October 16, 2019
Capitalism is increasingly coming under attack as the political discourse in this country continues to veer off-course. Capitalism should not be the focus of debate. Rather, the real issue for discussion should be the inability of the federal government to manage capitalism’s most pressing imperfections.
This paper identifies and prioritizes the failures that come with capitalism in today’s economy and provides a roadmap to correct them.
In a perfectly competitive market, the “invisible hand” of the market assures the most efficient production of goods and services demanded by consumers. If too many suppliers rush to meet a demand, prices and thereby profits will drop, resulting in a reduction in supply. Similarly, if the demand isn’t being met, the scarcity will drive up prices thereby attracting additional supply. Over time, consumer welfare is maximized via these competitive forces.
Of course, not all markets display the underlying characteristics of perfect competition. In the real world, there are five major anomalies that undermine the efficient functioning of an unfettered market economy: 1) an undue concentration of suppliers, 2) external effects from the production of goods such as pollution that are not reflected in the supply and demand curves, 3) the imperfect nature of information available to the public to make informed decisions, 4) unfair foreign competition and 5) public goods such as national parks or national defense that don’t follow the rules of supply and demand (e.g., they don’t dissipate with use and/or cannot be withheld for lack of payment).
Framework of Analysis
This study assesses the extent of the five imperfections in the United States in order to prioritize the most important market failures for the federal government to address at this point in time.
To start, this study utilizes the framework established by the federal government for industry classifications as a part of its North American Industry Classification System (“NAISC”) Reports.
Taken together, there are 2200 industries which are clustered into 24 sectors and comprise today’s roughly $20 Trillion U.S. economy.
Market Failure #1 – Undue Supplier Concentration
Economists use the so-called Herfindahl-Hirschman Index (“HHI”) to determine whether a market has undue concentration. The HHI is calculated by squaring the market share of each firm competing in a market and then summing the resulting numbers.
A market with an HHI of less than 1,500 is considered to be a competitive marketplace, an HHI of 1,500 to 2,500 to be a moderately concentrated marketplace, and an HHI of 2,500 or greater to be a highly concentrated marketplace.
For example, a market with only four firms that have market shares of 30%, 30%, 20%, and 20% would have an HHI score of 2600. Likewise, a market with the four largest firms capturing 90% of the market with shares of 30%, 20%, 20% and 20% (along with two other companies with a 5% share) would yield an HHI of 2150.
Every five years, the federal government undertakes a comprehensive survey of businesses in the United States. The Census collects concentration ratios for the top 4, top 8, top 20 and top 50 firms in each of the 2000+ industry classifications listed above.
This study presumes that a concentration ratio of less than 90% for the top 4 firms in a particular market signifies that the market is not highly concentrated (or, in other words, that it is workably competitive). The Census data show that only 24 industries have 4-firm share over 90% and that these industries represent less than 2% of the overall economy.
These concentration statistics provide good news for consumers. That is, the vast majority of markets in the U.S. appear to be workably competitive. In other words, government intervention to manage the inefficiencies and excess profits from undue concentration should be the exception, not the rule. While the profits of certain companies may be extremely large, this fact alone does not warrant government intervention.
Of course, there are several caveats with using the business Census data in this manner.
First, the data is old; mostly from 2012 and some from 2007. Markets can change quickly, particularly in the Information sector. For example, the dominant shares of Google in the search business or Apple with its dominance of smartphone operating systems are not accurately reflected in the above numbers.
Second, the government's data is not complete. It is missing information for a few percent of the overall market, including markets relating to mining and construction.
Third, the information is extremely voluminous and subject to error. Therefore, while broad policy conclusions can be drawn from the data, government interventions in specific markets require more accurate and current information.
Fourth, the geography boundary of the markets in this study is the entire U.S. In some cases, this distorts the picture of consumer welfare. For example, the coverage of health insurance providers is artificially restricted to particular states. This has the effect of greatly increasing the incidence of undue concentration in certain geographies.
Fifth, a cut-off of 90% market share for the Top 4 firms is arbitrary and not as revealing as the HHI. For example, the ratio of the Top 4 firms in the wireless communications industry is less than 90%, but the industry is dominated by 2 players. Predictably, this industry does not provide services as efficiently as would a workably competitive market.
Finally, government regulations may erect barriers to entry leading to an inefficient allocation of resources. The FDA requirements for drug approvals is a good example of this phenomena. The FDA process for clinical trials – not including its involvement in pre-clinical research – results in an average of over $1 billion to be spent on research for each drug approval with an average time from Phase I to drug approval of 12 years. The FDA’s procedures have the effect of creating a barrier to entry. Not surprisingly, the FDA’s charter is to avoid harm as opposed to maximizing patient welfare.
Despite these caveats and exceptions, undue economic concentration in the U.S. should not be a cause for concern for politicians and the general public. On an overall basis, the Department of Justice and the Federal Trade Commission have done a good job to discourage or block mergers and acquisitions that would create a highly concentrated market or increase the concentration in a highly concentrated market.
As a result, the invisible hand of the marketplace can be relied up in most private markets in the U.S. to deliver efficient outcomes – subject to the effects of externalities, imperfect information and unfair foreign competition in those markets, as discussed below.
Market Failure #2 – Negative Externalities
An externality is a cost or benefit incurred or received by a third party that has no control over the creation of that cost or benefit. In the case of negative externalities, there are costs imposed on society that are not reflected in the supply decisions of the producers or the demand decisions of consumers.
A classic example of a negative externality is the side effect of product production that makes land, water, air or other parts of the environment unsuitable for people. The most publicized form of such pollution is the release of dangerous gases into the atmosphere such as carbon dioxide, which is warming the planet through the greenhouse effect. Essentially, these gases absorb the infrared radiation that is released from the Earth, preventing the heat from escaping.
Regulators have two tools to address pollution. The more utilized regulatory approach has been environmental protections. Unfortunately, this approach has not produced an acceptable outcome in the face of global warming.
Alternatively, governments can impose a tax on the production of pollution equal to the external cost imposed by the pollution. The proper imposition of this type of tax would be to reduce the output of the activity causing the externality to the amount that is considered efficient (thereby offsetting the external costs).
Some might dismiss this approach as an interesting theory. However, the impacts of global warming were predicted accurately well over 30 years ago and are now coming to fruition. There is no credible evidence to refute the fact that global warming (if left unchecked) will cost trillions of dollars in lost labor, reduced crop yields, health problems and crumbling infrastructure.
These issues are not hypothetical or theoretical. More greenhouse pollution causes a greater amount of global warming which causes a greater severity in environmental events such as hurricanes, fires, etc., which translates into accelerating damage to the environment as the intensity of these events rises.
The fact is that the United States is poised to take a powerful economic hit from climate change. For example, three storms that made landfall during the 2017 Atlantic hurricane season — Harvey, Irma and Maria — together cost the United States at least $265 billion, according to the National Oceanic and Atmospheric Administration. Going forward, there are credible estimates as high as 10% of the U.S. economy being at risk from global warming.
This issue, by far, is the greatest challenge to capitalism and the success of the American economic story. To date, those politicians who have promoted more efficient regulatory measures have been vilified and rendered impotent by the lobbying arms of the largest polluters along with their political allies.
Market Failure #3 – Imperfect Information
Market failure from imperfect information occurs when consumers and/or suppliers have inaccurate or incomplete information and resultantly, make the wrong choices or decisions.
In contrast to the source of the other anomalies, information gaps exist in most markets. These gaps become an information failure when the gap distorts consumer buying decisions or impacts producer supply decisions. Typically, distortions are more likely to occur from imperfect information as the complexity of the market increases.
The government addresses information failures in a number of ways: 1) compulsory product labeling, 2) improved product information such as expanded nutritional values, 3) consumer protection laws (e.g. rights to refunds) and 4) industry standards to ensure a consistent and beneficial outcome.
For the most part, these tools have proven to be very effective in curbing inefficiencies where information gaps exist.
The exception to this broad success occurs in the healthcare industry. The healthcare industry suffers from a series of different information failures.
The largest information failure in the healthcare industry relates to the complexity of care of chronic diseases, which creates inefficiencies in a market equivalent in size to almost 15% of the U.S. GDP.
The inefficiencies from imperfect information in this nearly $3 trillion subset of the healthcare market are exacerbated by a lack of shared information and joint planning by the supply participants. As a result, medical practitioners, research organizations, device manufacturers, drug manufacturers, insurance companies and the government (the FDA) are not moving in the same direction, thereby creating excessive costs in addressing chronic illnesses. Similarly, no entity – private or public – has the responsibility or resources to establish or address an overall objective and approach to the various chronic diseases.
The healthcare industry also suffers from two smaller information failures. First, the information is asymmetric. For example, practitioners have better knowledge of specific matters than patients even for relatively simple issues such as tooth extraction and filling. Second, when it comes to insurance, those people more likely to need it (given knowledge of their personal situation), are the people more likely to buy insurance. This latter anomaly was addressed indirectly in the Affordable Care Act by imposing tax penalties on those healthy people electing not to take health insurance.
The challenges in healthcare are daunting. Practitioners have to be superstars just to know all of the medical aspects of their specialty. To understand all of the other components of healthcare such as scientific research, regulations, insurance, etc. adds additional layers of complexity. Moreover, the type of skills needed for science and medical matters are different for than those needed for regulatory, economic, strategy, political, insurance and other matters. All of these challenges exist for only one chronic illness, and yet many people have more than one chronic illness.
These challenges cannot be solved efficiently by the “invisible hand” of the market. For example, healthcare spending as a percentage of GDP has increased from 7% in 1970 to about 18% today.
All in all, the information failures in the healthcare industry are the second biggest deterrent to an efficient U.S. market economy.
Market Failure #4 – Unfair Foreign Competition
Free trade across country boundaries can lead to greater efficiency and an increased selection of goods for consumers. However, unfettered trade can lead to unfair trade competition where overseas workers are exploited in deplorable work conditions to gain a cost advantage, trade secrets are stolen to shorten a competitive lead, government subsidies are utilized to gain competitive advantage and conversely, lax regulation of negative externalities such as pollution are condoned in certain countries to confer an unjust advantage upon their polluters.
Moreover, while free trade can produce more jobs from exports, the overall effect can be negative with corresponding spillover effects to the economy as a whole.
Today, the United States imports about 50% more goods than it exports, or almost $1.7 trillion in net imports through August of this year. More than 65% of the U.S. trade deficit is in goods with China. The main U.S. imports from China are consumer electronics, clothing, and machinery.
The increase in the trade imbalance over time has had a big effect on portions of the manufacturing sector of the economy.
We know that about 32 percent of American workers held manufacturing jobs in 1953, but that share was down to less than 9 percent in 2015. On the other hand, removing the price effects from GDP so that comparisons over time are the result of changes in the quantity produced (and not pricing), manufacturing's share of real GDP has been fairly constant since the 1940s, between 11 percent and 14 percent.
To frame the issue, even if 25% of the entire negative trade imbalance with China and all other countries were to be eliminated from the curtailment of unfair trade practices, this would have an impact equivalent to less than 3% of the U.S. economy.
Therefore, while unfair foreign competition remains an important political and economic issue, it should be not a Top 3 economic priority for the average American consumer.
Market Failure #5 – Public Goods
The public goods and services provided by federal government comprise roughly 20% of the overall economy.
By their very nature, public goods represent a market failure in that the push and pull of market forces will not create an efficient supply of goods and services.
The greatest risk from this sector of the economy is that fiscal mismanagement will lead to excessive government debt causing spiraling interest rates and a possible default on loans.
The current size of the annual deficit is roughly $1 Trillion per year and the cumulative deficit is over $20 Trillion.
Americans might not realize it, but each and every full-time worker is carrying an extra $130,000+ in debt on his/her back courtesy of the cumulative federal debt. In comparison, the median net worth of Americans is about $80,000 (not counting the offsetting federal debt).
Given the size of the deficit and its growth over the last twenty years in good and bad economic times, this issue is the third greatest challenge to the success of American capitalism.
Summary of Findings
The U.S. economy is strong and continues to grow, but it is far from being a textbook perfectly competitive system. On the positive side, the economy is not significantly hampered by undue concentration from dominant firms. That is, well over 95% of all markets enjoy a workably competitive environment.
Moreover, despite some serious foreign anticompetitive behavior, foreign competition is not having a large negative impact on consumer welfare in this country, given size of the overall trade deficit and the magnitude of the improvements if concessions can be garnered.
In contrast, negative externalities in the form of pollution and the imperfect information in the healthcare industry are beginning to have far-reaching and growing negative impacts on the economy and the public.
Finally, the federal government is operating with a $1 Trillion annual budget deficit in good economic times, while carrying a $20 Trillion cumulative deficit. Continued government mismanagement of its finances poses an increased risk to health of the nation in the form of higher interest rates as well as a potential government default as the economy cycles downwards in the face of an unexpected event.
The competitive structure of the U.S. economy can yield substantial benefits to the health and welfare of the public – provided that the rules of competitive engagement are enforced and that the key market failures are addressed.
Given the three critical flaws identified herein with the U.S. economic system, decisive action is needed on all three fronts.
First, the Executive Branch should pull together an interdisciplinary team from all segments of the healthcare industry to develop an industry-derived solution to overcome the information failure and inefficiencies in treating chronic illnesses.
In the absence of a workable solution to these problems from the industry itself, Congress should establish a quasi-independent standards body to develop comprehensive standards for preventing and treating chronic illnesses.
Second, Congress should establish a mechanism whereby an independent “Blue Ribbon” panel of experts (without conflicts of interest) provide binding guidelines for phasing in a carbon tax that ultimately will equate to the damage to society caused by carbon pollution.
Third, Congress should adopt structural rules such as Pay-as-You-Go, budgetary caps and hiring freezes to manage the federal government’s finances. Moreover, the federal government should be required to use Generally Accepted Accounting Principles in reporting its fiscal budgets and results.
In the event the federal government cannot act in the public interest on any of these three critical matters, a new approach to managing market failures should be adopted.
More specifically, we know that citizens at the state level have used ballot initiatives over 2000 times to address various issues and challenges, of which over 40% have been adopted. The ballot initiative process is also commonly and successfully used at the county and city levels of government.
Currently, there is no ballot initiative process at the national level. Nevertheless, adoption of a nationwide federal ballot initiative process can be achieved with the support of a majority of the citizens in 38 states seeking to improve the functioning of the federal government. Such a change cannot come quickly enough if the federal government continues to flounder on addressing the economy’s three largest market failures.
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