Market Failure 7: Government Failure (There’s Always a Catch)

If men were angels, no government would be necessary. If angels were to govern men, neither external nor internal controls on government would be necessary. In framing a government which is to be administered by men over men, the great difficulty lies in this: you must first enable the government to control the governed; and in the next place oblige it to control itself.

Federalist No. 51

The Nirvana Fallacy is a term coined by Harold Demsetz, an institutional economist. He made the observation that arguments over different institutional arrangements often compare a messy real-world institution with the arguer’s idealized alternative. The imperfections of the real world are much easier to see than the inevitable flaws that even the best-conceived idea will have once it is implemented.

Up to this point, I have spent most of this series discussing the limitations of markets – to describe how markets are powerful yet flawed tools, rather than magic pixie dust that can be sprinkled on any problem. This post is about describing government’s practical limits in much the same way. The reality of policy analysis is that you will always be choosing between imperfect options, and you can’t do that intelligently without understanding what the imperfections of each option are.

One important thing to note before I dive in is that every government is different. All states will have a least a little of each of the high-level flaws I’m going to outline, but each government is better at some things and worse at others. A good understanding of your government’s strengths and weaknesses is important when deciding what your government should and shouldn’t do.

One of the important government failures is the tendency of politically-advantaged constituencies to seek policies that advantage themselves even though they are allocatively inefficient (they benefit the constituency less than they cost everyone else). This may manifest as failing to correct a market failure, distorting a market in the absence of a market failure, or responding to  market failure in a way that benefits them over solving the actual market failure..

A lot of ink has been spilled on how this works in practice, going back to Adam Smith at least. The standard approach in policy economics these days is Public Choice Theory. The central insight of Public Choice Theory is that it treats the business of controlling government like a Collective Action Problem. A small, homogeneous group will have less trouble coordinating itself than a large and diverse group. This creates the opportunity for an interest group to wield disproportionate influence over an aspect of government that they have a stronger-than-average stake in. Since the group with the strongest interest in how a regulator behaves is the industry being regulated, this can lead to regulatory capture – the process by which government agencies can come to serve the interests of the group they are supposed to oversee. Regulatory capture can lead to solutions that appear to have a role in controlling for a market failure, but primarily have the effect of enriching the incumbents in that industry.

For example, consider taxi regulation. In many cities, taxi numbers are limited by a licensing system. A fixed number of taxi licenses are issued, barring unlicensed drivers from entering the market. The stated justifications for this are that either:

1. The market overproduces taxi services, imposing negative externalities on other road users; or
2. That it is important to impose quality control on taxi services since it’s hard for passengers to evaluate the quality of taxi drivers ex ante.

The first reason takes us back to Part Two of this series. Assuming we can indeed identify negative externalities from taxi services, let’s consider how best to go about dealing with them. The most straightforward approach is to tax the negative externality directly. So have a license system, but don’t limit the number of licenses – to work as a taxi driver you pay the government for a license (the price of which is set to equal the estimated externality) but anyone who pays the fee can get a license. This increases the cost of running a taxi by the amount of the negative externality, leading to a reduction in taxi services.

The second reason is more of an information asymmetry argument, as we discussed in Part Five. Here the government could use a voluntary registration system, which would come with a quality mark that only taxi drivers who passed certain tests could legally display. If there was a concern that voluntary registration wouldn’t be enough to properly inform consumers (perhaps it would be too hard to let tourists know about it), then it might make sense to drive all the lemons out of the market entirely by making the registration compulsory – create a taxi license that has a nominal administrative cost and a proficiency test. Failure to live up to a performance standard could be punished by suspension of the licence,

These two approaches could be combined – have a taxi license that combines a proficiency test to ensure quality and a pigouvian tax to internalize externalities of the taxi industry. But note that neither approach includes an explicit cap on taxi numbers. The reason for this can be found in Part Three on imperfect competition. A fixed number of taxi licenses acts as a barrier to entry, thereby allowing incumbent taxi drivers to raise their prices and even cut back on services since they have no need to fear competition. This is the danger of badly-designed policy interventions, even when there is a solid justification for intervening. Rather than fixing the taxi market, all that has happened is that the government has broken it further, while enriching a private business interest at the expense of the public.

Furthermore, once made this kind of mistake can be difficult to correct. The medallion system creates a relatively homogeneous constituency, medallion owners, who now have strong incentives to oppose any reform. Worse – the more the system restricts supply, the more the medallion is worth and the harder that constituency will fight to retain their privilege. Often the least efficient interventions are the hardest to reform.

Naturally a constituency won’t do so by saying “we deserve to make supernormal profits at the expense of our customers; the discipline of the market is unpalatable and we want nothing to do with it.” Instead they’ll typically argue for the benefits of regulation in general, as if there were no alternative to the status quo other than total deregulation. This is why it it so important to look at the mechanism of a policy proposal, and to compare that mechanism to the specific proposal it is trying to solve. If all you do is think in terms of more or less government involvement, you may end up becoming the unwitting accomplice of a group of rent-seekers (rent in this context meaning the return to an asset or activity that exceeds the economically-efficient return on that asset or activity).

In recent years, some efforts have been made to apply behavioural economics to government as well. One such attempt was Bryan Caplan’s Myth of the Rational Voter. He argued that behaving rationally is work (this squares well with Kahneman’s writings about System 1 and System 2 in the brain), and people are more likely to engage their rational faculties when the consequences to them are the greatest. However, since no one person has any real effect on the outcome of an election, it hardly makes sense to think carefully about the consequences of your vote. As such, voting behaviour is even less likely to be rational than market behaviour. Caplan’s model helps fill in a few gaps in standard Public Choice Theory, for example why interventions like agricultural tariffs are often electorally popular even though they benefit farmers at the expense of anyone who buys food. Public Choice Theory would explain why these tariffs happen, but not why they are popular.

Since the voting public has little knowledge of how to design a policy in response to a market failure (or even tell a good intervention from a bad one), political decision-makers have no incentive to think along those lines. And so they will gravitate to policies that do little to address the core problem. Naturally, rent-seeking groups will be more than happy to suggest solutions that benefit them.

Another problem is that most governments have real difficulty in changing their behaviour in response to new information. Tim Harford’s book Adapt argues that one reason markets are effective is that they have an inbuilt tendency to punish failure. If you keep screwing up, you will lose access to capital and your business will go bust or be bought out by people who can fix your mistakes. Governments, by contrast, don’t need to respond to failure the way businesses are forced to. In fact, the political incentives for government often run in the opposite direction. Voters value decisiveness and persistence, and people who are seen to admit mistakes or change their mind are dismissed as flip-floppers. This leads to governments not responding to new evidence, as that would appear to be a sign of weakness. Governments are often reluctant to even collect robust data on a programme’s performance, since such data could be used against them if it is unfavourable. Even the most skilled policy design will probably be wrong in at least some of its details, because the only way to find out certain things about your policy is to try it in the real world. Not being able to correct mistakes is a serious handicap for anyone trying to do something as difficult as designing competent government policy.

So, how do we grapple with these problems? The biggest thing to keep in mind here is simplicity. The voting public will have an easier time holding the government to account when the policy interventions involved are simple and easy to understand. Transparency is also important. This is one of the reasons why most economists support Carbon Taxes over Cap-and-Trade. Theoretically, both policies are just two different ways of doing the same thing, but in practice, it’s easier to install loopholes in Cap-and-Trade. Tax rates are relatively simple for the public to grasp, but if you give a few carbon permits to favoured industries, rather than auctioning them all, it becomes harder for the public to understand what is going on. Also, you will probably make fewer mistakes in implementing a simpler policy.

A better-informed and more empirically-minded voting public would help a lot, but that’s easier said than done. Which means that ultimately you have to limit your ambitions as to what government can achieve. There are plenty of market failures that are large and / or simply corrected. These should be the prime candidates for government intervention. Smaller or more complex failures may be too difficult to fix with the tools we can realistically implement in the real world. That’s not to say we shouldn’t be trying to make government better at dealing with problems, but government is an imperfect instrument and we live in an imperfect world.

That brings us to the end of the main part of this series. The next post will be a discussion of economic policy issues that fall outside the market failure model entirely.