Freedomnomics: Why the Free Market Works and Other Half-Baked Theories Don't (13 page)

Some people doubted there was any way to make listeners pay. In 1922, Herbert Hoover, then Secretary of Commerce, declared: “Nor do I believe there is any practical method of payment from the listeners.”
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Others assumed that radio transmissions would eventually be funded by paying subscribers, but no one could devise a method for limiting broadcasts to subscribers’ receivers. Consequently, some believed the government would have to provide the service. In 1922,
Popular Radio
magazine claimed that radio was “essentially a public utility” and discussed using city telephone wires to sell broadcasts to subscribers—in other words, providing radio service over the phone.
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So what happened? Did private businessmen throw up their hands and invite the government to run the industry? Was society denied the benefit of radio because no one could solve the free-riding problem? Of course not. The problem was eventually resolved in 1922 when AT&T discovered it could make money by selling radio advertising airtime. In hindsight, it’s hard to believe that private radio almost died in its infancy because people couldn’t figure out how it could make money. And it’s a good thing that the government decided not to turn radio into a subsidized enterprise, since it is highly unlikely that the state would have distributed payments as efficiently as advertisers do.

With enough at stake, companies find amazingly creative ways to solve free-riding problems. Government subsidies only deaden the incentive to discover these solutions. For example, many analysts used to regard beekeeping and apple farming as a classic free-riding problem.
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Apple blossom nectar provides food for bees, which pollinate the blossoms as they gather the nectar. Economists feared that apple growers were free-riding from neighboring beekeepers, and that this would eventually result in too few apples as well as too little honey. But apple growers and beekeepers devised a number of solutions to this problem. The
most obvious method was for apple farmers to set up their own bee-hives.
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However, as Steven Cheung showed, the more common solution was for apple growers and beekeepers to create markets where they transacted regularly. The Yellow Pages in rural Washington State developed long listings of pollination services available to farmers. Yet, despite the evolution of free market solutions, beekeepers cited the existence of this potential free-riding situation as an excuse to lobby the government to implement a honey price support program. The program began modestly in the early 1980s, but quickly grew into a massive subsidy scheme costing U.S. taxpayers around $100 million annually by 1984.
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Government attempts to solve free-riding problems are typical examples of the state’s economic inefficiency. In fact, we’ve grown so accustomed to the inadequacies of government that we typically use different standards for evaluating private and public spending. For example, economists deem private markets to be efficient when the cost of an additional unit of some product reflects how much buyers value it. But when is that ever a consideration in government spending? Just look at tax payments generally: the top 5 percent of income earners pay 57 percent of federal income taxes, while the bottom 50 percent pay just 3.3 percent.
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In a democracy, those who provide little of the government’s income have more of a say—in the form of their combined votes—over how to spend government funds than those who provide most of the money. Of course, this is not to suggest that the votes of big taxpayers should be weighted more than those of smaller ones. It’s just to point out that government spending is inherently inefficient because those who actually pay for most government services are not the ones who determine how the money is spent.

This helps to explain why government intervention is so often inefficient.
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In private markets, you can’t get people to pay more for a product than they value it. If the asking price is too high, they simply say “no.” But there is no similar limitation on the government, which pays for things by levying taxes. And taxes are coercive—you can’t
refuse to pay taxes just because the government is paying more for something than you value it.

Take government programs such as flood insurance. These aren’t like traditional private insurance programs where people are charged according to the risk they represent. Private insurance companies closely match the premiums to the risk level or else they quickly go out of business. If they charge too much, their customers go elsewhere. If they charge too little, they lose money. While things have improved somewhat in recent years, for decades the government insurance programs charged everyone the same amount regardless of risk. The government charged the same flood insurance premiums for beachfront houses as it did for homes in the middle of the desert. As late as June 30, 2005, the Congressional Research Service was still reporting on the “repetitive loss problem,” where people in high risk flood areas paid such low flood insurance premiums that they would keep on rebuilding only to have their homes repeatedly swept away.
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As
USA Today
noted, “One Houston property valued at $114,480 has filed for losses 16 times and received $807,000 in total payments.”
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Only the government can continually get away with this kind of wastefulness—a private insurance company that was this profligate would be driven out of business. Democratic Congressman Earl Blumenauer (Oregon) put it succinctly: “The federal government is aiding and abetting patterns of living that are unsustainable and draining significant resources.”
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By creating insurance programs with below-cost premiums, the government allowed its insurance clients to free-ride off the American taxpayers.

Many economists have pointed out severe problems caused by the government’s inability to set prices correctly. Indeed, some blame the bankruptcies seen during the savings and loan crisis of the 1980s on the extremely low prices charged by the government for deposit insurance at risky banks. The bailout ultimately ended up costing taxpayers over $175 billion.
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If charging too low a price will create market distortions, then handing out services for free—which the government often does—will really create some perverse incentives. For example, government search-and-rescue teams frequently decline to charge anything for their services. These expeditions can be extremely expensive, with use of a helicopter costing $10,000 per day.
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Even worse, free rescue services give hikers and mountain climbers an incentive to take more risks. In December 2006, a large-scale search and rescue operation was undertaken at Oregon’s Mt. Hood to find three climbers stranded on the mountain. Tragically, one hiker was found dead, while the other two were never discovered. In light of the incident, Oregon lawmakers floated the idea of requiring high-altitude climbers to wear electronic locators. The proposal was opposed by climbers, who argued the devices would cut down on the “adventure” and the “beauty” of the sport’s danger.
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Perhaps after getting stuck with a $10,000 rescue tab, climbers might think twice about the kind of risks they take.

The government’s difficulty in getting prices right is vividly illustrated in the application of eminent domain—laws that allow the government to confiscate homes in order to clear the land for other developments. The government—as well as private developers—face considerable economic problems when trying to clear out homes from a certain area. Suppose that a developer needs to tear down the houses on an entire block in order to build a skyscraper. The obvious approach would be to buy everyone’s house, but this doesn’t always work. Some homeowners with a sentimental attachment to their property will even refuse offers that far exceed the fair market value of their homes. In this case, developers who are unwilling to pay exorbitant amounts have little choice but to look elsewhere for their project.

Other homeowners might act strategically, hoping that by refusing early offers, they will entice much higher bids later. This presents a complex problem, for a single hold-out could stymie the project. Eminent domain seeks to solve this problem by forcing owners to accept
the “fair market value” of their property. The government offers the fair market value—the price for which similar nearby houses have sold—and if the homeowner refuses, the government can pay this price anyway and seize the property. The recent U.S. Supreme Court decision
Kelo v. New London
decreed that eminent domain, until then usually invoked to allow for government projects such as highways and railroads, can also be enforced for private development projects if the local authorities determine that the projects will benefit the wider community.
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One of the main problems with eminent domain is that the fair market value is typically too low. If people only valued their homes at the market price, they would have already sold them before receiving the developer’s offer. The fact that they haven’t means that they value their abodes more than what is being offered on the free market. The real difficulty lies in figuring out how much more.

Fortunately, there is a solution that businesses used for years before they gained access to eminent domain. Whether they seek to build a pipeline, a road, or a building, companies almost always consider multiple possible locations. Koch Industries, the largest privately owned company in the United States, built 4,000 miles of natural gas and oil pipelines across the country without using eminent domain until relatively recently.
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Instead, it typically offers a contract to property owners along different possible routs; the deal goes to whichever complete set of property owners signs the contract first. The owners might be offered, for example, 25 percent above the fair market value. If they value their property more than that, they don’t have to sell. But this approach discourages people from indefinitely holding out for better offers. If homeowners don’t really value their property much more than the market value, they risk losing this 25 percent profit. The government should consider this market-based approach as an alternative to forced sales at prices that, in reality, are anything but “fair.”

Bill Dougan, former chairman of the Economics Department at Clemson University, devised a similar solution to a problem plaguing
many academic departments.
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When a department is hiring a new professor, there will often be several candidates who are roughly equally good. The risk is that when the job is offered to one candidate, he many take weeks to decide whether to accept, often using the offer simply to try to get a better deal from another school. If the candidate ultimately signs on with a different school, the department may be left with nobody, since the other candidates may have already taken jobs elsewhere. Dougan’s solution? Offer the job simultaneously to all the top candidates, stipulating that the position goes to whomever accepts first. It’s a good thing these kinds of free market solutions are developing before someone suggests imposing eminent domain on hiring practices.

University of Washington professor Jonathan Karpoff recently provided another striking example of how inefficient government enterprise can be. Karpoff studied the thirty-five government-sponsored expeditions, along with the fifty-seven privately funded voyages, that explored the Arctic, the Northwest Passage, and the North Pole from 1818 to 1909. Arctic exploration, like space missions, is an excellent example of a public benefit that many would assume could not be achieved privately. Much of the exploration is similar to pure scientific research that offers no immediate commercial benefit. Compared to their private counterparts, government expeditions to the Arctic enjoyed much better funding, bigger ships, and crews that were over four times larger (averaging seventy members versus seventeen for private voyages). Nevertheless, public expeditions were more likely to end in tragedy—an average of nearly six crewmen died on government voyages, compared to fewer than one on the average private trip. Furthermore, government expeditions lasting over a year suffered scurvy rates that were four times higher, while the chance of losing a ship was over double that of private expeditions.
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Despite their smaller crews and lower funding levels, the private teams accomplished five of the six major Arctic discoveries.
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Karpoff elaborated some of the reasons behind these results. Government expeditions had to operate by committee and political factors
played a role in dictating their crews’ composition. Private expeditions, in contrast, were more efficient and much faster at learning from past experience. Perhaps most importantly, private voyages were more responsive to incentives for success—their decision makers directly bore the costs and reaped the benefits of their own actions.

These kinds of inefficiencies plague government efforts in realms ranging from welfare to education. Private charities ensure that 80 to 90 percent of donations get to those in need, while only 30 percent of government welfare spending actually reaches the intended recipients.
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Likewise, non-teacher costs make up over 40 percent of the budgets in public schools compared to less than 20 percent in private ones.
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Overall, the per pupil costs of public schooling are about twice as much as for private schools despite the fact that children typically learn much faster in private institutions.
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These statistics indicate that private charities and schools can provide better service than public ones even if they receive just half the funding.

The market isn’t perfect, of course. But the government is usually much further from perfection. Even when the state intervenes in the economy with the best intentions, it frequently only succeeds in making things worse.