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Market Failure - How Adam Smith would approach government and personal responsibility

Updated: Nov 20, 2023


The risk of market failure is a policy advocacy criticism for a decentralized and individual choice environment. A market failure is found in the free market setting and the competitive economic model context. The classic definition of market failure is "the economic situation defined by an inefficient resource allocation in the free market. In market failure, the individual incentives for rational behavior do not lead to rational outcomes for the group."


About the author: Jeff Hulett is a career banker, data scientist, behavioral economist, and choice architect. Jeff has held banking and consulting leadership roles at Wells Fargo, Citibank, KPMG, and IBM. Today, Jeff is an executive with the Definitive Companies. He teaches personal finance at James Madison University and provides personal finance seminars. Check out his new book -- Making Choices, Making Money: Your Guide to Making Confident Financial Decisions -- at jeffhulett.com.


A standard example of a market failure is the climate crisis. Higher carbon emissions of the free market economies of the industrial age have left a world in a climate crisis. The question is, if the free market works so well, why did the climate crisis occur? Wouldn't an efficient market prevent this via its pricing mechanism? Adam Smith provides a framework to answer these questions in his book, The Theory of Moral Sentiments ("TOMS"). As we discuss next, Smith challenges the notion that "rationality," as used to define market failure, is a single point found on the aggregated spectrum of individual decisions. This means the 'lack of rationality' premise as a cause for market failure is not correct because rationality itself is misunderstood. The article concludes with a comparative debate between later students of Adam Smith - F.A. Hayek and J.M. Keynes. We explored Hayek's and Keynes' likely perspective on Smith's framework.


The Four Sources of Moral Approval


In TOMS, Smith describes the 4 sources of moral approval. These sources are appropriate for market interactions or more general life interactions. Think of these sources as the approval between agents for some interaction. This interaction could be buying a good - such as a car or a factory using high carbon emissions.


The four sources of moral approval (TOMS 326-327.16), are:

  1. Approval of the giving agent. (supply)

  2. Approval of the receiving agent. (demand)

  3. Approval of the interaction environment (These are the rules or norms governing today’s interaction environment)

  4. Approval of the unseen (long-term impact of 1, 2 & 3)

As Smith points out, the 4th source is the most challenging, as it is less salient at the time of the market interaction and it is found in the more uncertain future. Smith suggests this is where most people need help.


In the case of a car purchase decision, a decision to sell the car from a car dealer or private owner requires the 1st source of moral approval. The person buying the car provides the 2nd source of moral approval. The norms and laws, such as the law of how a car is sold, the laws of the highway, safety laws, and many others provide the 3rd source of moral approval. Laws and norms are considered an approving agent in this example. The buyer and seller must agree on the price and terms, including norms and laws before the sale is consummated.


Finally, the environmental focus provides the 4th source of moral approval. This is the degree to which carbon emissions are accounted for in the car purchase price. In the past, the environmental impact costs were transferred to society as an externality. Basically - this externality is a liability so diffuse that no one feels obligated to pay it. As a result, the environmental cost is ignored. But the critical point is that it is a liability that ultimately must be paid. Not paying the 4th source of moral approval is akin to 'kicking the can down the road.' The question remains -- is the environmental liability better paid by those making the car purchase and enjoying the car benefit? If the 4th source of moral approval is to have a voice at the time of the car transaction, then it must be reconciled with the other 3 agents. Effectively, remanding the environmental cost as an externality demotes the environment's voice from the car transaction.


It is more challenging for the first 3 agents to value the environmental impact of their actions further into the future. There is an obvious reduction of welfare in a future world with a poor environment. However, the perception of the reduced value is obscured by challenges such as the tragedy of the commons or the Trolley Problem. These and related challenges impact the other agent's evaluation of the 4th source. By the way, 50 years ago, it can be argued the long-term environmental impacts of carbon emissions were not as clear. Thus the cost of the environmental externality or even that there was an environmental cost at all may not have been known. Even if this was true, an efficient market has the ability to update as cost information becomes available. The lag between the realization of the cost and updating the 4th source of moral approval is a signal of a market failure.


All 4 sources of moral approval must be considered along with their related trade-offs. In general, the first 3 sources have the ability to say “no” if the interaction doesn’t meet their needs. Often, the 4th source does not have a voice to say “no.” For example, at the time a market decision is made, the environment will not say no to being abused. It is up to the other agents to implement the 4th source.


Circling back to rationality, via the 4 sources of moral approval, Smith suggests "rationality" is not a single point on a continuum. In this case, it is more of a dynamic, potentially multi-modal set of decision points impacted by our relationships with the other sources of approval. As an example, if you are buying the car as the 2nd source, you are greatly impacted by the other 3 sources. As they change, so will your perception of the best price or best decision for you when considering the car purchase. As such, "rationality" is user-defined, subject to intertemporal change, and greatly dependent on time and situation considerations.


Given the dynamic nature of "rationality" and the voiceless nature of the 4th source of moral approval - a different approach needs to be taken to ensure decision information is received and properly integrated from all 4 sources of moral approval. This provides an appropriate role for the government to represent the voiceless 4th source of moral approval. This is also a good role for personal responsibility. No one is making you buy that gas guzzler.


Carbon Tax or other regulation considerations


How the government should provide a voice for the voiceless is less clear. In the Smithean and Hayekian context, legal guardrails should seek to enable us to make choices with only essential regulations defining legal boundaries. By contrast, regulation should NOT prescribe how to make those choices. As such, some level of carbon tax may make sense. The carbon tax should account for the price of the carbon emissions - thus giving a voice to the voiceless - and do so in a way that minimally impacts the goal of transportation and associated transportation choices. The government's goal should be to enable all costs and preferences from all 4 sources of moral approval to be made available to an individual's car transaction. Once this is done, the updating of an appropriate carbon tax to the other 3 sources of moral approval may cause people to seek other substitutes for cars that have lower net carbon emissions, such as public transportation. Conceptually, with a carbon tax, all 4 sources of moral approval will be available to inform the market price. However, regulations will not direct how people make those transportation choices.


An appropriate carbon tax should be indexed to vehicle carbon emissions - this gets challenging since a larger, lower MPG vehicle will be able to transport more people. So determining the tax based on both carbon emission per vehicle and per person transported will be necessary. Perhaps a combination of carbon tax per vehicle and a tax credit linked to family size is appropriate.


Ex-ante v ex-post rules and regulations


Another essential aspect of environmental tax or regulation is in the context of ex-ante or ex-post rules and regulations.


Hayek emphasizes the importance of the ex-ante rule of law in decentralized and democratic-based resource allocation countries. This means, the rules should be clearly defined, ahead of time, as a way to enable market participants to respond and react in their economic best interest.


Ex-post rules, on the other hand, are generally the means by which socialist-leaning resource allocation schemes behave. This means ex-post rules would be more reactionary, subject to volatility, and place the burden of uncertainty on the market participants.


As such, proper implementation of environmental tax regulation should favor clarity in advance of implementation over the preciseness of the environmental cost. Effectively, the government will need to absorb the uncertainties associated with the proper carbon cost.


So, perhaps the environment is a market failure example. But not because the free market competitive economic model did not work. In this case, the understanding of how rationality relates to a market failure is flawed. Different, but not singularly "rational" decisions could be made regarding how carbon-emitting cars are bought and sold. The market failure occurred because the government failed to do its job by giving a voice to the voiceless 4th source of moral approval. Also, the second agent could positively impact the potential for market failure by being more sensitive to the environment. This could occur via some informed action to include the environment as a higher-weighted part of their buying criteria. This relates to personal responsibility.


As a related historical aside, F.A. Hayek lived at about the same time as another famous economist, John Maynard Keynes. Keynes and Hayek had an adversarial intellectual relationship. While Hayek was a defender of Adam Smith's market principles, Keynes was a challenger to those market principles.


Regarding the 4th source of moral approval, Keynes challenged it by saying, "In the long run, we are all dead." Keynes suggested that the 4th source of moral approval could safely be ignored. In the context of the time, with the economic turmoil from the Treaty of Versailles, the hyperinflationary Weimar Republic, and then the war production economies of World War II, there is some sympathy for Keynes' point. It was all leaders could do to manage tomorrow. The more distant future of the 4th source was challenging to consider in the context of the time.


Hayek demonstrates how central planning is on the slippery slope leading to communism, fascism, and other forms of totalitarianism. Hayek showed how the natural incentive for central planners is to expand the bureaucracy and reduce individual choice. Hayek shows how ex-post central planning leads to arbitrary government as compared to the ex-ante rule of law that leaves individuals free to pursue personal ends and desires. Hayek suggests the rule of law is not for telling someone how to do something, but the rule of law should aspire to provide guardrails as to what not to do when an individual desires to accomplish something. [i] Hayek was an Austrian-British economist who fought in World War I and emigrated to England. He lived in London during the rise of Nazism and the Battle of Britain. He readily admits capitalism is not perfect. However, Hayek concluded that the alternative of central planning is far worse than the imperfections of decentralized resource allocation. Essentially, based on Hayekian principles, while people may sometimes make dumb decisions, central planners will make far dumber decisions for those people.


Smith also made a good point. While it may be more immediately expedient to ignore the 4th source of moral approval, eventually, it will be heard. We are certainly coming to grips with that now that the climate crisis is upon us. Hayek's point about the power of central planning bureaucracies to self-perpetuate is also valid. Nazism, communism, and related totalitarian regimes are important reminders.


The brilliance of Smith, Hayek, and Keynes was that they could be correct in their unique time and place context.


Notes


[i] "The distinction we have drawn before between the creation of a permanent framework of laws within which the productive activity is guided by individual decisions and the direction of economic activity by a central authority is thus really a particular case of the more general distinction between the Rule of Law and arbitrary government. Under the first the government confines itself to fixing rules determining the conditions under which the available resources may be used, leaving to the individuals the decision for what ends they are to be used. Under the second the government directs the use of the means of production to particular ends."


Hayek, The Road To Serfdom, 1944, Chapter 6

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