Adam Smith and "Market Failure" Fixers

system of natural liberty free market public works public goods government intervention market failure

Jason Briggeman for AdamSmithWorks

Smith did not intend for us to view the system of natural liberty as an ideal system; he himself advocated some interventions...Some government actions sacrifice the ordinary laws of justice to an idea of public utility, and some of those actions ought to be taken.

February 16, 2022
Among the higher purposes of economics is to delineate actions or roles that the modern state should and should not take on. Over generations, economists have produced a massive discourse toward such purpose. To join and participate in this discourse today, as an economist, is to have learned and bought into ideas or modes of thought that have become fundamental to the discourse. Specifically, economists writing on the role of the state might be said to agree both on a presumption or starting point for the discourse and on the acceptable forms of argumentation that participants in the discourse may bring to bear.
The starting point for the economists’ discourse on the role of the state can be traced at least to Adam Smith. Smith put forward “a strong presumption against government activity beyond its fundamental duties of protection against its foreign foes and maintenance of justice.”2 A presumption in favor of a principle places the burden of proof on those who propose contravention of the principle, as the presumption of innocence places the burden of proof on the prosecution. Smith illustrated the presumption by placing two broad rationales for government action in tension with one another, e.g.,
To hinder, besides, the farmer from sending his goods at all times to the best market is evidently to sacrifice the ordinary laws of justice to an idea of public utility, to a sort of reasons of state; an act of legislative authority which ought to be exercised only, which can be pardoned only in cases of the most urgent necessity.3

Smith’s “system of natural liberty”—being devoid of “extraordinary encouragements” and “extraordinary restraints” to any “particular species of industry”4—is essentially equivalent to contemporary economists’ notion of ‘the market system’ (or ‘free market’). Economists implement Smith’s presumption for liberty by requiring justification of ‘interventions,’ i.e., governmental actions aimed at effecting some broad alteration to the market system. Interventions are those instances when “the ordinary laws of justice” are sacrificed to “an idea of public utility.”
The system of natural liberty is not tantamount to anarchy; Smith explained that, within the system, “three duties of great importance” attach to government. Furthermore, while the first two of these duties were national defense and the administration of justice, the third was that the sovereign is charged with
...erecting and maintaining certain public works and certain public institutions which it can never be for the interest of any individual, or small number of individuals, to erect and maintain; because the profit could never repay the expence to any individual or small number of individuals, though it may frequently do much more than repay it to a great society.5

So, Smith allowed that provision of “certain” public works and institutions was within the scope of the system of natural liberty. A fire department is an apt example. Smith taught his law students, right at the beginning of his course, that government provision of “the security of the inhabitants against fires, or other such of too trifling a nature to be reckoned a branch of jurisprudence.”6 No sense debating the obvious.
Furthermore, Smith did not intend for us to view the system of natural liberty as an ideal system; he himself advocated some interventions. Smith states openly, when endorsing one particular restriction on the issuing of banknotes, that he was thereby endorsing “a manifest violation of that natural liberty which it is the proper business of law, not to infringe, but to support.” He proceeds to affirm that “those exertions of the natural liberty of a few individuals, which might endanger the security of the whole society, are, and ought to be, restrained by the laws of all governments.”7 Some government actions sacrifice the ordinary laws of justice to an idea of public utility, and some of those actions ought to be taken.
If the system of natural liberty wasn’t supposed to be an ideal, then why did Smith articulate it? The system has value for us because it is “obvious and simple”—the three duties of government under the system are “plain and intelligible to common understandings”8—and therefore the system can serve as a benchmark or vantage point, as a starting point for discourse. Our puny human brains can, without too much trouble, wrap themselves around the system. We can do this because we each have some strong understandings of what are considered to be proper relationships between people and things, which is to say, of proper-ty, and that there are proper and improper methods of bringing about a rearrangement of the proper relationships. When we enter another’s room, we experience only a little uncertainty about what it would be proper and improper for us to do with regard to the objects in the room. It is doubtful you have ever, as an adult, tried to take home a nice chair that you saw in a friend’s house. We are schooled to understand that asking for such a chair would be proper, offering to buy it is proper, and even bringing a lawsuit would be proper, though aggressive and rude or hostile. Even when we believe some object is properly ours, when we also know that others do not believe that is the case then we understand that simply taking the object is improper, and we must resort to the proper methods of bringing about a rearrangement of the proper relationships, i.e., we must pursue—properly!—a situation of concurrence with others that the object can now be properly ours. Whatever extent those strong understandings come from nature or nurture notwithstanding, those understandings—these beliefs that there are proper and improper actions a given person can take with regard to the things in the world—are generally shared, and thus can be drawn upon as a basis to begin discourse about economic policy.
By contrast to the system of natural liberty, the status quo—the way things are—cannot be apprehended in any amount of time. The status quo is an immensely complex empirical reality, and our wee brains cannot grasp or say much of anything sensible about it even after decades of study, let alone weeks or hours. The status quo policies of the United States federal government, say, would serve very poorly as a presumed basis of sufficient common knowledge by which one would expect to connect with a reader, student, or friend and therefore begin a conversation about good or ideal public policy. It is far easier to understand what the government under the system of natural liberty would do in some situation than it is to understand what the United States federal government would do.
Even so, the system of natural liberty does not give us a precise line between ‘the market’ and interventions. What it offers is more the ability to say: some government policies are clearly not interventions, some are hazy, and some government policies clearly are interventions. And this gives us a guide for allocating the limited time we have in life for evaluating public policy: we should demand and supply justification for those interventions that are pursued or proposed, and not spend time doing so with regard to government duties that are simple and obvious.
In the economists’ discourse, the acceptable forms of argumentation that may be brought forward to justify an intervention are variations on the theme of ‘market failure.’ A claim of market failure is, essentially, a claim that Smith’s “system of natural liberty” must fail in some substantial and particular way to bring about good results, though here good can mean either comparatively better or notionally ideal. Sometimes, an economist’s talk of market failure implies she has attempted an analysis in comparative systems: the market is said to fail because it is deemed not as good as some alternate arrangement, viz., a system that incorporates remedial interventions. But economists are also apt to use ‘market failure’ to denote the failure of the market to achieve certain perfections that are given meaning by a model, metaphor, or allegory. In the latter usage, the failure is more fairly described as absolute than relative, and therefore it does not equate to a case for intervention. This latter usage is the one in play when an economist says that the existence of multiple market failures leads him to advocate the acceptance of a “second-best” scenario.9 This usage is also generally in play whenever an economist speaks both of market failure and of ‘government failure,’ the latter consisting of substantial and particular ways in which interventionist systems fail to bring about ideal results.
An economist’s judgment on the desirability of an intervention, then, should be consonant with her views on the relevant market failures. An intervention can only be judged desirable if either:
  1. the market is said to fail relative to that alternate arrangement where the intervention has been imposed, or
  2. the market is said to fail because it does not achieve certain perfections and the intervention is expected to bring the market closer to those perfections.

Unsurprisingly, yet importantly, under both of these standards the effects of the intervention itself are part of the rationale. This is merely an operationalization of the idea that pointing out an imperfection in some state of affairs does not mean it is easy, or even possible, to reach a superior state of affairs.10 A judgment in favor of an intervention therefore should be founded upon supporting argumentation that the intervention itself—viz., the policy being proposed as a remedy to the market failure—does lead to outcomes that are preferable to the situation where the intervention is not put in place.
On the foregoing reasoning, each extant intervention should be strongly connected, by economic argumentation and evidence, to one or more market failures. Consider, say, the suggestion that we should treat as justified a complete embargo on imports simply on the presumably true ground that American consumers are on average likely to know more about goods produced at a lesser physical distance from them than they know about the sources of goods produced further away. Such a suggestion should be tentatively rejected by the upholder of the presumption for liberty, who should immediately raise questions such as: What do we know about the magnitude of the knowledge difference? About the magnitude of the resulting costs (if any)? Who bears those costs? By how much would a complete embargo reduce or eliminate those costs? Does a complete embargo have other costs? What are the magnitudes of those costs and who bears them? What alternatives to a complete embargo are there? Does alternative #1 also reduce or eliminate the costs of the knowledge difference? Does alternative #1 have other costs? What are the magnitudes of those costs and who bears them? And on to alternative #2, and on and on. The demanding of such a robust chain of argumentation and evidence is the distinctively ‘economic’ method of contesting the implementation of sweeping interventions on flimsy grounds.
The requirement of a strong connection between an intervention and underlying market failure(s) does not mean that all proposed interventions must founder in the face of an endless stream of demands for evidence and comparisons against alternatives. It does mean that when contemplating a potential source of market failure, one should begin one’s consideration of possible remedial interventions with candidates such as: (1) the narrowest imaginable intervention that could plausibly redeem the failure and (2) the narrowest of whichever imaginable interventions are aimed at directly undoing the source of market failure. For if the narrowest imaginable intervention suffices to treat the failure, then no further search for superior alternate interventions is particularly necessary, at least for the time being (perhaps, in the future, as-yet-unimagined narrower forms of intervention could be evaluated). And the economic analysis of interventions that are aimed at directly undoing the source of market failure should be easier to conduct and communicate, and thus should be more convincing to audiences, than would be the analysis of interventions that do not directly address the market failure and as such almost surely require more extensive reasoning or evidence. So in the example where the potential source of market failure is that consumer knowledge of goods produced nearby is on average greater than that of goods produced far away, the first remediating interventions one should contemplate are those which, in the least obtrusive or costly fashions that one imagines to still be effective, aim directly at closing that gap.11 In my own imagination, the most obvious such intervention is the supplying of knowledge to consumers in those instances where such additional knowledge would most effectively reduce the relevant costs. It may be, of course, that one finds reasons that this intervention will not be worth implementing. But then one moves to an alternative that is less narrow or is aimed less directly at undoing the source of market failure.
In developing a judgment on alternative policies, even though the alternatives as they might be implemented in reality cannot be fully depicted or understood, one does roughly envisage or sketch their shapes and imagine oneself as being in position to choose among the sketched versions. One cannot quantify precisely the costs and benefits of the different sketches,12 most certainly not when the sketched institutions are very different from those prevailing under the status quo, but still a considered choice must involve the identification and weighing of pros and cons.13 A productive debate can ensue once rival parties achieve some concurrence on basic truths (or facts, insights, formulations) surrounding an issue and have assembled those basic truths so as to assess the central tradeoffs, i.e., the pros and cons that weigh most heavily. While there is no definitive and complete formulation of truths and tradeoffs, a good policy analyst surely aspires to gain a firmer and more intelligent (or powerful, enlightened, persuasive) handle on the issue.
The preceding is an explanation of how an economist may aspire to think about market failure and government intervention, but it is of course not a description of the way in which government interventions actually come to pass. The economist, trained in the above method, confronts the political environment of status-quo interventions, the historical causes of which are perhaps murky at best. Some economists may feel able and free to challenge, and possibly validate, the status-quo interventions with their findings using the ‘economic’ method.14 Some economists may feel constrained by politics or personal commitments; for example, they may believe that the ‘economic’ method provides the best policy ideas, yet they are concerned that their giving voice to some particular conclusion would undermine broader political values or reduce their own effectiveness in influencing events. And some may see the ‘economic’ method described above as importantly insufficient in some way that eludes explicit explanation; for example, they may presume there is some unarticulated wisdom in the political process that generated the status-quo interventions. Potentially, such non- or extra-economic thinking is partially valid and the ‘economic’ conclusion is in fact inadequate in some respect. But the aspiration to this ‘economic’ approach gives us a benchmark against which we can try to identify and discuss such departures. The ‘economic’ approach is in this way perhaps not unlike Smith’s system of natural liberty, which again is not an ideal system but which being “simple and obvious” gives the analyst a starting point for extended discourse.

Want to read more?
Is Market Failure a Sufficient Condition for Government Intervention? |Econlib

Adam Smith's Jurisprudence | Adam Smith Works 

  1. This essay is a revised and expanded extract from Searching for Justification of the Policy of Pre-Market Approval of Pharmaceuticals, my doctoral dissertation (George Mason University, Department of Economics, 2015).
  2. Jacob Viner (1927), “Adam Smith and Laissez-Faire,” Journal of Political Economy 35: 198–232, p. 219.
  3. Adam Smith (1976/1776), An Inquiry into the Nature and Causes of the Wealth of Nations, eds. R. H. Campbell and A. S. Skinner (Oxford: Oxford University Press), p. 539, emphases are mine.
  4. Smith (1976/1776), p. 687.
  5. Smith (1976/1776), p. 687.
  6. Adam Smith (1978), Lectures on Jurisprudence, eds. R. L. Meek, D. D. Raphael, and P. G. Stein (Oxford: Oxford University Press), p. 5.
  7. Smith (1976/1776), p. 324.
  8. Smith (1976/1776), p. 687.
  9. R. G. Lipsey and Kelvin Lancaster (1956), “The General Theory of Second Best,” Review of Economic Studies 24: 11–32.
  10. Harold Demsetz (1969), “Information and Efficiency: Another Viewpoint,” Journal of Law and Economics 12(1): 1–22.
  11. Wesley A. Magat and W. Kip Viscusi (1992), Informational Approaches to Regulation (Cambridge, Mass.: MIT Press), p. 4.
  12. Daniel B. Klein (2008), “Colleagues, Where Is the Market Failure? Economists on the FDA,” Econ Journal Watch 5: 316–348, pp. 339–342.
  13. Gordon Tullock (1995), “Thinking About Thought,” European Journal of Law and Economics 2: 119–125.
  14. Daniel B. Klein (2012), “The Forsaken-Liberty Syndrome: Looking at Published Judgments to Say Whether Economists Reach a Conclusion,” American Journal of Economics and Sociology 71(5): 1250–1272.