Governments or markets? Public or private?

I’ve been meaning to write this since I wrote that piece on neoliberalism vs. neo-marxism but lacked motivation. Then this week I went to a good public talk on this stuff where I said some stupid things about market failure. The end result is that I was galvanised to clarify my thoughts.

Too often in public policy discourse, especially in lay talk, we fall into a false dichotomy between getting the government to do everything and the market to do everything. Some quick examples:

There are libertarians in the United States that think we should have private police forces. Lol.

Then there’s the Greek government who seem to think the state needs to own restaurants. Lol.

There are some basic criteria for deciding whether a good is best provided by the government or the market. The market is very good at allocating scarce resources when the following conditions are met:

-          No externalities

-          Perfect competition

-          Perfect information

-          Clear property rights

-          Private goods (rivalrous and excludable).

In such circumstances (which are common), prices act to communicate willingness to pay and the person who is willing to pay the most gets the good. This is market justice and it has elegance to it. Producers supply enough of the good to clear the market without making a loss; this efficiently handles the cost of production. Many if not most economic matters are best handled by markets—butter, shipping, construction services etc.  

You only need to consider getting the government involved if there is a market failure. This includes cases where you have:

-          Externalities

-          Missing markets

-          Information asymmetries

-          No property rights (also common property rights)

-          Public goods (non-rivalrous and non-excludable)

There may also be cause for government involvement in some cases of moral hazard (though that is usually a reason for private provision) and adverse selection (a kind of information asymmetry).

Externalities are where a market transaction imposes a cost or benefit on a third party that isn’t priced in the transaction. For example, if a factory producing phones emits pollution but isn’t charged for it then you have an externality. Typically you correct externalities by pricing them, as in carbon taxes and emissions trading schemes. In the case of positive externalities there is sometimes a role for government to step in and provide the service at below the market price and recoup the difference through taxation. One example is public transport. Mass transit reduces transaction costs and thereby increases the total size of the economy. This is a benefit that goes beyond the individual person buying a ticket. As such, it makes sense for the government to provide public transport, charge less than the market clearing rate so that more people use it, and then recover the difference through taxation, which is lucrative because of the increased market activity as a result of the lower transaction costs.

Public goods will not be provided by the market. This is because they are non-excludable, which means that you can’t stop people from using them and so you can’t charge them for usage. One example is street lights. There is an argument for government provision because they are non-rivalrous, which means that my consumption of the good does not prevent your consumption of the good. Music is one example. This means that once the good has been produced the marginal cost of giving one more person access is zero. As a result, the social benefit of production can easily outweigh the private cost.  Take a lecture for example. I can exclude people by restricting access to the lecture hall, so private provision is a possibility. But lecturing 1 person is as expensive as lecturing 300 people, so it might be better to have the lecture paid for by the state and then as many people as want to listen to the lecture, including people who get a benefit from it but wouldn’t want to pay 5c to listen can still benefit.

Information asymmetry and missing markets often go hand in hand, often with a bit of adverse selection thrown. An example will help illustrate: health insurance. Insurers don’t know whether someone asking for cover is super health or only moderately healthy, so they charge them both as though they were moderately healthy. This is not efficient, but without this approach the insurer would go broke because they aren’t managing their risks efficiently. If you don’t let them charge extra then they just won’t ensure people who are clearly a risk, which leads to a missing market. One solution is to have the state act a single provider of health insurance and everyone has to buy insurance from the state. This means that the state can take the entire probability distribution of the population and make efficient decisions. However, the state is inefficient because it suffers from moral hazard, which is where you spend money that you didn’t earn (i.e. the taxpayer gave it to you) and so you’re loose with it. One partial correction for this is to make the state sub-contract a lot of its health services to providers who compete amongst themselves to lower the costs while maintaining quality i.e. inject competition into the sector. The state is very powerful in this market because it is a monopsony purchaser of health services. This is an example of imperfect competition, but here it is arguably helpful.  

This idea of a state monopsony coupled with competition among subcontractors is an example of a hybrid approach to public policy. Such hybrid approaches is where the future of public policy lies. It distresses me immensely how many people fail to grasp the above basic points about what government is good at and what the market is good at. Recently on a project syndicate piece I actually read someone who otherwise seemed educated suggesting that the government should not provide student loans because they are too risky owing to adverse selection. That is precisely why governments must provide student loans—the market won’t do it, and there is a net social benefit to having student loans available. The educated grow up to pay more tax and you can recover the costs. On the other side of the coin you see people advocating for the government to subsidise farms because they aren’t competitive—that’s called subsidising failure. Let the farm be bought by a more productive competitor and the net social gains with be positive. Most importantly, don’t get trapped in a false dichotomy between markets or government. There are plenty of cases where we can combine the market mechanism to get efficiency with government involvement to ensure equity and/or maximisation of a social welfare function as opposed to private welfare functions.