When markets aren't perfect, government can help

In response to a question about economic theory and its role in the financial crisis, Nobel Prize-winning economist Joseph Stiglitz said:

"The strange thing about the economics profession over the last 35 year is that there has been two strands: One very strongly focusing on the limitations of the market, and then another saying how wonderful markets were. Unfortunately too much attention was being paid to that second strand."

Even worse, those who have pointed out the markets' limitations have often been attacked as anti-market, against capitalism or favoring large government. That' a mischaracterization of this point of view.

Perfectly competitive markets have attractive features. They deliver goods and services to consumers at the lowest possible price, use resources efficiently and respond flexibly to changes in tastes and technology. And they do this without any need for a government central planner to direct their operation.

But no market is perfectly competitive. All fail to one degree or another to live up to their promise.

When government steps in to try to correct these market failures -- breaking up a monopoly, regulating financial markets, forcing firms to pay the full cost of the pollution they cause, ensuring that product information is accurate and so on -- it's not an attempt to interfere with markets or to serve political interests. It's an attempt to make these markets conform as closely as possible to the conditions required for competitive markets to flourish.

The goal is to make these markets work better, to support the market system rather than undermine it.

Most people understand that too much monopoly power is a problem, that financial markets need some degree of regulation to prevent fraud and to insulate against financial crashes. And it's widely agreed that companies need to be prevented from creating pollution that can impose costs on society. Similarly, the need to regulate natural monopolies such as the utilities that deliver water and electricity is broadly accepted.

In other cases, it's less well understood that failure is the reason for the government to regulate a market, or even provide the goods and services itself. Social security and health care come to mind. But once again, the private sector's failure to deliver these goods at the lowest possible price, or to deliver them at all, is at the heart of the government's involvement in these markets.

Retirement savings suffer from a problem economists call "moral hazard" -- people who don't save enough, or anything, for retirement because they know a compassionate society will provide enough to serve their basic needs. The solution to this problem is to induce them to save some of their paychecks each month so that, even if that savings doesn't fully cover their retirement expenses, at least they'll contribute something.

That's what Social Security does. It provides a mechanism that forces people to pay for their own retirement instead of relying on the goodwill of society to bail them out when they can't afford the basic necessities they need to survive.

Health insurance markets also have well known market failures. The first is, once again, moral hazard, and it's similar to the moral hazard problem in retirement insurance markets. People know that a compassionate society will care for them if they break an arm, contract a life-threatening disease or have some other severe health problem. They can always go to the emergency room at society's expense, and for that reason many will choose to go without insurance.

A solution to this problem is to force everyone to buy insurance and contribute to the care they get. That's what Obamacare does.

The second health insurance problem is known as "adverse selection." This is an information problem that arises because people know more about their own health than their insurance companies. And that makes it difficult for insurance companies to sort people into pools with premiums that match their expected health costs. If they charge enough to cover the high-cost patients, the healthier patients tend to drop out, leaving only the most expensive and unprofitable patients in the market.

A way to overcome this problem is to create large pools that prevent people from hiding their health conditions and then choosing low-cost policies and then getting expensive care. And you can force insurance companies to cover everyone (preexisting conditions or not). These are also features of Obamacare.

Health care markets have other problems as well, such as patients not knowing enough about treatments to be informed consumers. But government regulations or, as in most other developed countries, government-managed health care systems, can help to make these markets work better.

Conservatives tend to have more faith in the ability of markets to self-correct when problems exist, and less faith in government's ability to step in and fix market failures without creating even more problems. Honest differences on this point are likely, but there are certainly cases where most people would agree that some sort of action is needed to overcome significant market failures.

However, when ideological or political goals (such as lower taxes for the wealthy or reduced regulation so that businesses can exploit market imperfections) lead to attacks on those who call for government to make markets work better -- often in the guise of getting government out of the way of the market system -- it undermines government's ability to promote the competitive market system the opponents claim to support.