 Welcome to Free Thoughts, a podcast about libertarianism and the ideas that influence it. Free Thoughts is a project of the Cato Institute's Libertarianism.org. I'm Aaron Powell, editor of Libertarianism.org, and a research fellow at the Cato Institute. And I'm Trevor Burrus, a research fellow at the Cato Institute's Center for Constitutional Studies. Many policies are justified on the basis of market failure, that when markets fail, government needs to step in. But what is market failure? What does it mean for the market to fail? Joining us to discuss this is our colleague Peter Van Dorn, senior fellow at the Cato Institute, an editor of Regulation Magazine. Peter, a lot of the times when people are calling for government to intervene in some way, there ought to be a law, they're doing it based on this notion of market failure. They say the market has failed in some way, so government has to step in and fix it. So what do people mean when they talk about market failure? Well, within an economics market failure has a very precise definition, and for that I have to do a little bit of intellectual history. In a written blue book exam, one would, in my class at least, I would want the following answer, which I'll then unpack, which is market failure simply is the failure of a set of institutions called markets to implement a theoretical ideal called the Pareto Rule. So market failure exists as a way of thinking about a set of institutions, and the set of institutions are a device to implement a rule, so the Pareto Rule. Filfredo Pareto is one of the fathers, if you will, of modern neoclassical economics, and so lots of things in economics are named after him, and the Pareto Rule simply stated is just that if we look at an economy transaction by transaction, the Pareto Rule says that all transactions that make someone better off and no one worse off should occur. So this is good to go to their highest and best uses type of thing? That's another way of saying it, but basically the Pareto Rule says let markets flourish, sorry, let trades flourish. That make both parties better off. Well that makes someone better off and no one worse off, and that's the weak Pareto Rule. The strong Pareto Rule is that everyone's better off through all the transactions, but let's say the weak Pareto Rule is what I have in mind, and then a separate sentence would say under many circumstances markets are a sufficient condition to perfectly implement the Pareto Rule. So what would be some of those circumstances, just like five people in a room trying to trade some small gadget, something they all have, and then everyone can make a trade and everyone can feel better off or worse off, or no one feels worse off after the trade. That's the key, right, and so that's a small person, a small an economy, and then you scale it up and you've got the United States and the world, et cetera. So this is like, I've heard this kind of experiment for teaching this to kids which seem to clarify somewhat this giving out candy in a classroom, so you have the teacher brings in a bag of candy, different kinds of candy, and it gives them out to all the kids, every kid gets a piece, and every kid is happy that they got candy, but then you give all of them the opportunity to exchange this candy and they choose to, and suddenly all of them are even more happy because these trades, no one's worse off. They all, if they like the candy they have, they kept it, and they certainly don't have candy now after the trading, but if you like Hershey bars more than M&Ms, you can trade them and everyone gets happy, and so we end up in a more Pareto-optimal situation. Without producing any more goods. Well, right, a Pareto-optimum is a state of affairs in which all Pareto improvements have taken place, and no further transaction is possible because the transactions would violate the Pareto rule, i.e., it would make someone worse off to, of course, in a free market no one can impose something on someone else, and so the definition of the Pareto rule leads you to think about, well, then why wouldn't markets, under what circumstances would markets fail to implement the Pareto rule? When we talk about better and worse off, I guess by what criteria or by whose standards are we talking? So we're talking like in this case, you know, these children, each child thinks he's better off because he's got a candy he likes better, but someone else could say, no, you're not better off because the candy you got is smaller or it's really like, you know, this one is worse. It will hurt you in the long run. It will hurt you in the long run. So are we talking, like when we judge Pareto, who's doing the judging? Well, in fact, that's a big part of any intro to economic, well, at least in my view, it's a very important concept to distinguish a benthamite view of welfare or utility and a paration or neoclassical view, and the transition from benthamite social science to Pareto is, marks the division between something called economics and something called political science. Oh, interesting. So the benthamite rule would be what? Well, bentham thought of utility or welfare as an intra-psychic concept, which could be measured through the equivalent of a thermometer, a utilitometer. I mean, that there was this didn't really exist, but in wealth and kind of benthamite thinking, there were interpersonal comparisons were possible. And so I could tell through some utilitometer that Aaron is 55 units of happy and 53. For example, this gets right to redistribution, which is in most economics classes, you're taught that the decreasing marginal utility of money, right? Meaning the more you get the less valuable it is. So taking a dollar away from Bill Gates and giving that dollar to someone that's homeless would obviously improve welfare in a benthamite setting because the decrease in utility from Bill Gates is infinitesimal because he has $40 billion and so taking one away can't mean much to him. But that's a benthamite view you're saying. Right. And then I'll go to Pareto. But giving a dollar to the homeless person would improve their welfare ginormously. And thus in a benthamite world, the losses are low and the benefits are high and therefore that kind of transaction in a benthamite world would be approved. Pareto, right, the shift to Pareto and the division between political science and economics is this subtle but very important transition to an intra-psychic concept of welfare where we could add and subtract utilities across people somehow to the person and only the person can judge whether or not a transaction makes them better off or not. And we no longer actually have a separate measure of welfare. All we actually observe is behavior. So it's like almost like BF skinner behaviorism, all I can see is what you do, I can't look inside your head. So we end up with welfare in a paration world being defined tautologically with trading. So bentham thought we could figure everything out and some modern views of the welfare state are often thought of as benthamite in origin whereas in neoclassical economics, there's just trading and then there's coercion in some states. If people trade, they're better off because they trade. How do we know they're better off? Because they trade. Why do they trade? Because they're better off. A tautological definition of welfare or utility in a paration world and it's just a different way of saying we observe people trading. And then so what does modern economics have to say about transactions that make some people better off and some people worse off and the answer is nothing. It has nothing to say about such transactions. Because we're outside of the benthamite world. No, no, we're outside of the paration world. We would have to be benthamite and there are no interpersonal comparisons in modern neoclassical economics and so the shift to Pareto, in effect, I have a diagram in my class that I use where I talk about a two-person economy and I have one person on the x-axis and another on the y and I talk about four kinds of trades between them, trades where both of us are better off, trades where one of us is better off and one is worse off and then a fourth quadrant is where trades between us make us both worse off and I joke and say quadrant one is modern economics, both people are better off because they're trading. Quadrants two and three are political science or sociology where we discuss whether using coercion to redistribute from somebody to somebody else does or does not make the society or them or whatever better. Peter's making scare quotes there for everyone. The society. And then quadrant four I joke just to see if they're awake is about relationships between people and it's psychiatry where you're married and you think you're better off but you're not and you don't know it and then they laugh and then they... So maybe sometimes people talk about market failures and we talk about the types of ones there are where people are trading or maybe not trading or it's some sort of non-peraito optimal state of the market where you're not achieving peraito optimality. So you can think of two, I mean to me their most economics classes have lists of market failures and they have different categories but once you think about them you realize they're all fall into and I believe at least two kinds of arguments and then you could even say that actually just falls into one so let me illustrate. So the first class is what are usually called public goods where it's difficult or impossible or expensive and we could talk about the difference between those three things to restrict consumption of that good to those who pay for it. So that's non-exclusability. And consumption of that good is non-rivalrous, those are the two part definition of a public good. A public good must have both of those characteristics. No non-rivalrous meaning that if someone uses it you don't take it away from someone else. Whereas so I'll give an example so an apple is a private good so we can restrict consumption to those who pay and consumption is rivalrous. You and I cannot chew on the same apple at the same time. And then the students go ooh right if I talk about it. So a public good, think of knowledge, the knowledge of anything. What goes into a smartphone, what goes into the knowledge about anything. Consumption of knowledge is non-rivalrous. Once it exists you're knowing and using the knowledge does not detract in any way from my knowing it. And it is difficult or impossible or expensive to restrict consumption of knowledge to those who pay. And so that's why you can think of the Constitution and even in the libertarian world had this notion that maybe- Copyright. We ought to try to create quasi-property rights for information but that's very difficult to do and they ought to be of limited term etc etc. Is national defense another example of these to public good? That's the one that I hear a lot of. The usual classic example in any kind of economics class of a pure public good is defense and that by defense we mean the protection of people within a border i.e. because if you add more people within the border it doesn't raise the marginal cost of defending the border and consumption of the defense of the border for all those within it is non-rivalrous. You and I and all of us can consume the defense of the United States at the same time. So I think that we've just said that public good here is a very economics definition. This is what an economics textbook would tell you, non-rivalrous, non-excludable. And it doesn't mean good for the public which some people maybe use that it's good for the public. They say this is a public good, universities are a public good, roads are a public good and they usually mean I think that it's good for the public. Public goods in economics can also be public bads. That is that you can have a commodity that has negative effects on people but you can't restrict that easily to those who pay for it and consumption of the badness is non-rivalrous. So the term good in public good has nothing to do with its desire. It's not a value judgment. In many, most things offered by the, well, take education, when you ask most people, even economists sometimes will say education is a public good, no it's not. You can restrict the consumption of education to those who pay for it. Because education is not knowledge in this situation. It's learning. And interaction with an instructor and whatnot and it occurs within, I used to say classrooms now it can occur online. And consumption is, you could talk about whether it's rivalrous or not but the key is that classrooms, well, do they have congestion once, like roads? Once the class size gets to be a certain level, is there a degradation in quality from the point of view of the educational consumer? The whole rationale for small liberal arts colleges is that the answer to that question is yes, is that the big flagship state universities don't pay attention to you, you'll be a number, come to, you name the college and you'll be in the classes of 12 and 15 and we care about you. So going back to market failures, we had public good ones. And how are public goods an example of a market failure then? Of them not being provided, would that be an example? Yeah, like what makes them fall within that? The private provision of public goods would be difficult or expensive or impossible. So because the private entity that tried to supply the good, the commodity, would have difficulty or impossibility of being paid for that item. And second, even if initially they provided it, they couldn't then restrict newcomers from consuming because it's non-rivalrous. So it's those characteristics of a commodity that make it, I'm repeating here again, difficult, expensive or impossible to provide privately. Libertarians are often fond of trying to provide clever examples of ex-exist, therefore it's not a public good, right? Somebody tries to, they're mercenaries and blah, blah, blah, well, I mean, again, but mercenaries are paid by governments. Yeah, they haven't disproved them. They're private armies. Yeah, national defense. And then gangs try to improve. Provide some of those benefits and costs. And they try to get paid for it by blowing up buildings and people and things. But I think even talking about those examples illustrates the point. Okay, so what are some of the other categories of? Well, okay, so public goods are a class of transactions that are Pareto improvements but do not occur through voluntary behavior easily. All right, let's, the opposite of that are transactions that occur easily or not easily that degrade someone's welfare without their consent. Oh, so these are the two broad categories you're talking about, one of them are transactions that don't occur and one of them are transactions that do occur. Exactly. So public goods in class are normally thought of as goods that don't occur that ought to and then government should tax or something and provide them. Then there's something called externalities that are things that occur that should not occur. But if you think about it you realize those are just the public good that's not adequately provided there is actually property rights. Property rights protection for someone to prevent their degradation of welfare without their consent is the thing that's under provided. So one thing governments do is provide and enforce and defend property rights. Would this be like if Trevor and I got together and sold each other some sort of polluting material or whatever and then burned it in our yard and the smoke wafted into your yard and you were harmed. So you are not a party to the transaction but you're being harmed by it. Correct. The question is what system could be created to try to protect me from the side effects of your transaction and historically in economics there's been two views of these matters. One is the Paguvian view of the provision or the dealing with externalities and another is the Cosian view named after Ronald Coase who just died this fall and taught for years at the University of Chicago. In the Paguvian world the purpose, a purpose of government is to charge or put a price on the negative behavior that you just described. You have a bonfire and then the smoke comes into my property etc. So you ought to pay a price for it. In a small end world of two or three or four people one could think of the common law and trespass and nuisance as government provided apparatus that allows the creation of an enforcement of torts of action, again what's the right legal way to… Torts of nuisance. Okay. Yeah. Proceedings that use a governmentally created and provided entity called the courts, the civil law too if you will create and enforce complicated property rights about small numbers of person externalities. And that would be the Coasean view on that side? Well, you can even think in a Paguvian sense that they would agree that the common law exists. So that's almost like a tax to some extent. You have to pay for this apparatus and then I mean I'm sure there's literature that talks about complete user fee common law system where no one who doesn't use it doesn't pay for it. This has to pay for it. Yes, absolutely. But in most, I don't know of any jurisdiction that actually does that, I mean most jurisdictions that I'm familiar with in effect tax people and provide the civil law as a public good. So then the Paguvian system tries to ascertain some sort of value and there's a lot of ways you can do that too. The regulatory agencies, maybe a carbon tax, correct, would be an example of trying to price an externality and then allow people to trade in it. So that would be an example of this really being a property rights problem in the sense of the externalities problem of bads that come from transactions is just a problem of property rights not being adequately delineated and defensible in the market. I mean Pagud takes it further and says in a Paguvian world there's always a harmer and a harmee. There's a kind of normative notion of who ought to pay for what here. So in the smoke, in the bonfire, the leaf example that you described earlier, Pagu would and most people probably would say right away that you ought to pay me to accept the smoke and pollution from your behavior. Now what Coase did is kind of take the normative out of it and say- The normative being that who has the right to be polluted and who has the right to pollute. In Pagu, yes, this implicit notion of who the tax or what behavior the tax ought to be on. Which is the polluter and then the pollutee. In the Coasean world, there's two entities, two people, two corporations, two whatever's that want to use the same property at the same time for different uses and they have a conflict. So the property here is like the air or the whatever. So one person wants to use it to breathe and the other person wants to use it to pollute or wants to use it to enjoy fresh air and the other person wants to use it to pollute and there's no normative judgment there about who has the right to breathe fresh air or to pollute. Correct. So this typically infuriates any students or people you start talking to. So they think it's obvious. Yeah, that it's obvious, but Coase let's stand back and in the classic example in the Coase article in 1958 in the Journal of Law and Economics, the problem of social cost, there was a farmer and a railroad, an old fashioned steam coal railroad that emitted soot, fire and embers and those damaged the farmer's crops. And so Coase asked, would the eventual equilibrium amount of pollution allowed differ depending on whether the train had initial property rights to pollute as much as the train wished or the farmer had initial property rights to an environment completely free of trains? And then Coase started out this discussion with a bargaining game imagining that alternately that one entity had the property right to do whatever they wished and then because it was a small person game, the other entity then bargained with the initial owner of the property rights to say, I'll pay you to pollute less or if the farmer does not have rights and has to pay the train or the train then says to the farmer, I'll pay you to accept. And Coase said, asked, does it matter how we start out this game for the eventual equilibrium amount of pollution that results and that's strict as a part of a bargain And the Coase and answer given assumptions that we can talk about was no, that the efficiency, the eventual amount of yuck that occurred in a society was invariant to the initial distribution of property rights. But is it more related to the transaction costs than the things that stand in the way of making a bargain? Well Coase said and for purposes of illustration, he used a very simple example, which is two people. And so we can go back to the common law example that we described with your bonfire and me as the neighbor. In a Coasean world, common law might have created rights or something, but Coase said I don't care, I'm an economist, I just, does it matter whether the neighbor has to bribe you to stop burning your bonfire or you have to bribe me to accept? And the Coasean answer was no, it matters for wealth, i.e. you're always wealthier if you get money from someone than if you have to pay someone. So property rights create wealth. The initial distribution of property rights is clearly important, but it's not important for efficiency, which is what economists care about, i.e. So the resolution of market failure in a Coasean context has two aspects. One is a distributional aspect, which is who gets, who has, who ought to have the property rights, but as an economist, I don't have an answer to that. That's lawyers figure that out of the political system or something else, but what I do care about is efficiency. As an economist, do I care about whether polluter pays pollutee or pollutee pays polluter? And the answer in a strict Coasean framework is no. The resulting amount of smoke or particular matter in the atmosphere will be invariant to how the political system or legal system allocates initial property rights. Does this depend in order for this to work? There is a depend on some sort of distribution of wealth in the sense that like if the railroad company is polluting and I'm the farmer, I have to at least have enough resources, enough money to pay the railroad company in order to get to whatever that threshold is that they're willing to accept to reduce their pollution. Aaron, the clever student always figures out where the professor is going and he has just, that is the, so the asterisks and footnotes to the Coase Theorem are all about that the initial distribution of wealth, other than this particular property right is such that adding this particular property right to whatever is going on elsewhere in the world is not so fundamental from a wealth distribution standpoint that the willingness to pay and the willingness to accept are not affected by the alteration of this particular property right given everything else that is in question. But Aaron's hit his head on it which is it will be affected by other distributions. Well, the thought experiment that my colleague Jerry Taylor and I engaged in in our energy policy discussions is ANWAR, the Alaska National Wildlife Refuge. We proposed in an op-ed to instead of fighting over whether it should be developed or not and having environmentalists fight over it, give the ownership of this to environmentalists. See how much they will cost for them to let you pollute. Give it to the Sierra Club and then would they, are they really serious that they would give up a trillion dollars? Easy to say, hard to. Well, there's actually an example, believe it or not, the Audubon Society of a Bird Preservation Organization owns private wetlands in Louisiana and they for years leased those lands for oil and gas development in Louisiana. And Jerry and I found out this example and we used it and others had did as well. And then the publicity was so bad for the Audubon Society from their members that they stopped leasing it. But our point was they're always trade-offs and but the point was illustrated that if the property right in question is so valuable to in the eyes of those owners relative to the rest of their wealth as Aaron suggested, then the Coase theorem doesn't work. I.e., the initial distribution of property rights does determine the resulting efficiency nature of the bargaining. And that and this is Peter's theorem, which is the biggest struggles that we see in the political world are those things or those venues, those policy areas in which the distribution of property rights is everything. And environmental politics are so vicious because probably the Coase theorem is violated. I.e., if you give initial ownership of Anwar to the Sierra Club, it will not be developed. And if you give it to the oil companies or auction it off and oil companies outbid environmentalists, environmentalists will never get enough money voluntarily to buy it away from oil development. And so the struggle over Anwar is not just a struggle over who's wealthier and who's not and has no effects on efficiency. It probably is such a vicious struggle because everyone knows it will affect the eventual outcome. So let me put this into a question. I like this environmentalist Anwar example. If someone says, someone comes to you from the Sierra Club and they say, and you tell them, well, why don't you purchase Anwar? And they say, well, we could never compete against the oil and gas money. If that was up for sale and it was just a bidding war between oil and gas versus us, the environmental concerns could never compete against the oil and gas industry. And an economist might say, well, in response to that, that means that the highest and best uses of that land is who pays the most for it. To which an environmentalist says, well, I disagree. The highest and best uses of that land shouldn't have that much to do with who has the most money in the bank, but future generations and how much environmental concerns are valuable to us and how beautiful bald eagles are and other concerns like that. And maybe it's just the case that they prefer bald eagles to oil and gas leases and oil and gas people prefer to bald eagles. And they want to use government to try and make sure that they win if they don't have enough money to win the bidding war. And then they might say that that's a market failure. It's a market failure if the initial distribution of wealth doesn't let us compete against the oil and gas companies to save the environment for future generations. And what would you say to that? It's certainly the cases like this are difficult cases in the sense that the easy-coast theorem cases are cases where we can show that the result is invariant to the initial distribution. And I'll give you an example other than the ANWAR and all that. And that's the distribution of cellular phone licenses in the United States by the FCC. Initially, well, prior to the current system we have, which is an auction, right? We used to have licenses by metropolitan area. And anyone could apply and they put their names in a drum. They literally did a rant. They just chose a winner randomly. OK, so that's a. That seems inefficient. Well, no, no, no. I would I would downgrade you on this. Notice if the coast theorem is right and the initial distribution doesn't matter for efficiency, it's not inefficient. It's just an arbitrary initial distribution. I they won the lottery and then they can sell and then they can sell immediately. And what we found in the cellular phone licenses in the old system is that exactly what happened? Weird lawyers represented people and then put in names many, many, many times. And sometimes little old ladies and nowhere won the cellular phone license for a major metropolitan area. And then within seven seconds, lawyers for the telecom company said, we'll give you $1 million. Would you give us a license? And that person would say yes. And so that's a perfect example of the coast theorem working, which is initial distribution matters for wealth, but it has no effect on efficiency and war. The distribution of things I who owns the property rights to development probably affects everything in in and war. And thus it's not I wouldn't call it a market failure, but rather politics is an appeals court for distributional things. And in this case, the economists would have to say, wow, the distribution of these property rights for this development will determine our future because it would it will be very difficult to undo it if we go down one road versus the other. If we give initial property rights to Anwar to the Sierra Club, there's high very much, much higher likelihood that it will not be developed than if we give those property rights to anybody else other than strong environmentalists, they will in turn sell to oil companies and oil companies will develop. And thus a fight to the death over that initial allocation over and over and over again. The broad preferences about weighing the value of oil and gas versus environmental concerns is already embedded in the distribution in the sense that these oil companies didn't start out forcing anyone. But they like it's not the oil companies just kind of appeared with wealth with wealth. They got that wealth because people wanted oil. And so every time I go out and I spend fifty bucks to fill my tank with gas, instead of sending fifty dollars to the Sierra Club, I am choosing oil over. Environmental groups never ever want to point at that. Oil companies have been bad in U.S. culture since their inception. Everyone has always hated them. And thus environmentalists, environmental groups always attack companies. They never go out to the suburbs and say, or everywhere, they don't go to the American people and say, all of you are the problem because you like cars and you drive them and you consume oil. Sometimes they do, but not as much. Some radicals do. But you don't raise money for causes by attacking everyone. But anyway, the bogeyman in American culture is always something called the company, whereas we, anyone trained in economics, sees the company as just the realization of lots of people buying whatever it's selling. And so you can just go blame the consumers, but that's not useful for... That comes up with a thing that Aaron and I often talk about, which is how much as politics just ultimately preferences, not liking what other people buy and wishing that the world had different preferences. I wish that the world, the environmentalists, I wish that the world had more of a preference for environmental future than they do, than they do for oil. And if you ask people in the world, the way we're going to save the wetlands is to go around to everyone in the world, the trans acts, whatever one do and talk about, and say you have limited resources and you can give it either to wetlands or to power, to light, to power television, or your plasma television, or your car. And so everyone gets a chance. Maybe they just all have a dollar and they get to put their dollar on one side. And at the end of the day, the television and car side has more dollars than the wetlands side. And that upsets some people. The first question is, and maybe you won't answer this from an economist standpoint, but should we be using politics to try and correct that via some sort of forceful coercion method? Isn't that when we go to politics? That's the division between the disciplines. I mean, when I taught, I always was a half political scientist, half economist, and therefore didn't fit in well with either. And the normative assumption within a political science departmental context almost always is that the purpose of politics and the correct purpose of politics is to fix and remedy and adjust market outcomes. But within an economics context, there's a much more limited view that, no, you should only do that if and only if there's something called market failure, which is what we've been talking about today. And then there's something called distribution and economics as a discipline has nothing to say about that. And then other disciplines do. And then you bring in public choice, which is the economics of government failure. And if all those work out, maybe you should use government. Would that be an accurate way of putting it, do you think? Yeah. Or for your viewpoint? Again, even if you want to do something about distribution, there's the complicated way and there's the simple way. And again, what I've learned over the years in studying all the markets I've studied is that most markets don't have market failures. Instead, the people's complaint with that market is really distributional nature. They just don't know it. And then you never should correct, even in an economic framework outside of libertarianism, within economics, you can see it now and struggle over the minimum wage and altering a price. Why would you want to alter a price? Well, you really want to make the distribution of income for poor people different than it already is. David Newmark, who's a good economist, had a blog post in The New York Times Sunday, Saturday, on, gee, we have the earned income tax credit. You don't want to alter the labor market directly what you wanted. The earned income tax credit directly gives money only to low-wage workers that have children, whereas the minimum wage gives it to teenagers. It's not a very targeted intervention. And it affects the price of labor, which is a disincentive for employers. Whereas the earned income tax credit, employer doesn't know whether you do or don't. It just sees your price for labor. If the society subsidizes that person additionally, doesn't affect the employer demand for one way or the other. And so from an economist's point of view, even if you want to do something about distribution, you should do it not through any particular market. You should do it more directly. Not distorting markets, but more directly to who you want to help. Does the minimum wage give us an example then of what goes wrong in a lot of this market failure and then government solutions, again with scare quotes, in that we have a situation that people have identified as a market failure as they're using the term. They're using it incorrectly as we've discussed, where they're saying the people at the bottom of the income distribution are not earning enough money. The market has failed them and failed all of us because it's not distributing enough money to the bottom of the income distribution. And they're using that term as you said incorrectly. They're not really saying against the trade here. They're discriminating. What they're really saying is I don't like this outcome and that's a misuse. And then they've intervened so that the solution then that they give is to have government go in and mess with prices by raising the cost of employing low-wage workers. So they're using government to fix what's not really a market failure, but it still is something they don't like. But then one of the problems is it often makes things worse because rather than getting lots of more money for the people at the bottom of the income distribution, you simply now price them out of the market and they're getting zero money. Yes. And David Newmark actually has done interesting work showing an ironic, weird side effect of a higher minimum wage is to increase the drop-out rate. Oh, that's a good… That makes sense. Because if you need less school to get a certain wage, you don't have to stay in school and a lot of people don't like school. If you're on the margin, I'm about to drop out. I'm like right about to drop out. If someone give me a job that will give me $10 an hour, I will drop out of school right now and then there it is, $10 an hour job. Not that that job was created by minimum wage, but that's what they would think. It didn't create jobs, it created a wage. It creates the possibility of being employed given your skill level at a higher price than you observed before this rule went into effect and therefore you change your behavior. Anyway, so one of the most interesting work on the minimum wage is by David Newmark. I guess my question then is this a common pattern? When you misidentify a market failure and then try to fix it with government making it worse, is this just a common thing that happens in lots of realms when people misuse this term market failure? I think so, yes. I've studied the microeconomics of market intervention since the late 70's and in all the markets I've studied and written about and taught about I tend to conclude that there really wasn't any market failure in this market anyway. Sometimes there is and then we could talk about those, but basically in most markets they work but they're outcomes of whatever or some organized group of some sort or the population as a whole doesn't like. What they don't realize is that thing they don't like is distributional in nature. Everyone wishes poor people made more money, everyone wishes things cost less. And that so, okay, we can use the tax code and we can rearrange the distribution of income and wealth. To do that, you do not need to have telecommunications regulation. OSHA. Environmental, well again, the environmental regulation there really are market failure. We don't have adequate property rights for the air and for the water and we need to create property rights and tradeable emission rights and things like that even in a libertarian world for those things and so that market there is a need for some policy intervention. However, what we've actually done with the Clean Air Act and Clean Water Act is nothing close to what an economist would recommend. So if we get bad policies when we misidentify market failures, how difficult is it to identify market failures in the first place because it seems like you gave these two broad categories of things that are market failures. One is the public goods and one is the negative externalities but both of those seem like the kind of thing where you can look at a situation and tell whether it meets that. Like you could ask is this a pure public good by this very restricted definition that use economics or are there negative externalities? The answer to those is no, then it's not a market failure and we shouldn't intervene. So that seems pretty straightforward. So why isn't it? If you read what I tried to do in my classes and what all instructors do and that teach master's and policy students to be policy people in Washington and if you read almost any economics blog regardless of the political persuasion of the author, economists are pretty strict in the way you described about that. And so what I've learned though is that most economists actually don't have aren't involved in regulation to a surprising degree that people from law schools are and so I'm sorry about that I think one of the most interesting intellectual trends since I was a graduate student is the role of tenured economists in elite law school training and I have I pin my own hopes on better government i.e. less government coming from that training so that the cavalier use of the term we're talking about today would shame people in Georgetown dinner parties once they have degrees from leading law schools now in a way that was not true 30 years ago where you could go through regulatory law and not learn what we're talking about today but you cannot escape elite law school training now in what I'm describing because of the the rise of the field that we're talking about which is law and economics. Okay so to summarize on a question of market failures and maybe just what should government be doing from an economist standpoint and we look at people who say government should be doing this and here's a problem and ideas of market failures that we've been discussing how would you summarize your view of when people think government should step in well I'm agreeing with what Aaron said earlier which is that the if we relentlessly pursue in a very careful language kind of framework that we've been using today a discussion like that about anything when I poke and pry the question of here's a problem and congress or the president ought to do and war is being drilled or not being drilled here's a problem and it needs to be fixed most of the like 95% of the time if I relentlessly pursue precise use of language with this person I will find and I tend to be able to convince them that in fact they're misusing the term market failure and misusing the term as a rationale for government intervention that in fact they're complaint with this market is distributional in nature they wish that the distribution of property rights or the distribution wealth or the distribution of income the flow that comes from those property rights they wish that were different somehow and rather than needing a specific intervention in that market be a telecom or energy or labor or in fact the person person wishes that rich rich people were less rich and poor people were not as poor and the and then I can describe then we need to drift off into what I call Rawls versus those normative political philosophy stuff and the economic capabilities of a government to redistribute whether it ought to and then the the more devastating insight I offer is that if you intervene in sectors for distributional reasons you actually will probably have no distributional effect and that's the expand on that a little bit well assume two cases a case one is a sector we throw a regulation at it or we throw money at it or something like that for distributional purposes but the sector has no entry barriers so land labor and capital can enter that sector post-intervention so can we think of a good example of such a sector to bring this out of the ground possibly let's well let me I can think of one more easily that has restricted entry and then I'll talk and I'll work so farm subsidies are a classic example there we intervene in that sector and we regulate the heck out of farming in a very surreal way yes distributional reasons there's a romance about the poor all of us if we go back three generations had farmers in our in our background we love family farms we love family farms and and if we're honest my my own family I'm the first generation not to farm farming's hard and most people who are now urban remember or know relatives that were farmers and know how hard it was knew the role that something called government programs may have played in resolving bad years for Uncle Bob and so there's an even among urban voters there's a sympathy to something called intervention in the farm sector this is a distribution problem though just yeah the your income on average is too low for farming or it's too variable there's there's only two things that can go on usually it's the variance that that's bad about farming sometimes it's the mean but a lot of the time it's the variance well the there's a limited amount of good land in the country and then there's lots of bad land and so good land is in Iowa it has a foot of organic soil and you can grow corn till the cows come home for that and it's you don't have to do much the input costs are low so if we throw money at farming that's a limited factor of production i.e. good land and so guess what happens because of our intervening in farming which is the value of land in Iowa goes up okay so the to use the jargon the subsidy gets capitalized into land values and once that happens and that happens only once all future farmers all future owners all new entrants into farming have to pay for the privilege of being subsidized which means they're not being subsidized so this is like Archer's Daniel Midland or any sort of large farm that captured the land and had it when the subsidy was granted their land suddenly became incredibly valuable and it's valuable until the subsidy goes away correct and now the subsidy is no longer it's captured once by the first seller and then every single other person just has to pay well to be precise it's actually captured by whomever owns the asset in question when entries are restricted i.e. it's good land and there's a limited supply of it and the market recognizes that the subsidy's going to happen so you can imagine it happening before the program's enacted but there's an expectations game yes and similarly with deregulation it's the opposite so if you ever I mean I've seen studies which is if we ended farm subsidies land values in the Midwest would go down by a third they're right so the difficulty of deregulating a sector once it's on the government dole and their entry barriers is that the deregulation would create wealth losses for some people for some now I wrote an article with an accountant almost 20 years ago now on taxi medallions in New York it's the same kind of thing where the restricted entry asset is explicit yeah it's this right to operate a vehicle a yellow vehicle in New York in Manhattan and hail passengers there's 11,000 or so of these medallions and they were created in the 1930s and the number is fixed it hasn't risen and there were about $700,000 that's on my check so I've seen over a million with the rebound from the recession so what does that mean well it is the capitalized value of the excess profits that come from the rate restrictions that the fares are governed by the city of New York and they're higher than they need be and blah blah blah so it's very valuable what my co-author and I did is we compared buying a medallion versus leasing and we said hmm if politics is if markets are forward looking and the expected value of deregulation is included in the value of assets in sectors that have privileges then the present value of renting a medallion in perpetuity will be higher than the market value of a medallion because perpetuity isn't maybe possible because could be deregulated so your theory would have been if there was an expectation to try and put this into layman terms like everything as a present value includes future expectations so buying something has a longer holding time theoretically than leasing something will the goodies for this thing go on forever or will they be limited so is there anyone predicting that deregulation is going to happen and guess what we found no I would imagine no we found yes they are believe it or not even though deregulation has never occurred in the medallion market for the city of New York we found that the market is acting as amortizing the rental value of the medallion as if it would have no value after year 20 hmm and so why is that we concluded that well we look for everything else and we think that the market acts as if there's a 5% chance of deregulation every year I guess it's not zero in a year and so the same thing for farmland in Iowa the farmers would demand this gets into libertarian theories of whether we ought to compensate entities when we change the rules of the game when I first came to Cato in the mid 90s there was electricity deregulation going on and Roger Pallon and I had a debate about whether we should compensate utilities for changing the rules of the game based on my work I said no because the stock value for the electric companies takes into account the possibility of deregulation and Roger said well no they didn't until we had the economists versus the we were talking about farming because you set it up as an example of a restricted entry to contrast it to unrestricted let's talk about housing I was trying to think of a market where we regulated and altered it through government policy a lot for distributional reasons but there's no entry restrictions so what happens in that sector well you throw money throw cash flow or throw a positive regulation at that sector land labor so initially some wages rise and profits rise and things in that sector everyone else realizes wow that's a good deal I'll get my realtors license or I'll get my housing license construction license I'm going to build houses well the new equilibrium occurs and then there's no excess wages there's no excess profits and there's no excess capital return on capital in that sector even with the subsidy because there aren't any entry restrictions everyone has entered the market to take every single excess one that could possibly be there there's too much capital too much land and too much labor in that sector it's inefficient it's been distorted by government policy but there are no distributional advantages to any of the participants so what's ironic once you have an economist view of helping sectors and not helping sectors and what happens you realize that all even though everything is distributional none of the sectors in which we do things for distributional reasons actually ever have distributional advantages if there's no entry barriers there's just too much stuff in that sector but no one's getting excess profits no one's getting excess wages and no one's getting excess land rents but if we change the policy if we deregulate a sector where we've thrown a regulation at it or money and we take that away then there's the bleeding you have to have capital going out labor going out and land going out of that sector and people don't like that so they resist politically usually so all this leaves us in the end pretty skeptical about government regulation from an economist standpoint even from distribution if you try to do it a particular market at a time you are wasting your time Peter for joining us today on Free Thoughts and thank you for listening if you have any questions or comments about today's episode you can find me on twitter at A-R-O-S-S-P and you can find me on twitter at T-C-B-B-U-R-R-U-S Free Thoughts is a project of Libertarianism.org and the Cato Institute and is produced by Evan Banks to learn more about Libertarianism visit us on the web at www.libertarianism.org