When markets fail

Should government keep its hands off the economy? It’s often said that government has no business being in business, and that government should not be competing with the private sector in things that the latter can do better. Neither should it interfere in the working of the markets and allowing the law of supply and demand to work. Economists are often faulted for such advocacy for free markets and liberalized trade. But even the most zealous neo-liberal economists know that government intervention is warranted in certain situations because free markets do not always yield the best outcomes. There is such a thing as market failure, and it is incumbent on government to step in and correct them when and where they occur.

Economic theory postulates that leaving the markets alone usually (but not always) leads to outcomes that are efficient—that is, one where the economy’s limited resources are put to their best and most productive use. When the government tries to “play God” and decides what, how much, how, and for whom goods and services are to be produced—i.e., the basic resource allocation questions facing any economy—it invariably messes things up. China and the former Soviet Union tried it for many years, but eventually decided to give it up to rely more on market forces, even embracing the World Trade Organization. Only North Korea has persisted in that path of a command economy, with disastrous effects.

Adam Smith, considered the father of modern economics, argued in the 18th century that left to themselves (laissez-faire), markets would be guided by an “invisible hand” that ensures the most efficient outcomes. But perhaps Adam Smith failed to explain enough that markets are far from perfect. Markets often fail to yield efficient outcomes, and more often, fail to yield outcomes that are equitable or fair. Textbook economics identifies three instances, among others, when market failure occurs: public goods, externalities and economies of scale.

“Public goods” are distinguished by being nonrival and nonexcludable. No one else can consume a pizza once you consume it; it is a rival good. But when you “consume” and benefit from street lighting or national defense, you do not prevent others from benefiting from it as well (hence it is nonrival). Neither can anyone prevent everyone else from enjoying that benefit as well (it is nonexcludable). These two features induce people to become “free-riders” and avoid paying for these services; hence, no private firm will be attracted to produce them. Government must step in and provide such public goods directly, if enough of them is to be produced.

When certain products and services are produced or consumed, some indirect damage (external costs) or benefits (external benefits) may be caused on others. A cement factory cannot be allowed to freely pollute a river and impose costs on others benefiting from the river. Government can impose strict pollution controls, or tax the factory in proportion to the pollution it causes. When the owners of dilapidated historic houses repair and restore their homes, society benefits from the improved ambience and preservation of cultural heritage. Thus, government subsidies on their restoration costs (such as through real property tax exemptions, as was in fact done in Vigan, or outright funding assistance) make sense. Such negative or positive “externalities” may warrant government intervention in the form of taxes or subsidies, or other penalties and incentives.

Bigger firms often enjoy a cost advantage over smaller ones due to economies of scale, leading to a tendency for bigger businesses to crowd out or “eat up” their smaller competitors. When economies of scale make bigness an advantage in an industry, government can impose rules that prevent big industry players from “bullying” smaller competitors with unfair trade practices, or that enhance and expand competition in the industry.  The new Philippine Competition Commission has this mandate provided by law, and similar competition authorities exist in other countries to address this particular market failure.

Here’s wishing a Happy New Year to us all!

[email protected]