A few days ago I came across a blog by one of my peers. (It is really decent and you can check it out here.)
I read a couple of his posts. One of them in particular caught my attention. I commented on it. He replied. I responded back. He replied again.
Click the links below to jump to those parts.
This is the link to the blog post.
Alternatively, here is the original (as of 21 December 2022) blog post, in full:
(In yellow are the specific segments my comment responded to. It would suffice to read them only.)
His Post
how market failure succeeds
“Government should be a referee, not an active player.” – Milton Friedman
If you studied Economics in school, you would definitely have learnt about market failure. Market failure occurs when the free market fails to allocate resources efficiently due to reasons such as externalities, imperfect information, asymmetric information or when the good is a public good. Market failure questions are deemed as “giveaway marks” by most students for reasons which you will soon see. The questions (something very similar came out during the 2021 A-Level paper; lucky me!) look like such:
a) Explain the cause of market failure in (insert market here) [10]
b) Discuss alternative solutions to tackle market failure in (insert aforementioned market here) [15]
The first part is usually a regurgitation exercise. If you correctly identified the cause of market failure and did the memory work, well done! The second part requires more explanation on how the policy solution works, followed by its pros and cons in the context of the market. This all seemed simple and straightforward, until I came across an idea that challenged my current perceptions and forced me to think deeper.
Should markets be regulated?
It is intuitive that free markets are not 100% efficient, which means that there is market failure to some extent in almost every single market. Hence, the government would need to step in with policies to improve economic efficiency. This is the paradigm of the neoclassical welfare economics, dubbed the Market Failure Theory (MFT). However, there is a contrasting perspective called the Public Choice Theory (PCT), which asserts that government agents are self-interested. This means that government failure is exacerbated by policymakers acting against the public interest for greater profits or for political survival. Naturally, PCT supporters promote laissez faire markets instead.
Admittedly, MFT has its flaws. It goes without saying that the government is not perfect, and thus government failure is inevitable. For example, by not having perfect information themselves, their size of the taxation or subsidy to tackle externalities will be inaccurate. Nonetheless, MFT plays an important role in public policy as seen in the case of Covid-19 vaccines, which were fully subsidised by the Singaporean government to address the market failure caused by positive externalities and imperfect information.
Challenging the PCT
However, the validity of PCT is questionable. If government agents were self-interested, who will provide for public goods? I for one cannot imagine a future without street lighting and national defence. Furthermore, according to Professor of Political Economy at LSE Abby Innes, self-interested government officials can be likened to entrepreneurs competing for a monopoly. To gain greater control over the state, politicians would devise policies that please voters. This causes self-interested voters to seek state privileges until democracy to crowd itself out in favour of totalitarianism. Once again, this logic is untenable.
PCT’s core tenet is that government agents are self-interested. What does the data say? We can extrapolate from an experiment about Game Theory, the Ultimatum Game. Basically, there is a pot of money, say $10, where one player proposes how to split the money and the other decides whether to accept or reject the offer. If the offer is accepted, they split the money according to the proposal and if rejected, nobody gets anything. Rationally, the offerer simply needs to give the other player the smallest increment, say $1, to guarantee that the offer is accepted, since some money is better than none. However, experiments on the Ultimatum game have shown that people have some inherent sense of fairness where offers below a certain threshold, usually around $2-$3, get rejected out of a sense of injustice that the player is being shortchanged. Clearly, we are not that self-interested and can act out of a sense of duty and fairness as well. This weakens the validity of PCT significantly.
MFT vs PCT: Who won?
It seems like MFT wins today, as there are clearly tangible benefits to government intervention. While the policies are not perfect, it is unlikely that it is due to government officials acting in their own self interests. However, more needs to be done than taking reactive measures to market failure, such as strategically structuring investments to crowd in private investments. This idea is proposed by Mission Economy’s author Mariana Mazzucato, but for now, that’s enough political economics for a day.
My Thoughts
I’ve never heard of a Market Failure Theory versus Public Choice Theory divide, so I looked it up. I couldn’t find anything related to it so I presumed it was a novel idea by the author of the blog post. There were things in the post that made me uncomfortable so I reread some parts of it to verify my feelings towards it and understand what disturbed me.
Indeed, I spotted several flaws in the reasoning and I decided to engage the author with a comment.
My Response I
START
MFT and PCT are not mutually conflicting theories, are they? You can have self-interested government agents mitigating market failure. It is erroneous to frame them as being “versus” each other. Belief in PCT does not preclude belief in MFT. PCT hardly has anything against MFT.
Next, government failure is a situation where government intervention causes greater market inefficiencies compared to a situation without government intervention. Self-interest in government does not necessarily cause that. Neither does imperfect governance. An inaccurate tax just means there is still inefficiency present in the market, not that government failure is present. Not all taxes are inaccurate enough to lead to government failure.
Also, why do PCT proponents prefer laissez-faire1 markets? Being a believer in PCT doesn’t mean opposition to government intervention. PCT is simply a model that explains government decision-making based on an axiom of agents being self-interested, among other things.
Additionally, a world of self-interested government agents does not necessarily imply a world without public goods. There can be self-interested reasons for government agents to provide public goods, such as improving one’s reputation and chances of re-election.
And rejecting low offers in The Ultimatum Game can be self-interested too, such as avoiding the bad feeling of being short-changed or gaining the good feeling of punishing someone who gives a low offer.
Hope you can reply to this, Ryan 🙂
END
The comment has not been posted yet, as it has to be approved by the author first. I hope he approves it and replies soon.
His Reply I
I woke up in the morning to a text from the author saying he had replied to my comment
START
Hi Yi Swee,
Thanks for the thought-provoking insights!
1. I totally agree with your criticism that it was indeed erroneous to pit MFT and PCT against each other because they are in fact not mutually exclusive. I think what I meant to say was that the logical conclusion if MFT were true, that government intervention is justified, was diametrically opposed to the logical conclusion is PCT were true, that is government intervention is not justified and we should have LF markets instead. My apologies!
2. I agree. I apologise for misrepresenting government failure as an inevitable feature of government intervention in markets when that is not the case in reality.
3. My line of reasoning was as such: PCT posits that govt. decision-makers/agents are self-interested. Hence, they prioritise their own private benefit over the larger, social benefit. Generally speaking, these politicians are wealthy and thus have an incentive to impose lower taxes so their wealth remains intact. (E.g. Donald Trump’s company’s tax fraud and suspect tax returns amidst a backdrop of passing bills which reduced income tax during his tenure as POTUS. As such, PCT proponents might prefer LF markets since government intervention would be self-interested and detrimental to society as a whole. I suppose this can be refuted with the context of strong legal and regulatory oversight that prevent such self-interested decision-making, but then these government agents might favour politically favourable bills over economically favourable bills, but just food for thought.
4. I agree. Just because govt. agents might be self-interested doesn’t mean there will not be provision of public goods. My bad!
5. I agree. On hindsight, the decision to reject unfair offers is arguably coldly rational and self-interested, if we look through the lens of human rationality as not accounting for strictly monetary gains but abiding by our principles and values such as fairness and justice, or like what you said, avoiding bad feelings and gaining good ones. I suppose ultimately my point was that humans can be altruistic, but the ultimatum game a poor example to attempt to prove this. Perhaps I should have used a repeated Prisoner’s Dilemma to explain it instead. Oh well.
Well, I’ve learnt that this was one of my more poorly-researched and poorly-written articles. Thanks for the feedback and I’ll try to do better next time! 🙂
END
My Response II
I responded to Points 1, 3 and 5 of his reply.
START
Thanks for the reply😄
1. Yes, PCT is a model that can account for how and why politics can lead to government failure, but I don’t think it expressly advocates for LF markets in itself. For instance, the field of PCT also suggests how government failure can be mitigated. Not all public choice economists are conservatives or libertarians. Many public choice economists take no political or ideological position. Some of them favour strong government. See here.
I also prefer not to talk about theories in terms of whether they are true or not true as I do not find it useful. A theory is an explanation or a model for observed phenomena. Theories do not fall under dichotomous categories of true or false; they lie on spectra2—on how accurate they are in describing the world we observe, rather than whether they are right or wrong. Less accurate theories can coexist with more accurate theories about the same phenomena. For instance physicists apply both Newtonian and quantum mechanical models to solve problems of motion even though one theory is more fine-grained and accurate than the other.
MFT and PCT are models that have axioms and make predictions. Some of these predictions aptly account for observed phenomena while others do not. For example some people have criticised PCT for not explaining why people vote since voting is ostensibly an irrational economic choice under certain considerations. That does not make the theory true or false; it just affects the degree to which it is deemed accurate and comprehensive in describing the world. Even if one day a theory more accurate and comprehensive than PCT emerges, it takes nothing away from the existing accuracy and comprehensiveness of PCT and PCT can still be useful in certain domains of applicability, just like how Einstein’s model of spacetime did not completely banish Newton’s model of spacetime to obsolescence.
3. I don’t think that self-interested bureaucrats and detrimental governance automatically come hand-in-hand. Government agents may face weak incentives to optimise the use of government resources and that is detrimental, but it does not follow that the intervention they bring about necessarily does more harm than good. The intervention could still be overall beneficial, but just not optimised due to the misalignment of incentives caused by self-interested bureaucrats.
5. RE: The link: Ah yes, I like evolutionary explanations.
Also, I’m interested to see how the Prisoner’s Dilemma can explain human altruism.
END
His Reply II
START
Hi Yi Swee,
Thanks for the insights once again.
1. Interesting read! I learnt that the crux of correcting govt failure using PCT is by providing some financial incentive for public officials to ramp up enforcement efforts, which clearly isn’t very LF.
I agree that theories are models and lie on a spectrum. This has led me to the thought that we need empirical evidence to verify the accuracy of our theories, which can be quite difficult to do given the myriad of variables especially in social sciences like economics and politics.
3. Yup definitely.
5. The repeated prisoner’s dilemma has an evolutionary flavour to it as well 🙂 It’s a long paper; the conclusion provides sufficient insight in my opinion!
END
Footnotes
1: In addition, laissez-faire is not a clearly defined concept. Would you consider an economy (that is otherwise mostly free) which bans the exchange of child labour between voluntary parties laissez-faire? There is no prescribed interpretation.
2: I afterwards regretted this part as I felt this isn’t the most accurate way to describe “theory”. Not sure “spectrum” is the right word, as it has a connotation of linearity or unidimensionality.
BLOGOPUS 
One thought on “A Tale of Two Theories 📜”