David R. Henderson  

Market Failure or Market Success?

Who Likes Democracy?... Hugh Grant on Ends and Means i...

(I got back from Minaki, Ontario last night.)

The textbook I use for a Cost/Benefit Analysis course I teach is Public Finance, 8th edition, by Harvey S. Rosen and Ted Gayer. There's much good in that book. I particularly like their exposition about why most of health care and of education are private goods rather than public goods or goods with large positive externalities.

One part, though, that is off is their exposition of market failure on page 46, specifically, the idea that markets fail by failing to exist. Here's what they write:

After all, if a market for a commodity does not exist, then we can hardly expect the market to allocate it efficiently. In reality, markets for certain commodities fail to emerge. Consider, for instance, insurance, a very important commodity in a world of uncertainty. Despite the existence of firms such as Aetna and Allstate, there are certain events for which insurance simply cannot be purchased on the private market. For example, suppose you wanted to purchase insurance against the possibility of becoming poor. Would a firm in a competitive market ever find it profitable to supply "poverty insurance"? The answer is no, because if you purchased such insurance, you might decide not to work very hard. To discourage such behavior, the insurance firm would have to monitor your behavior to determine whether your low income was due to bad luck or to goofing off. However, to perform such monitoring would be very difficult or impossible. Hence, there is no market for poverty insurance--it simply cannot be purchased.
Basically, the problem here is asymmetric information--one party in a transaction has information that is not available to another. One rationalization for governmental income support programs is that they provide poverty insurance that is unavailable privately. The premium on this "insurance policy" is the taxes you pay when you are able to earn income. In the event of poverty, your benefit comes in the form of welfare payments. (bold in original)

But if monitoring is difficult (i.e., high cost) or impossible, isn't that a relevant cost to take account of in setting up a market? There's no market for people to repair $10 calculators. Does that mean that there's market failure? No. It means that the cost of repair is high relative to the cost of a new calculator. The absence of repairmen is not evidence of market failure. On the contrary, it's evidence of market success. The market has weeded out services that are not worth as much as they cost. Similarly, the fact that someone cannot monitor people at low cost suggests that the absence of poverty insurance is evidence of market success, not market failure.

Notice also how Rosen and Gayer jump from their claim of market failure to an argument for government to provide poverty insurance. They don't ever say that government can monitor at a lower cost. I doubt they believe that it can. And suddenly "poverty insurance" isn't insurance at all, but, rather, is a tax-and-subsidy scheme. Maybe this is why they use the word "rationalization" rather than "rationale." It surely is a rationalization. Also, note that they assume away the problem of monitoring when government is involved, writing, "The premium on this 'insurance policy' is the taxes you pay when you are able to earn income." By using the word "able," they make it sound as if when you're not earning income, it's because you're not able to. But, of course, that's a problem of monitoring. As they wrote in their first paragraph, when discussing the private insurance company, "the insurance firm would have to monitor your behavior to determine whether your low income was due to bad luck or to goofing off. " So, just like the private insurance company, the government would have to figure out whether you were able to earn income or unable to earn income.

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CATEGORIES: Political Economy

COMMENTS (26 to date)
Ieremius writes:

Actually it did strike me that there is at least one example of insurance against becoming "poor." College athletes that show tremendous promise can purchase insurance against career ending injuries. The difference here, of course, is that it is easy to monitor such injuries; precisely the point made in the post and text.

El Presidente writes:

What if people could afford to purchase poverty insurance in private markets? Well, then they'd have enough money that they wouldn't need to purchase it. That's the real problem underlying the analogy.

It's a question of priorities and goals. Markets allocate based on private profit, not public good (i.e. the General Welfare). These don't have to be mutually exclusive, but they are distinct. If we have priorities and goals that cannot find private profit then a market, the way we understand that term, will not exist spontaneously. If we subjugate all of our priorities and goals to profit, are we better off or worse off? If we are worse off, then we need something besides unfettered markets in order to maximize quality of life for all.

I would prefer to think of the example offered, "poverty insurance" (or it's real counterparts: welfare and unemployment benefits), not as a case of market failure, but as a necessary compliment to markets in a society that is concerned with the wellbeing of all. I agree with the Libs in theory that this is a misapplication of the term "market failure". It is not a failure of competition, per se. Its absence would not be market failure but rather social failure. It is the elevation of private material profit above the wellbeing of at least some; the pursuit of maximum aggregate output per capita at the expense of human consideration, resulting in the failure to attain the best of either.

gabriel rossman writes:

it actually seems like the problem with a hypothetical private market for "poverty insurance" isn't asymmetric information at all but moral hazard and/or time inconsistency. that is, unlike an automobile that has a latent but static propensity to break (ie, the "lemon" problem), a human being's propensity to become unemployed, indebted, divorced, chronically intoxicated, or any of the other myriad risk factors for poverty is sensitive to incentives, and one of these incentives would be insurance. thus the insurance makes more likely the behavior is insuring against, which is moral hazard. it is only an asymmetrical information problem to the extent that such defection is foreseen (by the applicant but not the insurer) but nonetheless unavoidable.
in other words, it's an asymmetrical information problem if the applicant knows he is about to be laid off, or has a degenerative illness that will soon make work impossible. however so long as the applicant's future behavior is contingent on the policy being awarded then it's moral hazard, not asymmetrical information. since they refer to "monitoring" rather than "screening" it's clear that their model is actually a moral hazard problem.

E. Barandiaran writes:

I used to teach Welfare Economics with a focus on cost/benefit analysis. I have never used a textbook that argued that markets fail by failing to exist. The authors of any textbook supporting this idea have no idea of what a market is; enough reason to show them a red card. I used to teach that many markets do not exist in the sense that either the price or the quantity would be zero (when price=0, the quantity actually transacted is usually considered as a gift; when quantity=0, all we can "observe" is the "high" price at which some people will be willing to offer some positive amount but we know that there is none willing to pay that price). The purpose of teaching these two extreme situations was to explain how markets emerge by shifts in either the demand or the supply curve or both curves.
You're right to point out how ignorance of some costs may lead some economists to draw wrong conclusions. Actually one of the main reasons to teach cost/benefit analysis is to help students to develop skills to both identify and evaluate ALL costs and benefits. As we know from policy debates, the most common mistake is to ignore some costs and/or benefits.

forager writes:

Definitely an important point. My jaw hit the floor when the NY Times posted a front-page story about the "market failure" that no unemployment insurance could be purchased in the private market. It was clearly their attempt to convince people how the insurance companies and insurance market are inefficient, corrupt, mean, etc. (as in, hint hint, healthcare companies). It was no surprise that almost immediately in the comments people started using it as "evidence" against private health insurance.

David Henderson: 1
New York Times: 0

Blackadder writes:

The market failure in this case is the existence of asymmetric information. This causes the market not to function properly (or exist at all, as in the case of poverty insurance). A market failure is not a failure of a market but a failure for there to be a (complete) market.

Colin K writes:

Short- and long-term disability and workman's comp are all forms of market-based insurance against unexpected loss of productive capability.

Besides accidents, illness, and on-the-job injuries, what sort of poverty-causing events could we try to insure against?

1. Business cycle variations
2. Rapid obsolescence of skills
3. Extreme deterioration of regional economy
4. Catastrophic devaluation of financial assets

The real issue, which is seen frequently with state Unemployment Insurance trust funds, is that the government wants to underprice the cost of insuring against these risks.

If I was insuring against (2), I would likely require the insured to take regular training and perhaps raise rates if they stay at the same employer for more than X years without being promoted. In other words, it would be regressive.

If I was insuring against (3), I would probably offer to cover the cost of moving rather than providing any sort of open-ended income stream. The best thing the government could do for anyone who is currently unemployed and living in Michigan would be to pay for them to relocate to Texas.

As for (4), you need to consult the Tooth Fairy because otherwise, you're back to the old conundrum of the price of a riskless asset.

David R. Henderson writes:

El Presidente writes:
What if people could afford to purchase poverty insurance in private markets? Well, then they'd have enough money that they wouldn't need to purchase it. That's the real problem underlying the analogy.

That doesn't follow at all. You try to insure against a state you're not in, not a state you're in.

El Presidente writes:

David R. Henderson,

Uh, yeah. Wealth _is_ 'insurance' against poverty . . . barring calamity, stupidity, or profligacy. I wasn't making a remark about the concept of insurance. I was remarking that we anticipate the price to be so high, as a result of the presumed moral hazard, that if a person could afford to pay that much they must certainly also be able to manage such a large sum and their personal decisions well enough not to need that particular type of insurance. It's an assumption, but I think it's a pretty fair one, unless we have better reasons than price and/or moral hazard for the nonexistence of that particular type of insurance.

Colin K writes:

El Presidente,

I'd like to refer you to my comment above and ask your thoughts. I think that looking at specific risks clarifies things.

For instance, it is possible to imagine insuring against risks that do not involve substantial moral hazard. For instance, job loss that occurs subsequent to a bankruptcy or liquidation of one's employer. Big stable companies would love this since the premiums for their employees would be much much lower.

Another trigger might be a policy that begins to pay benefits after X months of unemployment only if the unemployment rate in the state is over some triggering level. Of course, such insurance would be highest in states like Michigan or California that have in recent years had the highest levels of long-term unemployment.

Again, I would restate my point that government effectively crowds out the possibility of such insurance by offering an underpriced "public option" known as Unemployment Insurance. Unlike private-sector insurance, this doesn't actually need to be economically viable on its own so long as the general fund of the state, or these days, federal government, can bail it out when it is underpriced by too much for too long.

Arguably, a market-based pricing system here would have major structural effects as insurance rates would respond to economic policy changes much faster than taxes.

Skills are the largest and hardest problem. One issue is that many companies don't care all that much about developing their peoples' skills all that deeply--and if they do, it is most likely to be the top 1-20% who don't actually need help. Mandatory insurance against income loss due to skills obsolescence might help to balance this by assigning a price for the "externality" of employing someone in a job for 20 years and cutting them lose with no useful skills. This is deeply problematic in many ways, but one thing is sure--I cannot imagine any way to price this effectively except by a market-based mechanism.

Niccolo writes:

Back in the bad-ol' days there was actually something called Mutual Aid societies that did act as a kind of poverty insurance. The Knights of Columbus is a modern example.

Shayne Cook writes:

There is a commercial, market-based insurance against "poverty" - it's Aflac. You know, the commercial you've seen on TV with the duck.

But there is a far better "insurance policy" available against "poverty". It's called a savings account. I'm reminded of that every time I see the Aflac commercial, and the theme ("now what's the name of that ...") leads me to answer "savings account", while the duck screams "Aflac".

And it seems I'm not the only one who recognizes the value of this "poverty insurance" - the U.S. savings rate has increased rather dramatically of late.

Shayne Cook writes:

P.S. - Welcome back, David. Good post.

Garrett Schmitt writes:

Here are some examples of private "Poverty Insurance" that have been advertised to me. None of them are quite as generous as state-run unemployment insurance, but neither do they have federal income-tax receipts as a backstop (AP: Congress moving to shore up depleted fed programs).

1. Bank overdraft insurance
2. Disability insurance
3. Insurance against bank loan default due to loss of income
4. Insurance against credit card default due to loss of income

Maybe Rosen & Gayer are on a No-Call list or something. These are just offers from firms I patronize that I can find in ten minutes.

Marcus writes:

This is government as the great externality maker.

We have a business model which doesn't work because the costs exceed the benefits. Solution: use government to externalize the costs.

Or, it may be a business which would work 'if only'. If only people did what they were suppose to. If only everyone participated. If only...

David R. Henderson writes:

Thanks, Shayne, on both.

El Presidente writes:

Colin K,

First, we would need to define poverty. We can use a measure of absolute poverty (e.g. $1/day), accept the federal poverty thresholds, or we can choose a measure of relative poverty (e.g. 50% of regional median income). I choose the third, but others may not. We would also have to decide whether our priority was to maximize insurance profits or minimize the incidence of poverty. These will lead to different sets of policy preferences and different definitions of things like “underpricing”.

Subsidizing is not underpricing if the goal is long-run economic more than short-run fiscal. That is, where a private insurer would need to cover costs and earn a competitive profit on a continuous basis, government can use more credit (deficits) and forgo the explicit profit altogether because, in the long run, economic output fuels the tax base for the subsidy if both taxes and subsidies are correctly designed.

The advantage to fully privatizing this market would not be greater coverage or better average outcomes. It would merely be to transfer coverage to the private sector and reduce the percentage of people covered or the amount of coverage offered, or both. It _would_ increase insurance profits, most likely at the expense of other industries. If that’s the goal, congratulations! You’ve solved Rubik’s Cube. If it isn’t the goal, then we require a different policy. There may be crowding out under the existing scheme, but it might very well be more economically efficient than the alternative and certainly offers greater consideration for those who would be priced out of a private market because they are too ‘risky’.

El Presidente writes:

Sorry, bad link for the poverty thresholds. Here's a good one.

Colin K writes:

El Pres,

Here is my basic line on this: I believe private unemployment insurance might create a new agent on behalf of workers' long-term development, something they seem very much in need of.

The dominant trend seems to be structural rather than cyclical unemployment. I suspect the trend is even more pronounced in underemployment, particularly of workers approaching retirement age.

Employers might care about development of their workers' skills, but only in the context of their business. GM and Chrysler might want to have better assembly-line workers, but they have zero interest in helping those assembly-line workers develop skills as IT or healthcare professionals. In this sense, these dying companies are as likely to take their workers down with them as their investors.

State workforce agencies are likewise problematic because they do not really get involved until a person has been laid off, and because they are often configured mostly to service the current large employers in that state, regardless of the long-term health prospects of those employers.

Workers obviously have a long-term interest in their career trajectory, but in most cases they are the only ones. Unions clearly have a stake, but like state agencies they tend to be too tied to preserving the status quo. Headhunters and talent agents provide some of this, but only to a relatively narrow group of people.

Andrew Biggs writes:

It seems to me there are two things going on: the first that Rosen and Gayer cite isn't assymetric information, it's moral hazard: "if you purchased such insurance, you might decide not to work very hard." Government can't do anything about that; government programs aren't solving that problem, just institutionalizing.

The second problem, asymmetric information, occurs even if behavior doesn't change, simply because some people know they have a greater chance of falling into poverty and therefore are more likely to purchase insurance. Government can help with that problem by making insurance universal.

Whether a government program is worthwhile depends, I guess, on our judgments of which of the two problems is larger.

El Presidente writes:

Colin K,

That's an interesting persepctive. I know there are government agencies that help companies conduct layoffs. They are most useful when a company foresees a structural change and knows they will have to let workers go. Sometimes that means a plain old layoff, but other times that means restructuring. They may train some up and some out in order to end up with the right skill sets to move forward. There is often some reduction or rebate of employer contributions to unemployment insurance if the employer works with the agency to give advance notice and enable retraining or job placement without as much downtime for the employees.

A different problem that I've seen is that there are fewer comparable jobs ($) for these people to train into. That is, as manufacturing and other goods-related production declines (due to outsourcing, labor-saving technology, etc.), it is replaced with service employment, and generally a large portion of the replacement jobs are at lower wages. There is a resistance on the part of the displaced worker to settle for a lower wage and to retrain in order to facilitate that transition. The structural change is as much about the distribution of income as the organization of production. That's not one we can solve with retraining insurance. That requires us to settle for a qualitatively different set of outcomes or to engage in redistribution.

Josh writes:

"The answer is no, because if you purchased such insurance, you might decide not to work very hard."

The view that unemployment insurance can't be provided by the private sector seems to be at odds with the common progressive belief that unemployment insurance does not cause people to reduce work.

El Presidente writes:


The view that unemployment insurance can't be provided by the private sector seems to be at odds with the common progressive belief that unemployment insurance does not cause people to reduce work.

Not really. If we were talking about "poverty insurance", then yes. But Andrew Biggs put it succinctly that there are two concerns at play. The moral hazard one doesn't apply to unemployment insurance as it is currently configured because it provides substantially less income than employment and because it does so for a limited duration. There's no reason why private firms _could not_ provide a similar service if government didn't already provide it. There is very good reason why private firms _would not_ provide universal coverage: it is not in their individual interest to do so. We don't need to suppose that unemployment insurance makes people less productive. It might very well encourage them to find a better match between their skills and their employment by providing extra time to search. It might actually encourage them to work more and be more productive once they are employed even if they take slightly longer to find that job.

Brandon Berg writes:

While you can't buy poverty insurance, you can buy insurance against certain causes of poverty. For example, you can buy long-term disability insurance. If you work for a publicly traded company, you could also buy out-of-the-money puts against your employer's stock to insure against its failure. Though the better solution is probably just to save money.

El Presidente:
You're begging the question in suggesting that subsidizing poverty insurance increases economic output in the long-run. The whole point of the post is that it's a good thing that private companies won't insure against poverty because the element of moral hazard makes it impossible to do efficiently. The case for this is self-evident: Mitigating the consequences of unemployment reduces the incentive to work.

If you want to argue that subsidizing unemployment has salutary long-term effects on the economy, you actually have to make that argument, not just assert that it's true.

Thomas Sewell writes:

Substitute goods for poverty insurance are low-risk investments and mutual assistance societies.

Obviously if you can self-insure in that way, it's going to give you the most flexibility and choice.

Some groups have been driven out of the market by government power in the form of mandatory taxes and the power of deficits, but they do still exist.

El Presidente writes:

Brandon Berg,

You're begging the question in suggesting that subsidizing poverty insurance increases economic output in the long-run.

I'm doing no such thing. I never suggested that with respect to "poverty insurance". Please be accurate when you critique my remarks. I'll endeavor to afford you the same courtesy.

The case for this is self-evident: Mitigating the consequences of unemployment reduces the incentive to work.

It's only "self-evident" if you have prior assumptions. What are your assumptions?

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