The Catholic University of America
Oct 26 2011

Whither the Government in a Market Economy

Posted by Ernest Zampelli at 3:20 PM
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- Categories: Economy

That Republicans have scuttled President Obama’s proposed jobs bill is no surprise.  Their obsessive compulsive adherence to an “expansionary fiscal austerity” philosophy, debunked by recent scholarship, along with their summary dismissal of the Congressional Budget Office analysis that estimates the bill would create about two million jobs if passed, is par for the proverbial course.  Their goal, of course, is not simply, nor primarily, to change the way fiscal and monetary policies are used for general economic stabilization purposes.  Their ultimate goal is to change fundamentally the role of government in a market-based economy by ridding private markets of any government involvement or interference, unleashing fully the power of self-interest and Adam Smith’s invisible hand to guide the nation’s resources to their most productive and valuable uses.  Witness the extreme right’s attacks on health care reform,  financial market regulation, climate change policies, and the Environmental Protection Agency, to name a few. 

Now, lest anyone get the wrong impression of me, please understand that I am first and foremost a market economist.  I believe in markets driven by the pursuit of self-interest and I marvel at the efficiencies with which they operate.  Just think about the fact that you can go into a grocery store at any time of day and find whatever you might want at a price you can usually afford.  Next time you’re in a Starbuck’s enjoying a cappuccino or latté or espresso, think about the myriad of transactions that had to take place to bring that drink to you in that place at that time.  Little or no government involvement, no central planning required—just price signals providing the proper incentives to businesses and consumers.  It really is astounding and each and every semester I implore my economics students to appreciate how amazing the mechanism is.  So the bottom line here is that you’re not reading the rants of a Marxist or radical.

But just as I ask my students to have an appreciation for the marvels of markets and the price mechanism, I also ask them to recognize that there are circumstances under which markets fail, and fail miserably.  The circumstances are those which distort market price signals to such a degree that they cannot and should not be relied upon to guide resources to their most productive and valuable uses;  they preclude the efficient workings of Adam Smith’s invisible hand.  It just so happens that such circumstances tend to plague health care markets, financial markets, and markets for environmental goods.  Economists have long recognized that such circumstances can justify proper government intervention and that with such interventions the specific markets and the economy in general can be made, potentially, much better off.  Let me just briefly identify the circumstances in some important markets that lead to market failure and might be used to justify some form of government involvement and why.

Health care and health insurance markets are plagued by what economists call “asymmetric information” problems.  Briefly, asymmetric information exists when one party in a transaction possesses more information about the quality, risk, benefit, and/or cost associated with a good or service than does the other party.  For example, patients usually know far less about the benefits, risks, and effectiveness of the diagnostic tests/procedures to which they may be subjected than their physicians.  This, in turn, may lead to the over prescription of such tests and contribute, therefore, to rapidly rising health care costs.  One possible remedy—a government appointed oversight board of physicians and medical researchers charged with the task of determining those tests and procedures that demonstrate an effectiveness supported by the preponderance of evidence from research and practice.   Health insurance markets are notorious for their “adverse selection” problem—when individuals know more about their health status, risks, and lifestyles than do insurers.  First, this raises insurance costs because of the screening insurers must do to gather such information.  Second, it raises insurance costs because it is likely that the sickest subpopulations will constitute the majority of participants in certain insurance programs as healthier individuals opt out.  This, in turn, can cause the “death spiral” in which the specific insurance market may eventually disappear.  Possible solutions—a single payer system, a government mandate that all individuals purchase the insurance, a more heavily regulated private health insurance market.

Financial markets are prone to what is called “counterparty risk” or “default risk”—the risk that a party in a financial contract will not meet their obligations.  Again, it results from asymmetric information—individuals and firms know their financial conditions and future prospects better than the individuals and firms with whom they are contracting.  Combined with the high degree of interconnectedness and the importance of leverage in the financial system, this means that the failure of one financial institution can have cascading impacts sufficient to bring the entire system to its knees.  Sound familiar?  I thought so.  Some remedies—greater regulatory oversight and increased monitoring of large financial institution and “shadow” banks, increased capital requirements, greater transparency in the financial derivatives market. 

The market for a good is most efficient when the benefits from consumption and the costs of production accrue mainly to those who consume and produce the good—the direct market participants.  However, when the consumption and/or production of a good causes important benefits and/or costs to “spillover” to others not directly involved in the market transaction then inefficiencies will likely result.  Market prices will not be fully reflective of all benefits and costs.  For example, refiners take crude oil and produce gasoline, heating oil, and diesel fuel which they sell to consumers for transportation and heating purposes.  The refining process, however, also produces any number of pollutants which can have adverse impacts on the health of individuals and of the ambient environment.  Market prices, however, will not reflect these “externalities” and hence will lead to the overproduction and overconsumption of refined oil products.  Too many of the nation’s resources will be devoted to the production of gasoline, heating oil, diesel fuel, etc.  A possible solution—a pollution tax or, in certain circumstances, a cap-and-trade program that forces refiners to pay a price for the pollution generated which, in turn, is reflected in the market prices of refined petroleum products. 

The bottom line is this.  The extent to which government should be involved in private markets should be based neither on a narrow libertarian political ideology of a “minimalist” state nor on a collectivist agenda that sees a role for government involvement in virtually all areas of the national economy.  It should be based on a careful assessment of the nature of the market, the seriousness of the market failure, and whether the government has the ability to intervene in such a way to make the market work better.  The government is not always the solution, but it’s not always part of the problem either.

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