"I may be wrong and you may be right, and by an effort, we may get nearer to the truth." (Karl Popper)

Friday, February 10, 2006

States and markets: the cardinal choice

The cardinal choice, as Charles Wolf Jr. termed it, is whether the state or the market should be the regulator of social/economic activity. Making the correct choice in particular cases, Wolf argued*, required an understanding of the limits of each. Wolf's central thesis is a compelling one, namely that policy choices will always be between imperfect alternatives. He contended that in making such choices we would be aided by a theory of "non-market failure" to correspond to the highly developed theories of market failure (instances where the pursuit of private interest does not result in an efficient allocation of resources, or to results objectionable on grounds of fairness) that had been articulated with the growth of welfare economics. This would describe how non-market institutions (not just governments) "fail", in the sense of producing undesirable results. Policy would benefit from such an increased range of analytical tools. Public choice theory; the work of scholars such as Oliver Williamson and Douglass North on transaction cost economics; and the so-called new institutional economics have gone some way in this direction. Problems of market distortion, imperfect information, regulatory capture, rent seeking and so on sometimes make the state an unnecessarily clumsy and inefficient way of solving problems. Government action needs to be finely calibrated if it is to avoid worsening the problem it sets out to solve.

The issue of government intervention is best viewed as "largely empirical rather than theoretical" (p.5). Comparative analysis of the costs and imperfections of state and market approaches is essential. The point I have in mind has been well made by Richard Craswell, currently of Stanford Law School, in a piece on freedom of contract**. The logic of his argument transfers quite neatly to the issues I have in mind, like healthcare and schools policy. He has written that it is essential:
"(a) to recognise that markets generally entail frictions or costs; (b) to recognise that the alternatives to markets ... also have costs; and (c) to begin the inquiry into the exact nature and extent of those costs, in order to figure out where and when each regime would minimise the total costs."

Later in the same piece he continues:

"In short ... both markets and their alternatives have imperfections, and ... the most interesting questions concern the nature and degree of the imperfections of each. ... If one starts with the premise that markets are always efficient, the inquiry will be over as soon as it is begun, and any analysis of the comparative efficiency or inefficiency of judicial and regulatory regimes will never get off the ground. If we instead recognise that markets may not always work perfectly, and we also recognise that this conclusion is not itself sufficient to justify legal regulation of contract terms [government intervention], we can then proceed to the questions that are really worth studying."

*Markets or Governments: Choosing between Imperfect Alternatives, 2nd ed. (MIT Press, 1993)
**See the collection entitled Chicago Lectures in Law and Economics, edited by Eric Posner. (New York: Foundation Press, 2000)


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