Why government bestowal of economic privileges is pathological

Matt Mitchell, a senior research fellow at George Mason University’s Mercatus Center, has written an important paper called “The Pathology of Privilege: The Economic Consequences of Government Favoritism.” We have discussed such favoritism, which also goes by the names “crony capitalism” and “corporatism,” from time to time. But Mitchell’s paper provides an economic analysis and unified theory of the phenomenon.

What are the privileges that governments bestow on particular firms or industries? Bailouts, such as the financial bailouts of 2008, are obvious examples. But such privileges have also included monopoly status, favorable regulations, subsidies, loan guarantees, targeted tax breaks, protection from foreign competition, and noncompetitive contracts.

By bestowing such privileges, the government diminishes the gains that accrue from exchanges. At the heart of modern economic theory lies the fact that in a market where no firm enjoys favoritism, free and voluntary trade results in gains for both sellers and buyers. As individuals expand the number of people with whom they exchange, they are able to consume a wider diversity of products while becoming more specialized in production. Specialized production, in turn, permits greater productive efficiency and allows us to do more with less.

But government-granted privileges diminish the gains from exchange. They do so because a firm receiving government-granted privileges gains pricing power that a competitive firm lacks. Thus, it need not accept the price that would emerge in a competitive market. Instead, it is free to set a higher price.

This means that the privileged firm gains more from exchange than it would if it were a competitive firm and consumers gain less than they would were the market subject to free competition. In addition, would-be competitors who are not blessed with monopoly privilege lose out on the opportunity to gain from exchange.

Moreover, total sales under monopoly are less than total sales under competition because the higher price drives some customers out of the market. On balance, the monopolist’s gains are less than the losses of consumers and would-be producers, which means that society as a whole is worse off under monopoly than under competition.

This is not the only evil associated with monopoly. Among the others are: productive inefficiencies; inattention to consumer desires; rent-seeking (whereby firms spend time and money to influence the government, with no benefit to consumers); loss of innovation and therefore long-term economic growth; macroeconomic instability caused by the excessive risks firms take when they believe they will be bailed out; the diminished legitimacy of both business and government; and diminished social trust.

For these reasons, says Mitchell, government-granted privileges are pathological:

Privileges limit the prospects for mutually beneficial exchange—the very essence of economic progress. They raise prices, lower quality, and discourage innovation. They pad the pockets of the wealthy and well-connected at the expense of the poor and unknown. When governments dispense privileges, smart, hardworking, and creative people are encouraged to spend their time devising new ways to obtain favors instead of new ways to create value for customers. Privileges depress long-run economic growth and threaten short-run macroeconomic stability. They even undermine cultural mores, fostering cronyism, blurring the distinction between productive and unproductive.

Tim Carney has more on Mitchell’s paper and Arthur Brooks has more on the subject.

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