The Road to Freedom (16 page)

There are plenty of similar government monopolies in America. Does your state have a lottery? You might say it's just good clean fun, and it's better to have the government running it than a bunch of private-sector hoodlums. Think again. Private casinos have a profit margin of just a few cents on the dollar. Meanwhile, the
average state government lottery pays just 52 cents for every dollar it takes in.
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Lower-income citizens typically purchase lottery tickets; a National Bureau of Economic Research study shows that they finance the tickets largely by reducing their expenditures on necessities like housing and food.
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The state lottery is nothing more than a government monopoly that exploits the poor and vulnerable.

So the bottom line on monopolies is that they are a source of market failure, but not in a straightforward or simple way. Sometimes, a monopoly is clearly predatory and bad; sometimes, it leads to better outcomes than competition. The right guide to regulating a monopoly should be, “What is best for the consumer?” not, “What will protect powerful industries?” nor, “What will generate the most revenues for the government?”

Unfortunately, when it comes to monopolies, the government has generally not proved itself competent or reliable in protecting the public interest.

Years ago when I was working on my PhD, my wife and I were living in a small apartment in a college town. I was studying a hundred hours a week and under a lot of stress. The one thing I really craved was a good night's sleep. Unfortunately, there were a lot of undergraduates in our neighborhood who were studying little, and partying a lot. Every Friday and Saturday, and many Sundays through Thursdays, our neighbors (the twelve guys living next door) made the most of their freedom, all night long. That meant lots of noise—and no sleep for me.

This problem was what economists call an “externality.” Externalities are things that affect your well-being outside the realm of prices and free markets. A classic case—and obviously a
more important one than my lack of sleep—is unabated pollution. A chemical company pours junk into a river without any law to stop it, destroying the river's life and beauty. Markets may not work to solve the problem, and it may be appropriate to pass a law saying the factory can't do that. Or in the case of my partying neighbors, many college towns have passed laws against having raucous keggers out on the porch between 10 p.m. and 6 a.m.

Externalities make markets fail, and that is why governments might legitimately pay attention to them. But government action is not the only way to solve externalities. The free market in many cases can solve this market failure even more efficiently. The economist Ronald Coase won a Nobel Prize in economics by showing that private bargaining works at least as well as government action to solve externality problems, if property rights are clearly defined.
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So instead of a law saying a factory can't pollute the river, the law can assign the property rights over the river to the neighbors, who can then make their own decision—or even bargain with the factory owner so he has to pay them if he wants to pollute. This idea is known as the “Coase Theorem.”

There are many cases in which the Coase Theorem has efficiently solved externality problems far better than government command-and-control. For example, few communities want a noisy airport in their midst. They often work simply to make all airport construction illegal, posing a huge problem in an era of expanding air travel. Some communities, however, have used their property rights to negotiate with airlines in reaching a win-win solution to price the noise of planes arriving and departing. They simply charge airlines more to land noisy planes at odd hours, and the landing fees go to the community. A noisy old DC9 arriving at midnight costs far more to land than a new 747 with a noise muffler arriving at noon.
¹²

The Coase Theorem has informal implications as well. I grew up in a neighborhood where many people didn't take care of their property. The woman who lived across the street had grass so long it looked like a field of wheat. (Another family on the block was raising chickens in their living room, but at least we didn't have to look at that.) My parents thought about filing some sort of complaint, but they quickly figured out that our neighbor had the right to cut her grass or not, as she saw fit. So they solved the externality problem privately: They told my brother and me to cut her grass while she was at work, convincing us that maybe she'd be grateful and pay us later. (She didn't—and we were lucky she didn't call the cops on us for trespassing.)

Externalities can be positive, too. Beekeepers create a positive externality for farmers whose crops are pollinated by the bees. Similarly, I get a benefit for free—a positive externality—from living in a neighborhood today where the other families are decent and considerate and the kids are a good influence on mine. (Maybe they say the same about us, but I won't swear to that.)

A policy-relevant example of a positive externality is that of companies locating in a city or state and creating jobs. One of Texas's claims to fame is that it is home to sixty-four Fortune 500 companies, the most of any state.
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Many of these companies, which moved to Texas from other parts of the country, were drawn by more than just good ol' Texas hospitality. The state offers a low-tax, low-litigation, low-union environment in return for the enormous positive externalities to the state that come from the 328,000 new jobs created between June 2009 and July 2011 (47 percent of all net job growth in the U.S. over that period).
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Like monopolies, externalities seem simple, until you dig in a little. Some are positive, and some are negative. Some can best be solved by the government, while others are best left alone. And as
in the case of monopolies, the government has a poor record when it comes to dealing appropriately with this market failure.

When I was a kid, the local Catholic archbishop was a famous antiwar activist. One of his public gestures against the American military industrial complex was to refuse to pay part of his income taxes to protest the United States' continued involvement in the nuclear arms race.
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He felt he should not have to pay for a part of the government that he did not value.

What would happen if everybody did that? Say the IRS Form 1040 were changed to let you pay whatever you thought the army and other services were worth to you. Would you pay $500? $1,000? To defend the nation at the current level, the average American would have to pay $2,462 for national defense.
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Assuming most Americans wouldn't pay that, what would happen to the national defense? What would happen to everyone's safety?

Maybe you think the U.S. spends far too much on defense, so spending less would be just fine. If so, then apply the same reasoning to the police department or the roads system. Imagine if the government went house to house asking people for contributions to keep the bridges safe. Are you ready to try your luck on the Golden Gate Death Trap?

National defense, police, fire protection, and many other things are public goods. They are things we want and need, but which we can't practically exclude people from using if they don't pay.
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For example, my archbishop refused to pay for the army, but he was still protected from foreign aggressors, just like the rest of us. In contrast, a “private good”—like a donut or a pencil—is excludable. If you don't pay for it, you can't have it.

Public goods can make markets fail, because private sellers will underprovide them when people refuse to pay. So the government doesn't fund them that way. Instead, it taxes citizens and pays for the public goods at a level that reflects public demand. It's a grand public bargain. We all recognize we want things like the police, but we don't trust ourselves or our neighbors to fund them voluntarily—so we all agree to pay, just as long as everybody else has to pay as well.

Of course, there's a dark side to this system: everyone has an opportunity to claim that his or her favorite hobbyhorse is a “public good” and needs public money. Public television? A public good, we're told—despite the lack of public demand—and thus in need of public money. Offensive art? Another public good, even if millions might say instead that it's a public
bad
. I might as well shove my way to the public trough and argue that this
book
is a public good, because America needs a strong defense of the free enterprise system, but people are simply not buying my book in sufficient quantities. Bail
me
out, Uncle Sugar!

In other words, the definition of a public good is clear, but the list of them is not. The concept is constantly abused, and government resources are wasted as a result.

Imagine that shortly after moving to a new town, your refrigerator breaks down. Not knowing anyone in town, you randomly call a repair shop. Are you worried? Probably, if you, like me, know nothing about refrigerators. The repairman can tell you almost anything is wrong with your refrigerator (“Your D-57 hoses are all shot. I see it all the time on these models. It's gonna be about 400 bucks.”), and you won't know if it is true or not. So all
you can hope for is his honesty—or sufficient licensing and threat of sanctions from the government to dissuade him from cheating you.

This is a case of what economists call an “information asymmetry”: where one side of a market has more information than the other and chooses to exploit the difference. In the example, the information asymmetry leads to worry and maybe an inconvenience. In the worse case, it can make markets melt down entirely. Economist George Akerlof won a Nobel Prize in economics for analyzing information asymmetries in a famous essay entitled, “The Market for ‘Lemons.'”
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He took the example of used cars, in which the dealer knows the lemons from the good cars, but buyers don't, and showed that the whole market can stop functioning as a result. On average, a car's price will be higher than a lemon is worth, but less than a good car is worth. Sellers thus have an incentive to increase the number of lemons (which turn a profit), while buyers are less and less able to afford a good car at a fair price. Slowly but surely, Akerlof showed, the lemons will dominate, and the market will dissolve.

Lemons can be people as well as cars, as every insurance company knows. One chronic information asymmetry problem is that the people who most want health insurance are those who are already sick. Insurance can't work this way because companies lose money on the sick and earn their profits on customers who
don't
get sick. If the sick are the majority buying the insurance, the rates will skyrocket, chasing away the healthy and wrecking the market.

Scandals and corruption on Wall Street are basically asymmetric information problems. A person or group trading with inside information means they know something the rest of the market doesn't. They trade on that and take profits at the expense of the uninformed.

The government can help in these situations. Policy makers can make it illegal to pass off a lemon as a good car by hiding problems. They can make it illegal for a person to tell a health insurance company that he's well when he is actually sick. They can require money-back guarantees or recourse to the attorney general when a product turns out to be defective. Similarly, the public sector can and should prohibit insider trading and many other financial market predations.

The government doesn't need to sort out all information asymmetries, however. In many cases, the private sector can do so instead. Money-back guarantees became commonplace in the retail sector in the 1960s, after high-quality companies realized that the guarantees would give them a competitive advantage by signaling to customers that they could be trusted. Car companies compete by offering better warranties than their competitors. Insurance companies require health exams before writing life insurance policies. (One hundred years ago, insurance companies were even more ingenious: Before elevators were common, health insurers would locate their offices on the upper floors of buildings and require prospective policy buyers to sign their policies at the office, in person. The idea was that if a prospective client could make it up all those stairs, he was probably healthy enough to be insured.)

Information asymmetries are a legitimate area of government involvement in the economy. But regulation is not the only—or sometimes, the best—way to solve the problem.

IN SUMMARY
, there are four big sources of market failure. Sometimes markets fail; sometimes they don't. Sometimes governments fix market failure problems by intervening; sometimes they try and
fail; sometimes they make things worse, by accident or on purpose. When should the government act?

To justify government intervention in a market, several things must be evident. A source of market failure must be clearly present. It must involve a monopoly, a negative externality, a public good, or asymmetric information. Many government policies fail at exactly this stage. For example, President Obama claims the housing crisis was due to an information asymmetry in the form of “mortgage lenders that tricked families into buying homes they couldn't afford.”
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But does anybody
not
know that prices of homes can both rise and fall? Or whether they can make a mortgage payment on their current wage? We all know that mortgage contracts are complicated, but is it really reasonable to blame lenders and markets, instead of a lack of common sense and personal responsibility?