“Market failure,” like many technical terms, is a misleading label.12 Not all ways in which markets fail count as market failure and market failure occurs in many contexts other than markets. It is most usefully thought of as a situation in which individual rationality does not lead to group rationality, in which the result of everyone taking the action he correctly believes to be in his rational interest is worse, in extreme cases worse for everyone, than if everyone did something else.

An Example Outside of Markets

It is a thousand years ago somewhere in Europe. I am one of five thousand men with spears, lined up facing south. The reason we are facing south is that another army, also with spears but on horseback, is coming at us from that direction.

I do a very quick cost benefit calculation.

If we all stand our ground some will die but, with luck, we will break their charge and most of us will live. If I run, horses run faster than I do. I should stand.

I have just made a mistake. I only control me, not we. If I stand and everyone else runs, I die. If everyone else stands and I run, reducing our army by one is unlikely to make much difference to the odds and, if their charge is stopped, I won’t be one of the ones who dies stopping it. If the line does break and run I will at least be in the lead. Whatever the rest of the army does, I am better off running than standing. Everyone else makes the same calculation, we all run, and most of us die.

Welcome to the dark side of rationality.

Two Less Exotic Examples

You are in a restaurant talking with your friends. Unfortunately, many of the people around you are talking with their friends, making it hard for you to hear or be heard by yours, so you talk a little louder. So, for the same reason, do the people around you. You end up with everyone talking as loudly as possible and still having a hard time hearing each other. You would all be better off if you all kept your voices down — but anyone who did would be worse off as a result.

Just south of the UCLA campus, where I used to teach, was the intersection of Wilshire and Westwood, about ten lanes each, claimed by the locals to be the busiest intersection in the world. At rush hour, cars on Wilshire trying to get across Westwood and not quite making it filled the intersection, blocking the cars on Westwood trying to cross the other way. Gradually the cars in the intersection filtered out, just in time to let enough cars on Westwood into the intersection to block it the other way. If everyone had followed a policy of not pulling into the intersection unless he was sure he would be able to get through it, everyone would have gotten home sooner. But any individual who acted that way would as a result have gotten home later.

The problem in all three cases is the same. Someone is making a decision that affects both himself and other people. He makes the decision on the basis of the effect on him; everyone else acts similarly. He gains from his decision, loses from theirs. The loss is larger than the gain, so on net he, and everyone else, is worse off than if they had all acted differently.

Economists describe such a situation as an inefficient outcome due to an externality. The actor ignores the external cost his act imposes on others and so takes an action which, if all costs are taken into account, ought not to be taken. If everyone makes the opposite choice everyone, at least in my examples, is better off, but each individual is better off if he makes the choice that is in his interest.

Considered as an Argument For Government

The central assumption of economics is rationality, that individual behavior can best be predicted by assuming that each individual takes those actions that best achieve his objectives. Obviously the prediction will not always be correct. Not only do I observe other people sometimes making mistakes, I observe myself making mistakes; even though I know I am overweight, bowls of potato chips in my near vicinity tend to mysteriously empty. I know myself well enough to predict my irrationality and try to deal with it by not having bowls of potato chips too near. But although rationality is not a perfect description of human behavior, it may be the best assumption available for predicting the behavior of large numbers of strangers.3

Rationality looks like a convincing argument in favor of institutions in which individuals are free to make their own choices, yet most economists are not anarchists or even libertarians. One reason they are not is that, even if each individual correctly acts in his own interest, the result may be worse than if each was compelled to do something else.

For economists, that is the standard justification for many, perhaps all, government actions. Public goods, goods whose producer cannot control who gets them so cannot charge for them, are underproduced, so tax people to pay to produce them. Negative externalities are overproduced, so regulate pollution, tax the production of carbon dioxide to reduce global warming. In some specific cases the argument turns out to be weaker than it at first appears — I discussed my reservations with the claim that CO₂ produces net negative externalities in my first post here — but the underlying logic is correct. It follows that even rational individuals can sometimes be made better off by restricting the choices they are permitted to make.

One response sometimes offered by libertarians is to deny the existence of market failure.

There is a better one.

Market Failure as an Argument Against Government

The government is not a wise, powerful, benevolent ruler, tweaking the outcome of the private market for the general benefit. The government is not an actor at all, in a very real sense does not exist. What we call acts of government are the outcomes of a political marketplace, a bunch of people each acting in his own rational self interest — just as in the economic market but under a different set of rules.

Market failure exists because individuals are making decisions much of whose cost or benefit goes to someone else. That situation sometimes occurs on the private market but there it is the exception, not the rule. Most goods are ordinary private goods, so the producer can convert much of the benefit to the buyer into a benefit to himself via the price he charges. Most production uses inputs — labor, raw materials, capital, land — that the producer can only use if he compensates their owners for what they give up by letting him use them. In the standard model of perfect competition, which assumes away problems such as public goods and externalities, what the producer is paid for a good turns out to be just what it is worth to the purchaser, what he buys inputs for to be just what they are worth to the seller, hence his private benefit is precisely equal to the social benefit, the total effect of his actions summed over everyone.

That is a simplified model of a market economy but at least a first approximation; individual actors usually receive most of the benefit and pay most of the cost of their actions, making market failure the exception, not the rule.4 On the political market individual actors — voters, politicians, lobbyists, judges, policemen — almost never bear much of the cost of their actions or receive much of the benefit. When you work to pass a law that benefits yourself at the cost of other people, you are producing a negative externality. If you spend time and effort figuring out which candidate will be better for the country — a problem sufficiently difficult that in every election about half the voters get it wrong — you are producing a positive externality, making good government more likely, a benefit of which you collect a trivial fraction. That is why most voters are rationally ignorant, choose not to pay the cost of information whose value to them is less than its cost.

Hence market failure, the exception on the private market, is the rule on the political market. Which suggests that the existence of market failure is, on net, an argument against government, not for it.

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