Market Failure and Factors of Production

Market Failure and FOP’s

There are facts that have gone unstated in recent, often heated or wild debates regarding both financial and health care reform. The first is that market failure is a concept enshrined even in the most conservative economics textbooks. The second is that the four most fundamental factors of production or FOP’s are land (resources), labor, capital and entrepreneurship (management, in some texts). Note that two of the four FOP’s required for all economic activity are, obviously, human agents.

Market failure includes, among other things, externalities both positive and negative. A negative externality is an external cost; that is, the cost of an economic activity that falls on third parties who were not involved in said activity. (Note that I paraphrased this definition from Ben Bernanke’s and Frank Rich’s 2002 text on microeconomics; page 278.)

The negative externalities that brought the global banking system to the edge of meltdown, caused bankruptcies and foreclosures, and resulted in worldwide recession were the work of management and workers in financial markets. To be more precise, entrepreneurial managers actually believed they had done away with risk by inventing the CDO (collateralized debt obligation) and the CDS (credit default swap), then convinced the thundering herd of cretinous lemmings on Wall Street and in Washington, D.C. that such financial instruments were perfectly legitimate and required little to no regulation – despite warnings from the likes of Warren Buffet, George Soros, Joseph Stiglitz, Paul Krugman, Noriel Roubini, Dean Baker, Simon Johnson, Nassim Taleb and many others. (Taleb was more than right, by the way.)

In other words, the failure of banking and related financial markets was caused by the two groups – entrepreneurs (or managers); labor (bankers, brokers, etc.) -- that are recognized by even the most conservative textbooks as basic factors of production in all economies. Those same textbooks also admit that government must intervene in markets to correct market failure through taxation and/or regulation. Yet the very same human agents who caused the negative externalities are now fighting tooth and claw against re-regulation of their activities. This is not just personal or corporate self-interest; it is madness. It would be hard to find or even imagine a more damning condemnation of neo-classical economic theory than the laissez-faire capitalism, little constrained by regulatory oversight and the rule of law, which caused meltdown and recession. Without accountability and strict oversight, it is all too likely that the human agents who caused market failure will do so again, as even The Financial Times and The Economist have warned repeatedly for well over a year.

After the bailouts, the risk of moral hazard is even greater because the managers of institutions deemed “too big to fail” can be highly confident that government will rescue them if similar market failures occur again. And don’t forget that most senior managers, brokers and speculators responsible for meltdown in the financial markets are still in their offices. Thus, the case for re-regulation and strict oversight is unassailable, as is the case for dismantling the titans thought too big to fail, which present the greatest risk of causing systemic failure. The fox guarding the chicken coop and all that.

In terms of the debate in the U.S. over reform of healthcare: It is a fact that healthcare markets have failed to provide coverage where it is most needed -- even and most egregiously when insured persons were all paid up on their insurance premiums. Hence government is obliged to intervene to correct the market failure; in this case, by providing a much-maligned “public option.” Opponents of that option rant against “socialized medicine” and rave against government intervention in healthcare markets. Apparently they have neither read economics nor understood that government is already deeply involved in all markets from healthcare to infrastructure to food.

Theory is straight-forward on this issue: A healthy workforce is essential to economic productivity, thus to economic growth and national prosperity. Labor and entrepreneurship are also referred to as “human capital.” They are the individual human agents who engage in and drive all economic activity. Hence an investment in healthcare -- in a healthy, productive workforce -- promotes economic growth and development. Supposedly “socialized” healthcare is actually a very practical, common sense investment in human capital that enhances economic productivity, just like investment in education. Full stop; end of debate. But that debate is based more on ideology than on economic theory or empiric reality. We must also recognize the corrosive effect of campaign contributions from the healthcare industry, which donates millions to the politicians who vote for or against healthcare reform. In short, institutional corruption. The same is true of Wall Street contributions to politicians in the House of Representatives, the Senate – and the White House. Again: corruption of the worst sort at the highest levels of government. (Call it what it is: bribery.)

In terms of government intervention, politicians and pundits who oppose it thunder on about “big government” or say “Let the markets solve the problem!” and “Get government out of markets!” This is laughable, even absurd, for the following reasons. One: markets fail or do not arise at all. Two: government prints the currency required for all economic activity. Three: only government can provide the rule of law necessary for economic activity, as well as the national defense and police forces that protect that law from enemies both foreign and domestic. Four: government rules, regulations and laws protect food and water supplies – albeit only somewhat effectively -- from contamination, thus helping to ensure a healthy, productive workforce. Five: the private sector will not provide infrastructure because private firms cannot maximize their profits by charging a toll or rent from each and every consumer who uses it. (Technically, the issues are non-rivalry and non-excludability of public goods.) Infrastructure is comprised of essential goods and services required for all economic activity: airports, seaports, roads and highways, railroads, water and sewerage, electrical grids, research and development, education, etc.

Sure, many governments have successfully privatized infrastructure, but in the vast majority of cases that infrastructure was first created by government. For example, the U.S. national highway system was created only in the 1950’s by the government of Dwight D. Eisenhower. The Internet was developed in the early 1960’s by DARPA, the Defense Advanced Research Project Agency, a military R&D lab.

So! For the rabid free market types out there, all one can say, simply, is “rubbish.” Or “nonsense.” Then confront them with market-distorting U.S. agricultural subsidies ($285 billion over ten years in 2008) and tariffs on imports. Then say “DOHA..” End of debate.

But that would demand more than the time of one or two commercials from ideologues or a TV-watching public. Oops -- I meant “workforce,” informed or otherwise.

Ned Boudreau teaches Economics and Theory of Knowledge in the International Baccalaureate Organization’s diploma program at Shanghai Pinghe School. He is a returned Peace Corps volunteer (Ghana, 1995-1997) who spent 20 years in the U.S. corporate sector.

word count: 1,116