Government Failure

I can’t even count the number of articles and blog posts I’ve seen asserting that markets can’t work in health care.  Or that they work very imperfectly.  Or that they suffer from serious “market failure.”  In every case, the writer just assumes that government can remedy these problems.

Yet when Gerry Musgrave and I wrote Patient Power, we concluded that our most serious health care problems stem from bad government policies, rather than from markets failing to work.  In other words, “government failure” not “market failure” is the source of most of what is going wrong.

Why is our perspective so different from so many other health policy analysts?  I think the answer is:  the vast majority of people in health policy do not understand the concept of “government failure.” For example, health economist Austin Frakt, following Nobel Laureate Joe Stiglitz, produced a list of “market failures” in health care and in health insurance at his blog the other day. These include imperfect competition, unequal access to information, external costs and benefits for others generated by private activities, etc. He then offered this observation:

In principle, government intervention can increase that benefit (economic welfare) in such cases.  In practice and in some cases, it’s debatable.

How does Austin know that government “in principle” can solve these problems without a model of government decision making?  He can’t.  Moreover, it turns out that many of the factors alleged to cause “market failure” also contribute to “government failure.” In fact, in the political sphere their impact is much worse. Here is the bottom line: There is no model of government decision making in health care (and in most other areas as well) that shows that government will reliably improve upon the market. (At least a real market.)

A model of government decision making is a theoretical structure that links public policies to the competing interests who help create them. There is no such thing as a pure dictator who can make decisions while disregarding the wants and wishes of everyone who is governed. Like the marketplace, political systems are complex systems in which the final outcome is dependent on complicated interactions of millions of people. A realistic model of government is one that recognizes that people can do things to influence what the government does:  vote, contribute to election campaigns, offer bribes, offer military support, form coalitions with others, etc.

When economists talk about “market failure” they begin with a model in which consumer welfare is maximized. “Market failure” arises when imperfections cause outcomes that fall short of the ideal.  If we were to do the same thing in politics, we would begin with a model in which the political system produced ideal outcomes and then consider factors that take us away from the ideal.

But here is the problem:  whereas in economics, “market failure” is considered an exception to the norm, in politics, “government failure” is the norm.  In general, there is no model of political decision making that can reliably produce ideal outcomes.

Let’s take an example.  Economists believe that an in an ideal market, price will equal marginal production costs.  On the buyer side of the market, people will continue to purchase a good until the value of the last unit acquired equals the price they have to pay. On the seller side, producers will continue to produce goods until the cost of the last unit produced equals the price they can sell it for.  The end result is optimal output.  The value of the last unit produced to consumers is exactly equal to the cost of producing it.

Now suppose we let government dictate the output level and allow consumers and producers to influence the decision through votes, campaign contributions, bribes, etc. Assume consumers always want higher levels of production (making the market clearing price lower) and producers generally want less output (making the market clearing price as well as profits higher). Is there any political system (majority voting, other types of voting, politicians selling their votes at auction, etc.) under which government will make the ideal decision? Answer: No.  Ideal outcomes are virtually impossible.

How do I know that?  Because I can state a general principle that has to hold to get ideal outcomes: The political “prices” that consumers and producers are willing to pay to get a dollar of benefit must be exactly the same.  And this is true regardless of the “political currency.” The currency could be guns, (military effort), money (campaign contributions), votes on election day, or something else.

Imagine that the parity did not exist. Suppose that producers (as a group) were willing to pay 20 cents to get $1 of extra profit and that consumers (as a group) were willing to pay only 5 cents for each dollar of consumer satisfaction they derive. Then political decision makers will be tempted to impose $4 of cost on consumers in order to create $1 of extra profit for the producers.  (The reason this is socially bad is that, summing over both groups, society as a whole is $3 worse off.) With parity, however, competing interest groups communicate through their bids that $1 of benefit is equally valuable, regardless of who gets it. Then and only then will we get optimal public policy.

Why, you might ask, would producers only spend 20 cents of effort to get a dollar of reward?  Why would consumers only spend 5 cents? The answer is: policy changes don’t benefit or penalize people as individuals; they affect whole groups of people. Each consumer, for example, benefits from more output and lower prices whether or not he contributes to the effort to change the policy.  So as individuals, we will be tempted to free ride on the efforts of others and not contribute anything unless we think our personal contribution will decide the election or put a legislative proposal over the top.

Despite complaints about the enormous amounts of money spent on elections, we all tend to understate our interest in policy questions in the way we reward politicians we like and punish those we dislike.  This understatement for most people is quite large.  In general, the signals we give to politicians are very imperfect representations of our true interests and these imperfections vary radically from group to group and market to market.

Phil Porter and I have shown that these principles are generalizable. In order to get an ideal government budget, for example, the political price offered by the beneficiaries of any one spending program must equal the price offered by the beneficiaries of every other spending program and these, in turn, must equal the political price taxpayers are willing to pay to keep an extra dollar of their earnings. Yet equality of political prices is an impossible condition.  There is no way we can reasonably expect producers and consumers in every market to make equal (marginal) political efforts.  Nor is there any reason to expect that beneficiaries of every spending program will make the same (marginal) political effort or that their effort will equal the effort of taxpayers who resist more spending.

Even more discouraging, Phil and I have shown that small differences in political prices will produce political waste and inefficiency far greater than the inefficiency that private markets are thought to contain.

Interestingly, Austin Frakt has written eloquently about what can go wrong in politics. But like so many others, he does not seem to see that what goes wrong is “government failure” and that failure is conceptually no different from “market failure.”

Nothing follows from the fact that there is “market failure.” To make the case for transferring decision making power to government one would have to show that the likely “government failure” would be less harmful.  In health care, that’s hard to do — particularly given the track record of government in health in the twentieth century.

Overall, the market and the government have comparative advantages in certain areas and the sphere where government has a comparative advantage would appear to be very small.

Comments (25)

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  1. Ken says:

    Excellent. Exactly what is needed to offset the “market failure” crap.

  2. Vicki says:

    Very clear. Very interesting. Makes sense.

  3. These are eye-opening ideas to this non-economist. Are they generally accepted by some large group of economists? Has anyone won a Nobel Prize for such insights?

  4. Devon Herrick says:

    In graduate school when I took classes on theories of political economy, there was a saying that the most efficient form of government was one controlled by a competent, benevolent dictator. However, the retort was the dictators rarely remain both competent and benevolent.

  5. John Goodman says:

    Bob: Thanks for that thought. Great idea.

  6. Greg Scandlen says:

    Fascinating analysis. I would add the point that “market failure” in health care is the result of government intervention, beginning with state licensing of medicine in the early 20th century. Every intervention since then has been trying to correct for the original intervention. We see the results in our current failed system.

  7. Joe S. says:

    This is excellent. Should be required reading in every health econ class.

  8. Al says:

    “whereas in economics, “market failure” is considered an exception to the norm, in politics, “government failure” is the norm.”

    Government failure can also be described as not getting reelected. Thus you have aptly stated the problem as which politician is going to be more successful? The one that destroys the system by promising all the healthcare that everyone wants or the politician that says healthcare is not a problem to be micromanaged at the federal level?

  9. John Seater says:

    At least some kinds of market failures are less of a problem than government failures because markets strongly tend to correct the market failures over time through technical progress. Many market failures create an incentive for innovation to relieve the failure. For example, many enterprises that once were natural monopolies have ceased to be monopolies because of inventions: telephones, television, and railroads are examples. No such incentive exists to fix government failures because by law government is and always will be a monopoly. Government faces no threat of entry by competitors to induce it to behave efficiently.

  10. Simon says:

    From the perspective of a public administrator, government failure is considered to be a failure to produce the goods and services “expected”, or when they are produced inefficiently or not equitably. As Dr. Goodman points out one major driving force in the role of government and how it delivers goods and services is public choice or “price offered”. To determine this price, politicians can view citizens as stakeholders, customers with individual choice, or as large groups trying to meet the needs of the majority. How government views citizens changes the paradigm of how government acts, and ultimately how it intervenes.

    In true market failure, government can regulate to simulate market forces or take over production. However, it is common that government intervenes too quickly or too invasively, preventing markets to function, and can cause additional negative externalities. This is commonly a knee-jerk reaction to public choice.

    In the world of Woodrow Wilson and large government, efficiency is theoretically maximized, but only because the goods and services produced were one-size-fits-all. As it turns out this paradigm wasn’t efficient. Throughout the 70’s to the late 90’s citizens were considered “customers”, as government stepped back from production and contracted for services. Government lost a portion of power, but this platform allows “price offered” to close the gap on marginal costs. Do people want choice in health care, or should health care be run like the DMV?

    I suggest watching the movie Brazil (1985), and think about it in regards to healthcare.

  11. Erik says:

    A market failure occurs when there is not a meeting of the minds of those involved in the activity.

    In health care that would entail being treated for an illness or injury without the cost of treatment or lesser alternatives being discussed by those involved (doctor and patient). This would lead to doctor’s greatest fear. Performance based on the highest quality at the lowest price point available.

  12. Joe S. says:

    Erik, what you are describing is an error. That is not the same thing as a market failure. The latter means there is some incentive flaw that makes things go consistently wrong.

  13. Virginia says:

    I think the biggest PR problem that libertarians have is convincing people that the problems with big corporations are caused by government regulations that give corporations unfair advantages. It’s easy for people to say, “Those greedy insurance companies!” But, most of the problems we have with insurance are the result of governmental interventions.

    My husband and I try to explain this all the time: If you own a big company and you can’t come up with any good innovations or products, then your only means of competitive advantage is to change regulations in your favor.

    If the public could understand just this one idea, then we’d be in a much better position to argue for free market health care.

  14. Interesting article. I agree that there are some fundamental issues with the government having power to regulate the markets in this sense. Health lobbies have the ability to manipulate the market through political contributions, etc. In addition, with the lack of transparency in services/prices and third-party (ie: government/insurers), patients have lower purchasing power. At the same time, with health being somewhat inelastic its hard to believe if there were no third parties that health services would become cheaper. Wasn’t the point of health insurers (HMO, PPO) to mitigate risk/cost to a large population and have the bargaining power. Should insurers instead be “non-for-profit, instead? HSAs have been brought up as a way to attain patient power again. However, in scenario like chronic care patients what would be the model?

    I think an HSA should be set up for all (partially funded by government nonrisk items.. dental, vision, checkups etc. But require catastrophic coverage for the rest (chronic diseases).

    All in all, health care is very costly and so far all countries have trouble with spiraling costs, we need something different.

    BTW, I’ve been reading your blog for a while now, first post.

  15. John Goodman says:

    @ Timothy

    Good post. Prices are lowest and health care inflation is lowest in precisely those health markets where the third party payers aren’t: cosmetic surgery, lasik surgery, walkin-in clinics, medical tourist facilities, etc. You don’t need anyone to bargain for you in competitive markets.

    @ Virginia

    In a previous post I compared auto insurance with health insurance. I won’t repeat eveything here, but the key point was that insurance works reasonably well unless regulators prevent it from working.

  16. Kent Lyon says:

    Today I saw an elderly patient with severe osteoporosis. She has not yet had any fractures. I had prescribed Forteo (a parathyroid hormone analog) that is the most effective treatment currently available for osteoporosis. It also avoids the potential problems associated with Bisphosphonates (Fosamax, Boniva, Actonel, Aredia) such as osteonecrosis and a rare type of femoral fracture (a not yet proved complication). Forteo is expensive ($10,000 a year vs. up to $1800 a year for Boniva) and is administered by injection daily for a course of two years. As an endocrinologist, my professional opinion is that it is unconscionable to treat with a bisphosphonate in this patient. Nevertheless, her part D intermediary carrier refused coverage for Forteo “until she fails on a bisphosphonate”. That means they won’t cover Forteo until the patient experiences fractures on a Bisphosphonate. Alternatively, they might allow forteo if over 2 years the patient doesn’t show improvement in her osteoporosis on followup bone density testing. Her osteoporosis is so severe she has a very high risk of fracture over the next two years (that risk would be reduced by a bisphosphonate, but remains high). My professional approach would be to treat her with forteo for the standard 2 year course, which would optimize her early therapy and most reduce her fracture risk over that time, with the lowest risk of adverse side effects such as osteonecrosis. If the patient were to experience a hip fracture, her mortality risk would be 50% within the first 6 months of the fracture. Women (and men) die from hip fractures related to osteoporosis. In my opinion, it is unconscionable to treat the patient from the outset with a bisphosphonate. The insurance carrier intermediary for her Medicare part D is substituting their financial benefit for my medical judgement and the patient’s well-being. They will claim there is no justification for my approach. I would disagree.
    My hands are tied unless the patient is willing to pay out of pocket for the Forteo, which she is not in a position to do. Is this a case of market failure? Or government failure? This is, in effect, a potential death panel decision allowed by Medicare via part D for this patient. Is this the type of medical care your readers want for America.
    (An alternative treatment that has recently become available for osteoporosis is Prolia, a monoclonal antibody that targets osteoclasts to reduce bone resorption and is given by subcutaneous injection twice a year. Any guess as to whether the Medicare intermediary will allow this alternative therapy?).

  17. John Goodman says:

    Kent, I think you are giving us a scary picture of what its like to practice medicine under managed care.

  18. @John Thanks for the response. Agreed those are great examples for lower care. However, is it a safe bet to believe that it would to extend to emergency situations though?

  19. Frank Timmins says:

    Kent’s post is most intriguing because it presents an example of the conflicts of healthcare policy between economic and moralistic values. While Kent’s example is not an obvious and immediate life/death situation, it is a more of a real world everyday sort of eventuality.

    It is, as John Goodman notes, an example of the problems of managed care. At the same time it is something that those of us supporting free market solutions should not ignore.

    Is this not a microcosm of the healthcare debate? If so, let’s make it a simple consideration. Pharmaceutical research comes up with a new improved (potentially life saving) drug. It would never have happened had the pharmaceutical company not been able to expect profits from its efforts. In other words, without profit potential the drug would never have been invented (at least not for many years). This is economic reality.

    Now that the drug is in existence the morality factor comes into play. If the Pharmaceutical company is rightfully allowed to charge what it pleases for its property, and the person who needs it to sustain life cannot pay for it, should someone else be “required” to pay for it?

    No one seems to want to answer this question in the political arena of the healthcare debate. IMO there is a clear answer that we have to start with and convince others not only of logical validity of the answer but that its reality does not condemn half the population to death or ill health. I am not trying to over-simplify a complex problem. Insurance, welfare and other forms of secondary considerations offer solutions as well as complexity, but all the discussion over the use of these tools masks the basic question that has to be answered in order build consensus to find the right solutions.

    Of course the operative word in the question is “required” and the obvious answer is NO. Can’t we just get that simple concept accepted as a basic tenet? Then we can let the caveats and modifications come into play.

    To answer Kent’s question, the failure is our reticence to address the basic question before trying to find solutions that equally accommodate all interests.

  20. Linda Gorman says:

    Suppose Dr. Lyon’s patient had a medical savings account rather than Medicare Part D and that after 40 years of saving that account had sufficient lifetime savings to allow her to have a very large deductible (say $200,000) for a policy that would cover both medical and long-term care costs once the deductible was reached.

    She would be able to make an informed decision in concert with Dr. Lyon, one that balanced the risk of fracture, disability, and potential long-term care costs, with the cost of the drug.

    Medicare worries only about the drug cost as it does not cover the long-term care that results from the disability created by the fracture that it chose not to prevent.

    Just another case of government policy failure.

  21. John V says:

    Yes.

    In short, economists view markets stringently and government charitably. Markets must be a perfect “10″. Government needs to simply be there.

    I once read that social theorizing untethered from economics is daydreaming. I’ll take that a step further and say that economic policy untethered from public choice theory is daydreaming as well.

  22. Doc Merlin says:

    ‘Bob Blandford says:
    February 23, 2011 at 8:52 am
    These are eye-opening ideas to this non-economist. Are they generally accepted by some large group of economists? Has anyone won a Nobel Prize for such insights?’

    “Are they generally accepted by some large group of economists?”
    By those that actually bother to read what they are, yes. However, most economists just treat the government as a magic black box where taxes flow in and unicorns and pixie dust flow out.

    “Has anyone won a Nobel Prize for such insights?”
    Yes, Buchanan did in 1986.

  23. Robert Kramer says:

    John,

    It is not the governments failure, it is not the privater sectors failure. What is really wrong is that the economic model is terribly flawed, and no matter who ends up with the responsibility, it will never work. I will be more than happy to discuss this with you further.

    -Dr Bob Kramer

  24. Mark says:

    I linked to this from David Henderson at EconLog. Excellent article.

    I think it extends well beyond healthcare.
    So many on the left take this approach: identify an issue; show two proposed solutions; attack the one you don’t like; leave your own unexamined; declare it the winner.

    It’s a very simple and effective response to simply turn that around, as you do.