Does government have a legitimate role in the market? Opponents of government intervention see the market as inherently resilient, stable and self-correcting. Therefore, they deny the reality of market failure and want government to allow the market to regulate itself.
Proponents, however, see the market as inherently fragile, unstable and self-destructive. Therefore, they accept the reality of market failure and want government to save the market from itself.
In balancing these two competing visions, policymakers should avoid bandying around the term “market failure,” which is as unenlightening as it is misleading. Market doesn’t fail; it’s either efficient or inefficient. That, at least, is how economists see it.
In theory, an efficient market maximizes the sum of net social benefits by facilitating mutually advantageous and voluntary exchange of goods and services with little or no transaction cost. Using this definition, can we have an efficient market without governmental action? In some cases, we can’t.
In their book Beyond Politics: Markets, Welfare, And The Failure Of Bureaucracy (1994), political scientists William Mitchell and Randy Simmons concede, correctly, that in a well-functioning free market economy, the government has to maintain a “stable legal structure containing a set of well-defined rights.” One such right is the freedom to contract, a type of voluntary exchange.
To be sure, exchange can still take place without governmental rules, but there’s no guarantee that it can never be involuntary or detrimental to at least one party in the transaction. Coercing someone into selling his or her labor with violence, or threats of violence, is a form of exchange we’d today call slavery. When exchange is neither voluntary nor advantageous to all parties involved, the market is no longer efficient by definition.
But the government can remedy this by passing and enforcing laws against various forms of involuntary exchange, such as armed robbery (where one party exchanges his money for his life), or human trafficking (where one party, usually women tricked into prostitution, exchanges her body for her life).
While critics of government intervention like Susan Dudley and Jerry Brito acknowledge in their book Regulation: A Primer (2012) that “[w]ithout a legal framework establishing and enforcing property rights and the ‘rules of the game,’ our free enterprise system could not exist,” they seem to want government to behave like a passive umpire who calls balls and strikes but never decides winners and losers. When sellers and buyers are free to choose when and what to exchange, everyone wins.
However, this argument assumes there are no costs associated with agents searching for and processing information for decision making. That is, transaction is assumed to be costless.
Critics have countered that the market, aided and coordinated by Adam Smith’s magnificent metaphorical “invisible hand”, does reduce transaction cost by providing information in the form of prices. True, prices help market participants decide what to buy, when to buy it, in what quantity, and from whom. But there are instances in which the price system doesn’t work efficiently, making it necessary for government to step in.
Consider a simple example. The U.S. Food and Drug Administration (FDA) requires sellers to put labels on all their products. If a consumer, say, wants to know how much fat, glucose and sodium are contained in a jar of peanut butter, he can find that out in one of two ways: 1) he can allocate his time and resource to do the research, or 2) he can just read what is printed on the product’s FDA-mandated label. Which seems better?
In short, an efficient market must satisfy two criteria. First, exchange has to be voluntary and advantageous. Second, transaction cost is sufficiently low. Government can address the first by creating legal boundaries within which all market participants must operate, and the second by making information easily accessible to everyone. Although government does have an important – some even say necessary – role in the market, the difficulty, ultimately, is determining the scope of that role and establishing the fine line between when government intervention ends and self-regulating market begins.