidized by government, markets tend to weed out businesses whose costs exceed their benefits. 

Under the “people could be different” fallacy, Demsetz criticizes the claim by Kenneth Arrow, who won the Nobel Prize in economics in 1972. If people weren’t so risk averse, according to Arrow, many markets would exist that don’t exist. Demsetz pointed out that just as people in private markets are often risk-averse, so are people in the government sector.

We see this regularly with the FDA. Think about the incentives facing an FDA official deciding whether to approve a drug. If he approves the drug and it works with minimal side effects, that’s great for society, especially if the drug saves lives. But how much credit does the official get? Zero or close to zero. Now imagine that the FDA official approves the drug but down the road the drug is shown to cause harmful side effects. The official could get hauled before Congress and lambasted. These asymmetric incentives cause the FDA to delay, often by years.

Conclusion

While the concept of market failure is important, economists often overstate it, either by attributing to the market a problem caused by government intervention, speculating theoretically that market failures exist, or by comparing actual markets with hypothetical ideal government intervention. Adopting any of these approaches is to engage in what might be called “economist’s failure.”"