From Market Failure to Market Success

March 3rd, 2015
in Op Ed

Become a Public Policy Thinker in Three Easy Steps

by Ajay Shah, ajayshahblog

Step 1:What's the market failure?

Each of us tends to get unhappy at some feature of the world or the other. As an example, I don't like rap music. But value judgements of this nature do not justify the use of State power - either to ban rap music or to encourage classical music. Such coercion by the State is just abuse of power.

Follow up:

When should the State intervene? The technically sound answer is: When you are certain there is a market failure, and when you are confident you know how to setup the correct State capacity for the intervention.

Market failures come in four kinds: 1. Asymmetric information, 2. Externalities, 3. Market power and 4. Public goods. These are technical terms in microeconomics and each needs to be carefully understood.

The first hurdle that must be crossed in policy thinking is the question: "Is there a market failure?" Every proposal to do something in public policy faces this test.

A good way to smell market failures is the prices being wrong. In a well functioning economy, the price should be close to marginal cost or to the Ramsey price. When the observed price diverges from these normative ideals, a market failure may be afoot. But while the price being wrong is the diagnostic that alerts you to a problem, direct intervention in the price is seldom the right answer

At present, most of what the government does in India is not about market failures. Using the coercive power of the State to meddle in the voluntary decisions of consenting adults is mostly a bad idea. The Indian State suffers from rampant central planning, license-permit raj, and shameless value judgments.

Step 2: What's the proposed intervention?

Once we agree there is a market failure, we have to figure out what we'd like to do about it. Here, it's important to understand the anatomy of the market failure, and solve it at its root cause.

If there is a causal chain x -> y -> z, leading up to a bad outcome z, don't use the power of the State to change y or z. Understand the root cause, and solve it there.

Example: Investors are not buying infrastructure bonds. Don't propose tax exemption as the solution.

Example: Micro-finance companies in Andhra Pradesh are mistreating their consumers. Don't propose micro-prudential regulation of micro-finance companies as an answer.

Example: OTC derivatives are not enforceable. Don't propose changing the financial regulatory architecture as the answer.

Government agencies in India are known to do a bait-and-switch. A problem is shown, outrage is created, and then a completely unrelated solution is pushed forward which will increase power and reduce accountability. We need to be skeptical and verify:

Does your claimed intervention address your claimed market failure?

Complicated microeconomic interventions which require volumes of law are generally abuses of power, and will not deliver on the original objective. At a heuristic level, the Indian capital controls don't work because the FEMA handbook weighs 3.5 kilos.

Occam's Razor in Public Policy: Many different interventions could possibly change the world in the direction that you like. The least intrusive intervention that gets the job done is the right one. In order to find this least-intrusive intervention, you have to understand the market failure deeply. Sound thinking in public policy requires understanding the anatomy of the market failure, and coming up with the minimum use of the coercive power of the State in addressing that market failure and in minimally disturbing the rest of the landscape.

Corollary: Macroeconomic problems require macroeconomic policy tools. It's almost always wrong to use microeconomic interventions to pursue macroeconomic goals.

Step 3: The hurdle of public administration

Okay, you are all dressed up and ready to go, with a demonstrated market failure, and a minimal intervention which solves it. Now the question arises:

Can you design a feasible solution with real world political economy and public administration?

Pressure groups will hijack well meaning policy frameworks to favour small groups at the expense of the diffused populace. Government agencies like to be lazy and corrupt. Politicians and officials work for themselves and not for the citizenry. Can we envision the accountability mechanisms through which the Principal (the citizen) is able to coerce the Agent (the government) to deliver results? A complex machinery of checks and balances has to be designed, including transparency, reporting, rule of law, due process, etc.

As a thumb rule, government should almost never be in the position of determining a price [example]. Prices must fluctuate every day, based on changes out there in the world. It is impossible for government agencies to figure out what the right price should be. Similarly, a government should not be in the business of determining business plans or business models. That's a tell tale sign of central planning.

We have to be careful about mission creep. Market power is the job of the Competition Commission and not the IRDA. Enforcing IPC is the job of the police and not of FMC. SEBI should not be forcing listed companies to have women directors; RBI should not be subsidising ATM placement in Assam, and so on.

Libertarianism of necessity vs. libertarianism of choice

Many times, even after we know there is a market failure and we're able to envision a surgically limited intervention, we have to fall back on doing nothing, as the market failure is not very large or significant, and it's not easy to design the public administration machinery through which we can make a government deliver the desired outcomes. When there is low State capacity, this happens more often. We do more subtle interventions in Sweden, we do more laissez faire in India.


Decades of Indian socialism have starved us of capabilities in economics. Everyone interested in the field of public policy should limber up with these three steps: (a) What's the market failure? (b) What's the minimal intervention that precisely addresses the root cause of the market failure? (c) How do we construct mechanisms through which government agencies in the real world will deliver the desired outcome, even though their first instinct is to favour laziness and corruption?

This is hard work. The outcomes of this process of thinking resist classification into prefabricated belief systems. I sometimes meet people who say "As I'm a Keynesian, I propose policy X".  That's a great economy of thought; by reading a few books by Keynes, you have figured out the world.

It's better to start from first principles, and analyse each problem on its merits, and engage with the gritty reality out there in figuring things out.

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