Beyond market failures - Does government intervention promote or hinder innovation?

Market failures and public goods are commonly accepted justifications for government intervention in the economy. However, governments sometimes cause more problems than they solve. At the LSE we debate whether governments are good or bad for innovation and technological progress. Join and invite others to participate!

Governments, public goods and market failures

Adam Smith's "invisible hand" does not always work. There are cases in which individuals acting in their own self-interest do not lead to an efficient allocation of a commodity or resource (Le Grand 1991). According to neoclassical economics, in capitalistic societies, government intervention is justified insofar as it addresses "market failures". Market failure theory explains that governments are necessary to ensure the supply of "public goods" and services and to create market mechanisms which would "fix" markets by internalizing external costs (Mazzucato 2015). In economics pure public goods are commodities or services which fulfill two conditions:

1. Public goods are non-rivalrous. The use or consumption of the good by an individual does not detract from other people enjoyment of that good. Additional consumption does not mean higher costs of production.
2. Public goods are non-excludable. This means that it is not possible to limit people's consumption or access to these goods and services.

Due to their non-excludable character, public goods create the incentive for free-riding and underprovision (market failure). Goverments are expected to supply goods such as defence, public lightning, and roads because the private sector has little incentive to produce them. 

Governments also address other market failures. For instance, governments introduce taxes on polluting companies to make them internalize the costs they are causing to the environment (negative externality) and to introduce and incentivise the adoption of more environmentally-friendly processes. Governments are expected to break monopolies which can limit competition. They also help to mitigate problems of imperfect information by introducing requirements and standards for labeling and information companies need to provide.

Government intervention problems 

Government involvement in markets remains a controversial issue. Intervention often leads to inefficiency and government failures. Public choice literature has explained some of the reasons why and mechanisms through which governments, aiming to solve existing market failures, actually end up creating other serious problems. These are some examples of government failures: 

• Governments influenced by lobbies sometimes give unfair advantages to some market players.
• Government subsidies often protect inefficient companies and lead to the problem of moral hazard. 
• Taxes can distort markets and increase prices artificially.
• Governments sometimes fix prices or price brackets, affecting the market equilibrium and leading to a pareto suboptimal allocation of resources.
• Public sector monopolies can limit consumer choices.
• Regulatory capture: public officials may not always act in the public interest but favor some interest groups.
• Conflicting interests and asymmetric policy consequences complicates government intervention.
• Short-term goals, often associated to the electoral cycle, may take precedence over long-term policy solutions.
• Publicly owned companies tend to be less productive and cost-effective.
• Bureaucratic processes can create additional costs and slow down the action of market actors.

Is government intervention good for innovation?

In general government intervention is necessary but at the same time it entails some risks and problems. Innovation-led growth has become a goal for most countries in the world. But to what extent is government involvement good or necessary to promote economic and technological innovation? Here again there are two conflicting views. On the one hand there are experts who perceive the government as an obstacle for free-market and innovation. They advocate for minimal government involvement. On the other hand, there are analysts who expect governments to become active drivers of innovation through regulation and funding of initiatives. These are some arguments for each of these positions.

Government intervention bad for innovation:

• Government funded innovation projects have less incentive to produce economic returns. Some of these projects are not sustainable and as soon as public funding goes the projects are cancelled.
• Many of the biggest inventions and technological achievements have been produced in private companies.
• Government bureaucracy is particularly damaging for the innovation industry as it slows down processes and limits the required flexibility.
• Competition leads to innovation, but governments have traditionally limited competition.
• Political agendas are often driving public funding for research and innovation.
• Regulation in some areas, such as stem cell research and animal testing, has constrained the capacity of companies to conduct research.
• Publicly funded initiatives can jeopardize competing privately funded ones.

Government intervention is good for innovation:

• Governments can enable researchers and small companies to undertake projects when private funding is not available or difficult to acquire.
• Historically, many of the greatest advancements in history were promoted by governments. The Internet, space exploration, vaccines and cures have been possible thanks to government funding.
• Government-funded universities train researchers and innovators and lead many innovation projects.
• Public and private initiatives are not incompatible. Alliances between the public sector and private organizations can be very positive.
• Policies can contribute to shape existing markets and to create new ones. A certain level of regulation is necessary to reduce uncertainty and attract the desired kind of investment.
• Government led innovation can be a solution in areas where the private sector is not operating due to the costs or the lack of economic return.
• Fiscal policy and favorable regulation can be used to create positive incentives for private innovation. Government can provide exemptions or reduce taxes to certain products or initiatives. Start-ups and tech industries have emerged partly thanks to government support.

What do you think? Should government action be limited to fixing market failures, such as the provision of public goods and services? How should governments participate in innovation: via funding, regulation or fiscal policy? 

Watch these videos about government intervention and innovation by Mariana Mazzucato (LSE) and Yaron Brook (Ayn Rand Institute):

Further resources:

• Le Grand, J. (1991) "The Theory of Government Failure" British of Journal Political Science 423-442 (article)
• Lodge, M and K. Wengrich (2012). Managing regulation: regulatory analysis, politics and policy. London: Palgrave
• Jacobs, M & M. Mazzucato (Eds.). (2016) Rethinking Capitalism. Wiley-Blackwell/Political Quarterly. Read especially pp. 1-23. You can listen here the podcast of the public lecture at the LSE in which the two authors presented the book.
• Mazzucato, M (2015), From Fixing Market Failures to Creating Markets in ‘Which Industrial Policy Does Europe Need?’ Intereconomics 50(3) (article)

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