Public choice, market failure and state failure

In order to understand why public choice theorists display such a hostile attitude towards the state, its development needs to be placed in the broader context of the history of economic theory.

Over the next few hundred years, the academic discipline of economics was transformed. Smith’s ‘classical’ economics with its emphasis upon the wealth of nations gave way to a ‘neo-classical’ focus upon the satisfaction of preferences. Political economy gave way to micro-economics and, at the same time, verbal reasoning gave way to mathematical formulae. Yet Smith’s defence of laissez-faire economics nevertheless remained (Ingaro and Israel 1990).

With the general parameters of general equilibrium theory having been set, a new generation of economists began to question the free-market orthodoxy in the late 1950s and early 1960s. As we will presently see, they were far from being the first to do so. But the willingness of these welfare economists to use the same basic methods as their rivals helped ensure their success. Arrow and Debreu had shown that perfect competition would lead to perfect results. Welfare economists argued that competition is rarely perfect and that markets frequently fail. I do not want to get sucked too far into the details of economic theory here. But the argument in subsequent sections will benefit from the discussion of three particular causes of market failure: monopoly, externalities and public goods (for an account of other forms of market failure see Sandler 2001: 20-6; and Stiglitz 1997: 27-64).

(i) Monopoly

For competition to be perfect there must be a large number of buyers and sellers who are individually unable to influence the price of their product. But many industries are very obviously dominated by, at most, a handful of firms who individually have a great deal of influence over prices. Firms with such monopoly power will be able to increase their profits by raising prices and restricting output. This will however reduce consumer welfare as those buying their product have to pay an inflated price.

(ii) Externalities

For competition to be perfect, the costs and benefits of producing and consuming a good must be borne exclusively by the person or persons producing and paying for it.

(iii) Public goods

For competition to be perfect, goods must be private in the sense of being both excludable and rival. A good is excludable if its owner can control access to it. A good is rivalrous if its consumption by one person reduces the amount available to be consumed by others. Some goods are however public goods. Consider the beam emitted by a lighthouse. It is non-excludable because ships sailing by cannot be prevented from seeing it. It is non-rival because the benefit one ship derives from the light does not reduce the amount of light available for others. Where consumers have preferences for public goods the market will fail because individuals will not contribute toward the cost of goods they cannot be excluded from using.

When competition is perfect, there is, as Smith, Arrow and Debreu demonstrated no need for state intervention. But when competition is imperfect there would seem to be an obvious prima facie case for state intervention to either prevent or correct market failures. When there are monopolies there would seem to be a strong case for using the state to either break up that monopoly or to regulate its prices. When there are externalities there would seem to be a strong case for using the state to either subsidize or tax production. When there are public goods there would seem to be a strong case for state provision.

Public choice theory emerged in a handful of North American universities in the 1960s (Grofman 1995). One way of understanding it is as a reaction to and critique of the theory of market failure. Public choice theorists argued that whilst welfare economists had shown how and why the market might sometimes fail they had simply asserted rather than demonstrated the ability and willingness of the state to correct those failures. In comparing the virtues of the state with those of the market, welfare economists had made a misleading comparison between the reality of imperfect markets and the fiction of a perfect state. In actual fact, public choice theorists maintained, the state would fail for many of the same reasons as the market. They concluded that the comparison ought therefore to be between imperfect markets and an equally imperfect state; a comparison which would undermine much of the case for state intervention.

Why will the state so frequently fail? In the following section I want to show how monopolies, externalities and public goods can also afflict state provision. In the final part of this section I however want to tie the argument about state failure to the core assumption of self-interested behaviour. Monopolies, externalities and public goods do not, in themselves, cause markets to fail. People cause markets to fail. It is because entrepreneurs are self-interested profit-maximizers that they exploit monopoly positions by raising prices and reducing output. It is because factory owners are self-interested profit-maximizers that they take no account of the effects of their actions upon neighbouring residents. It is because individuals are self-interested utility-maximizers that they ‘free ride’ upon the provision of public goods (Olson 1971). But welfare economists apparently assumed that self-interest had its limits. For in extolling the possibilities of state intervention to correct for market failures, they assumed that those working for the state would act as benevolent guardians of the public interest.