The Answer Is Transaction Costs

Dam Shame: It's not easy being government

• Michael Munger • Season 2 • Episode 3

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I have been interested lately in a paper Bill Keech and I were working on a decade ago,

It was called "The Anatomy of Government Failure."

Was AC Pigou the first "Public Choice" theorist?

There are two transaction costs problems in the background:
1.  Information asymmetries and the problem of ignorance
2. Incentive problems and institutional design

Market failure is actually a thing. And it can be complicated: Kleinman and Teles, "Market and Non-Market Failures."

But so is government failure.  There is no reason to expect government action to be Pareto Optimal. 

The problem is that every flaw in consumers is worse in voters!

It could even be argued (I did!) that a "good" industrial policy is impossible in a democracy.

Book o'da week:  The Next American Economy: Nation, State, and Markets in an Uncertain World . 2022, Encounter Books.  by Samuel Gregg. 

If you have questions or comments, or want to suggest a future topic, email the show at taitc.email@gmail.com !


You can follow Mike Munger on Twitter at @mungowitz


Speaker 1:

This is Mike Munger, the knower of important things from Duke University Market failure, government failure and the problem of transaction cost in passing and enforcing laws A new twedge Straight out of Creedmoor. This is Tidy C. I thought they'd talk about a system where there were no transaction costs. It's an imaginary system. There always are transaction costs. When it is costly to transact, institutions matter and it is costly to transact, I do a kind of political science called public choice.

Speaker 1:

The origins of public choice are partly the dissatisfaction with the notion of market failure, which was something that economists had come up with in the 20s through the 50s, and the idea is still widely invoked today. Market failures are situations where decentralized exchange solutions differ from the ideal allocation of resources that would be selected by an omniscient benevolent despot. Now, in plain English, that means that potentially beneficial cooperation fails to happen, but it fails to happen by comparison to let me emphasize this an omniscient benevolent despot. Those aren't widely available, so the comparison that's being made might be unfair if that's the standard for failure, but what I have suggested is that let's keep that standard, but this time let's not compare markets with what an omniscient benevolent despot would do, but let's compare what government actually does to what an omniscient benevolent despot would do. But let's compare what government actually does to what an omniscient benevolent despot would do. And the answer is government fails constantly. So public choice tends to focus on government failures. There's two problems knowing and wanting, that is, do experts in government know what to do? And second, is there any reason to expect they will want to do that thing? Well, you may be tempted to say well duh, don't all real world systems fail compared to some imaginary omniscient benevolent dictator who strives for Pareto optimality? And the answer is sure. I've often called this the pretty pig problem. The pretty pig problem is when we look at just one of deeply flawed alternatives and say, well, that's terrible, we should do the other one, without considering that the alternative also has problems. So the real question is comparative which flawed system solves the problems of looking with two eyes, information and incentives relatively better in a particular context and addressing a specific problem? Now, there's a conceptually simple but practically vexing answer according to economic reasoning, and I've already described it, but I'm going to go into a little more detail.

Speaker 1:

Failures of complex social systems are defined with reference to the ability of a group of people to capture all of the potential benefits of cooperation. A system that succeeds in capturing all the gains from cooperation is called Pareto optimal after Vilfredo Pareto. So let's start at the beginning. Resources are always in the wrong place. That's one of the big themes of beginning. Resources are always in the wrong place. That's one of the big themes of this podcast. Resources are in the wrong place and the reason is that there are frictions. Frictions often take the form of transaction costs. People don't know it's difficult to arrange the exchange or movement or cooperation. But if you want something more than I want it and you can pay for that thing with a reliable currency, so that I'm actually better off, we could exchange and society is better even if there's no increase in the amount of stuff. So if I buy a car from you, you're better off without the car but with the money. That's what the money is for and I get a car that I want more than the money. So both of us find our situations improved. If we want to act together and the result makes us both better off, we could both contribute to mutual gain. Now, that's true in what we often think of as government settings.

Speaker 1:

In addition to that exchange of a car, suppose four of us live in a village, we could take turns standing watch over the village providing defense. That's an outcome that none of us could achieve on our own. No one of us would be able to and we wouldn't try to defend the entire village on our own. Many kinds of failure of rule, design or practice might block this collective action. That is, the four of us, because of transaction costs, might find it difficult to organize ourselves so that we could provide the common collective good of defense. This is one of the fundamental insights of Douglas North is that many political institutions are designed to solve problems of transaction costs, to solve problems of transaction costs. Now, maybe they do or maybe they don't solve it. But that's the reason that we have political institutions is to enable people to solve problems like. We'd all be better off if the four of us could organize some fair, legitimate system for providing defense of the village. But we're going to have trouble doing that unless we have the right kind of institutions. Many kinds of transaction costs, lack of enforcement of property rights, regulation or other impediments might block all kinds of transactions even though in principle we'd be better off if we could exchange. Now the exchange could be commercial, as in the car example, or it could be political, as in the mutual defense example. Both are examples of beneficial exchanges that fail to take place, meaning that we fail to achieve a Pareto optimum.

Speaker 1:

Now I should explain. When I say political, I don't necessarily mean state or coercion. Politics is negotiation, cooperation using non-market institutions. That's why public choice originally was papers in non-market decision making. So it's how can people achieve cooperative outcomes in settings that require non-market institutions? Doesn't necessarily require the state when I say political. So we should be careful about what. Public choice is an analysis of politics. But it doesn't require that the state is the one providing these services. It might be that might be the lowest cost solution. It doesn't have to be so. All of this suggests that failure defined in Pareto terms is a broader concept that's been commonly realized. So let me describe market failure and then I'll turn to government failure. So market failure is a situation where some rearrangement of resources would benefit everyone. Yet exchanges organized by the price system alone fail to achieve that. Resource rearrangement, rearranging resources to make everyone better off, is called a Pareto improvement, again after Vilfredo Pareto.

Speaker 1:

Four basic kinds of market failure asymmetric, information, externalities, natural monopoly and public goods. Now there's good discussions of those problems elsewhere, so I'm not going to say much about them. But suppose, just for an example, there's a problem of asymmetric information. Seller of a used car knows more than buyers about the quality of the car. Since the buyer can't tell if the car is good or a lemon, the seller can't sell a reliable car if she has one. Buyers are only going to pay the price of the lemon for any car. So anyone who has a good used car holds on to it that there's a market failure, that mutually beneficial transactions that could take place don't take place because no one is willing to pay more than the price of a lemon, because they can't tell the difference. In that case the existing situation is not Pareto optimal. Now, in previous podcasts I've talked about there are private solutions to this. There are warranties, there's brand name, but problems of asymmetric information, if they are big enough, sometimes are used to justify government or state intervention. We might think, for example, of the Food and Drug Administration because of the problem of asymmetric information in the efficacy and safety of drugs. That's market failure.

Speaker 1:

What about government failure? Many analysts see the failure of markets to achieve Pareto optimality and they say, well, government should do something, but that doesn't follow. State actors actually lack both the information the first eye that they would need to do the right thing, and they also lack the incentive the second eye to do that thing instead of something else. That's why you have to look at any system with two I's information and incentives. Government is not exempt from the knowledge problem and state employees are not immune to incentives.

Speaker 1:

So, beginning in the 1960s, public choice theory asked whether it was plausible to assume that government knows what to do and that government officials want to do that thing and not something else. And I mean assume, because the market failure advocates literally assume both parts without evidence or even an argument. In this view, government officials know everything and they want what is good for us, not what's good for them. Both of those assumptions omniscience and benevolence are required for the market failure approach to work, as it's usually stated Well. 10 years ago this month, my friend Bill Keech and I were sitting in a coffee shop in Holden Beach, north Carolina, working on a review article describing government failure as a way of understanding that the market of failure approach is misleading. Now Bill has since passed away, but the article was published in Public Choice the following year and it's had quite a bit of impact. But it's useful to summarize our conclusions on this 10th anniversary of putting that article together to help people understand that the problem of failure is more balanced in terms of markets and government than many advocates for regulation think.

Speaker 1:

In welfare economics, government failure is what happens when authorities can't fix market failures. But of course, governments are able to fail all by themselves and, frankly, on a scale that dwarfs market failures, for sheer social damage and human suffering. It's been estimated that total killing by the state or democide exceeds 250 million in the period since 1800. Still, just as most market failures are mundane, most governments don't resort to mass murder. Keech and I divided these more mundane government failures into two types failures of substance and failures of procedure. These failures have exactly the same nature as market failures. They're situations where available unanimous improvements in which literally everyone who'd be better off are missed. Two types of government failure substance and procedure. So let's look first at substance. So for many political theorists, the alternative to the state is the Hobbesian state of nature from Thomas Hobbes, since almost any political order, even the most repressive, is better for everyone than the state of nature.

Speaker 1:

Failed states are examples of substantive government failure. So a failure to keep order, to maintain property rights, including collective control, to solve commons problems, to maintain a reasonably efficient and fair judicial system, to maintain the value of the currency, the ability to borrow by avoiding excessive debt, those are all problems of substantive government failure. Now, by those standards, many large US municipalities are astonishing failures, and have been for years At the national level. The regulation of the financial system, the availability of a system for adjudicating disputes, stability of the currency and the credibility to secure modest interest rates on the debt, as well as an apparent incapacity to provide the basic state function of controlling the border, those have all been government failures for a decade or more. In every case, taxpayers would likely be willing to contribute more toward the cost of competent and effective law enforcement if it were available, but the state is unable to provide those services coherently, and so government failure is everywhere.

Speaker 1:

Second, not all government failures are substantive. Some are procedural and these are closer, in a way, to being analogs to market failure. So the fundamental political problem is the choice among Pareto Optima. What markets do is ensure that we're getting closer to a Pareto Optima, but we need to choose among Pareto Optima. A Pareto Optima is a situation where no individual can be made better off unless at least one person is made worse off. But there are many Pareto Optima. Suppose we're comparing two different Pareto Optima. Some people are going to be better off, some are going to be worse off. Now, in markets, the way to solve that problem is with bargaining and payments. I'm better off with the car, but you're worse off without the car. However, I can pay you for more than you value the car, and then we're both better off.

Speaker 1:

The fundamental political problem is the choice among Pareto Optima. The reason is that any decision that's Pareto improving will, in principle, be chosen by unanimous consent, but there are often two or more alternatives to the status quo, both of which are Pareto improvements but which differ in who would benefit from the change or what amounts to the same thing. The existing situation is a Pareto Optimum and an alternative Pareto Optimum has been proposed. By definition, the new alternative is going to make some people better off, but some people are going to be worse off. Which of the alternatives is better, in the sense that it would be chosen by an omniscient, benevolent despot? Now you might think that's a ridiculous standard, but remember that's how market failure is measured. We have to use the same ridiculous standard to measure government failure.

Speaker 1:

So Keech and I argued that government must somehow choose the best Pareto optimum, meaning that the utilitarian problem posed by the Kaldor-Hicks-Gitofsky paradigm is going to yield the maximum gain to the gainers, which must be larger than the losses to the losers. So that's cost-benefit analysis. The philosophical basis for it is Kaldor-Hicks-Gitowski compensation principle. But what it comes down to is you sum up the gains to the gainers. If the gains to the gainers exceed the losses to the losers, then we should do that new thing, because it should be possible for the gainers to compensate the losers.

Speaker 1:

Now it's possible to argue that this entire welfare economics approach is nonsense, because no one could identify the best of all possible worlds that way. Fair enough. But Keech and I said let's grant that it is possible to identify the optimal alternative, just as we assume that in market failure, the point is that government, the state, is unable to achieve that optimum that is generated by having an omniscient, benevolent dictator. So we're assuming, ridiculously, that the optimum is known. The question is will government action achieve that? And the answer is no, never. Government will never achieve that, which means that government always fails. This puts a different face on the question of market failure. So we look markets fail to implement the ideal solution that would be selected by an omniscient, benevolent dictator. We'll use government. Wait, government doesn't do it either. Now we're comparativists, now we have to look at two imperfect systems. So, even conceding the dubious claim about knowing the correct solution, government always fails to choose the optimal Pareto optimum.

Speaker 1:

So let's look at a simple example. Suppose we're looking to build a dam for flood control over a large reason. Now the dam is going to be financed out of general tax revenues. That means that everyone in the country is going to have to pay an equal amount for the dam. So the status quo A is the current world with no dam. The alternative is B, where the dam is built. Which one's better? Many people will benefit if the dam is built Flood control, electricity. Some people, though, will be harmed because they have to leave the farms, homes and villages where their families have lived for generations. If we just pay them the amount their land is worth, that's less than they're likely to want for their land, because it's special to them. So the point is A the world with no dam is a Pareto optimum and B the world where the dam is built is a Pareto optimum, but moving from A to B is going to benefit some people and harm others. Which one is better?

Speaker 1:

This is a standard kind of collective decision. We're going to have to decide in a group whether to build the dam or not. So, procedurally, governments have two main ways of answering this question democracy or technocracy. Democracy means that we're going to vote. Technocracy means that we're going to ask experts to add up the costs and benefits, and in fact the US often uses one or the other or some combination of those two. Which one will deliver the best solution?

Speaker 1:

Well, suppose, for simplicity, there's just five citizens making the decision. Three of them would like for the dam to be built, but given the costs of building, their preferences are only slightly in favor of building. But given the costs of building, their preferences are only slightly in favor of building. So they think we should build the dam, but they don't care very much about it because it's pretty costly and the dam wouldn't benefit them that much. Two of the citizens who are going to lose their homes are very, very much opposed to the dam. They have to pay taxes to have the dam built because taxes are coercive in that way and they don't want the dam to be built in the first place by a lot. Now, if we could account for the value that the citizens place on the dam two of them really, really don't like it and three of them are slightly in favor we would not build the dam. But that's not how democracy works, democracy, we just ask for a very primitive binary you for the dam or against it? Well, three of the people are in favor, two are opposed. We build the dam.

Speaker 1:

That outcome is Pareto inferior. B is Pareto inferior to A because the two citizens opposed to the dam suffer harms that exceed the slight benefits to those who favored it. So using majority rule or any voting mechanism is a procedural government failure. It will often choose the inferior outcome, the worst of the Pareto Optima. Well, what about technocracy? What about expertise? After all, experts should be able to solve this problem because they know everything. All they need is information about how citizens value alternatives A and B. But there's an information asymmetry problem. Remember, information asymmetry was a market failure. It's a government failure too. When the bureaucrats ask the citizens which alternative they prefer, there's an incentive to exaggerate the value of whichever outcome is preferred. If I prefer that the dam is built, I'll claim that I value it very highly, since it won't affect the cost that I pay.

Speaker 1:

Now Keech and I considered a total of five different possible procedures not just democracy and technocracy and we showed that each of them fails to reliably identify the optimal Pareto optimum. Now, commercial exchange was one of the five. But the point is, when we look at all the ways that we have for deciding among Pareto optimum, now, commercial exchange was one of the five. But the point is, when we look at all the ways that we have for deciding among Pareto optimum, all of them fail by that standard. So singling out markets as failing to be able to identify the optimal outcome is misleading. All procedures fail to identify the Paretoum. That means that market failure theory fails on its own terms to solve the essential problem of resource allocation because governments fail, also saying that market fail. Therefore, government is illogical.

Speaker 1:

Whoa, that sound means it's time for the twedge, this week's economics joke. This twedge is not really a joke, but it's quite funny and insightful. It comes from a 1955 article in the Economist by C Northcote Parkinson, who was then a professor of history at the University of Singapore. Here's what Parkinson suggested that we should think of as Parkinson's Law. It's a commonplace observation that work expands so as to fill the time available for its completion. Thus, an elderly person of leisure can spend an entire day in writing and dispatching a postcard to her niece. An hour will be spent in finding the postcard, another in hunting for spectacles, half an hour in a search for the address, hour and a quarter in composition, and 20 minutes for deciding whether or not to take an umbrella when going to the mailbox in the next street. The total effort, which would occupy a busy person three minutes all told, may in this fashion leave another person prostrate after a day of doubt, anxiety and toil.

Speaker 1:

Granted that work, and especially paperwork, is thus elastic in its demands on our time, it is manifest there need be little or no relationship between the work to be done and the size of the staff to which it may be assigned Before the discovery of a new scientific law, herewith presented to the public for the first time and to be called Parkinson's law. There has, however, been insufficient recognition of the implication of this fact in the field of public administration and government. Politicians and taxpayers have assumed, with occasional phases of doubt, but not very much, that a rising total in the number of civil servants must reflect a growing volume of work to be done. Cynics, in questioning this belief, have imagined that the multiplication of officials must have left some of them idle or all of them able to work for shorter hours. This is a matter in which both faith and doubt are equally misplaced. The fact is that the number of officials and the quantity of the work to be done are not related to each other at all. The rise in the total of those employed is governed by Parkinson's law and will be much the same whether the volume of the work were to increase, diminish or disappear.

Speaker 1:

The importance of Parkinson's law lies in the fact that it is a law of government growth based on an analysis of the factors by which the growth is controlled. The validity of this recently discovered law must rely mainly on statistical proofs. Of more interest to the general reader is the explanation of the factors that underlie the general tendency to which this law gives definition. The two laws are this First, any official wants to multiply subordinates, not rivals. Factor two officials make work for each other, so end of quote. The nice thing about that is that Parkinson recognizes why. It might be true that adding more bureaucrats won't mean that everyone will be idle doing nothing. They're not lazy. Most bureaucrats actually work really hard. The problem is that the task will expand to fit the amount of time that's available, which is Parkinson's fundamental law, and that means that if we add more bureaucrats, the size of the task itself is going to increase, where it will become a kind of black hole and take more and more resources. So we might add Parkinson's Law as a category of government failure.

Speaker 1:

It's time for Book of the Week. This week's book is the Next American Economy Nation, state and Markets in an Uncertain World. It's written by Samuel Gregg, came out in 2022 by Encounter Books and it's a little more optimistic and uplifting, making for a good summer read. So again, the Next American Economy by Samuel Gregg, published by Encounter Books. The next episode will be released on Tuesday, june 25th. We'll have a new topic, another book of the month, another hilarious twedge and more next week on Tidy C.