Thursday, November 15, 2012

Spontaneous Order: Its Wonders and How Market Failures Limit It

I've heard enough people opine that capitalism is messy because it's unregulated, and thus chaotic. "The economy should be like a well-oiled machine," they think. "If we [the government] can manage things from central headquarters, it will work perfectly," so thinks the anti-capitalist/pro-government individual. The issue with this line of thinking is that the economy is not a single, large machine that can be fixed if we just replace a certain cog (think of how Keynesians approach the idea of aggregate demand). The marketplace is actually an ecosystem in which consumers and producers interact. In a [relatively] free society, that means doing so voluntarily, which leads to the idea of spontaneous order, i.e., out of seeming chaos comes the emergence of order from multiple, intertwined economic interactions. If anything has illustrated the concept of spontaneous order well, it is the short essay I, Pencil by Leonard E. Read. The Competitive Enterprise Institute recently created a short video summarizing the general idea behind this essay:

On the whole, the idea works brilliantly, both in theory and in practice. However, being a graduate-level student of public policy has made me realize that although it is easier to think in absolutes, the world rarely, if ever, functions in absolutes. This next part is going to drive the self-identifying Austrians/anarcho-capitalists/"hard libertarians" crazy: market failures exist. You read that right. I am a capitalist who realizes that market failures exist. Considering that humans, who are by definition fallible individuals who make irrational, ill-informed, and/or ignorant decisions, interact in the markets, it makes sense that free markets, by extension, would be imperfect.

Market failures exist in four primary forms: negative externalities, natural monopoly, public goods, and information asymmetry. Most public goods are not purely public goods and can, at least in theory, be privatized. As Thomas DiLorenzo points out, natural monopolies might not have even existed in practice, and even if they have existed, they would be considered exceptions to the norm. Internet has been the single greatest invention to counteract information asymmetry.

The only market failure left is the idea of negative externalities, which would by far be the most justifiable reason for a government to intervene in the first place. The reason I would call government intervention "justifiable" because being able to do whatever you want is not the sole value of libertarianism, albeit liberty is an exceptionally important and weighty factor in libertarian thought. There is also the matter of the axiom of non-agression, which states that as long as you don't harm another individual in the process, you are free to do whatever you want. Mainstream libertarianism recognizes this limitation to one's freedom. Negative externality is the fancy economic term for when an individual or entity violates the axiom of non-agression.

The classical example of a negative externality is that of pollution. A factory dumps a bunch of pollutants in the water and contaminates the water supply. In a free-market scenario, the company would not bear any of the cost while those who drank the aforementioned water would be exposed to contamination. The only way I would justify government intervention in such a case is the following were true. First, the market produces such a weak response, or even a non-response, to the problem, especially if the status quo is unacceptable (e.g., pollution causes irreversible damage to either the ecosystem or human beings). Second, the government would be the only entity to prevent such a violation of the non-agression axiom. In the case of water pollution, both hold true. The market has no viable short-to-medium-term solution (developing greener technology would be considered long-term), and the government can impose a Pigovian tax to retard, if not downright stop, the pollution. This is a realistic situation that libertarians such as myself don't like, but nevertheless reluctantly agree that the government needs to intervene because that's the reality of the situation.

In case it hasn't been made clear, an example such as the modest Pigovian tax on pollution is by far an exception. The only time to accept government intervention is when there is evidence of a market failure, the market cannot solve its own failure, and the government intervening, however imperfect it might be, is the best option to increase net benefits, both individually and socially.

I would like to conclude with two points. The first is to those who would like to call me a "statist" simply because I begrudgingly recognize that government does have a role to play, even if it's limited. The Founding Fathers recognized this reality, as did figures such as Milton Friedman and Adam Smith. If you look at the entries for my blog, I have overwhelmingly either called for deregulation or straight-up privatization.

The second is that government failures also exist. The biggest government failure is that bureaucratic agencies do not need to pass a market test to survive. If, or more precisely, when a bureaucratic agency fails or acts in a highly inefficient manner, it is all but certain that a) it will not be punished for making bad choice the way an agent in the private sector, and b) its existence will be perpetuated. Why are there higher inefficiencies in government? Competition forces firms to produce the best product possible at the minimum cost. Public agencies rarely, if ever, face direct competition (e.g., the United States Postal Service), and as such can survive amidst inefficiencies. The public sector is thus disincentivized to innovate and create a better product (read: worse output). There are also issues with valuation of public outputs. The reason that it's more difficult to measure is because in the private market, customers reveal their marginal value by their willingness to pay via purchases. With public agencies, their output is not sold competitively, which means determining input and output values is guesswork. Additionally, ex ante controls also cause inflexibility to innovate because there are protections on civil servants, such as restrictions on how employees are hired, fired, rewarded, and punished, which is another way to say "labor rigidities." There are also issues of electoral cycles causing more myopic views on policy for politicians, not to mention politics (e.g., lobbying, special-interest pandering, rent-seeking) getting in the way of good policy.

If we are going to analyze public policy objectively, we have to recognize that both market and government failures exist. With that in mind, one has to account for both types of failures within a given policy question and figure out which set of failures is worse. To quote Nobel Prize-winning economist Gary Becker, "on the whole, government failure is far more pervasive, damaging, and less self-correcting, than is market failure," and no surprise here, but I agree. Just to list of a few examples out of what can easily become a long list of many examples: anti-price gouging laws, the War on Drugs, funding the arts, the sin tax, minimum wage, affirmative actionprotectionism, the list goes on.

I don't see markets being completely free in the foreseeable future, and I don't think spontaneous order will exist in its purest form, but we should approach it as closely as humanly possible so that we can best benefit from what spontaneous order has to offer.


  1. Speaking of "I, Pencil" and spontaneous order, you are no doubt familiar with the quotation from Ben Zoma in Berachot 58a: "Ben Zoma once saw a crowd on one of the steps of the Temple Mount. He said, Blessed is the One who discerns secrets, and blessed is the One who has created all these to serve me. For he used to say: What labors the first person had to carry out before he obtained bread to eat! He ploughed, he sowed, he reaped, he bound [the sheaves], he threshed and winnowed and selected the ears, he ground [them], and sifted [the flour], he kneaded and baked, and then at last he ate. But I get up, and find all these things done for me. And how many labors the first person had to carry out before he obtained a garment to wear! He had to shear, wash [the wool], comb it, spin it and weave it, and then at last he obtained a garment to wear; whereas I get up and find all these things done for me. All kinds of craftsmen come early to the door of my house, and I rise in the morning and find all these before me."
    [Soncino translation]

  2. But murder and theft is also an externality by this reasoning. We need a system of courts so those people threatened or damaged by those acting without regard to the effects on others. Surely a company dumping pollutants in such a manner as to significantly effect others is a matter for courts. So far, we properly rely on government to operate such courts. . . but that doesn't satisfy the STATISTS. They want arbitrary bureacracy to regulate and control everything and everyone in detail.

  3. Dear lloydmillerus,

    I thank you for all of your comments. From what I have read thus far, I have found your comments to be thoughtful and constructive. I hope to get to all of them today, although some of them might have to wait for a later time.

    I'll literally give you the textbook of definition from my textbook from Intro to Public Policy course, which is entitled "Policy Analysis" (Weimer, David L., and Aidan R. Vining):

    "An externality is any valued impact (positive or negative) resulting from any action (whether related to production or consumption) that affects someone who did not fully consent to it through participation in voluntary exchange."

    By this definition, murder, theft, and dumping pollutants are all [negative] externalities that need to be dealt with by the courts. I also agree with your statement that proponents for Big Government feel the need to interfere in every last facet of life, and the idea of limited government has been all but lost in the public policy world.

    What I do have an issue with is the label "statist." It is used by Austrians and anarcho-capitalists to describe any individual who supports any level of government. The reason I find this bifurcated term problematic is that most libertarians, who are in support of limited government (as opposed to no government), would technically be considered statists. For those of us who care about liberty, I think it's counterproductive to even further divide those of us who would like to scale back the largesse of the government.