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Two Can Play This Game: Externalities Edition

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Here’s a letter to someone who believes that my “faith in the market blinds [me] to its shortcomings”:

Ms. Grant:

Thanks for your e-mail.

You support mandated paid leave because you “believe society benefits when parents stay home with newborns, but the market does not fully account for this beneficial effect…. Paid leave internalizes this externality.

With respect, I disagree.

First, in the U.S. today about two-thirds of working women have some form of paid leave [2] as part of their employment contracts. The market clearly has no trouble supplying paid leave to workers who value it sufficiently high to pay for it in the form of lower take-home pay.

Second, just because some action in the market yields positive benefits to third parties doesn’t mean that the market fails to adequately encourage that action. Nearly every action that each of us takes has effects on third parties, but only a tiny fraction of these effects qualify as externalities of the sort that economic theory suggests might justify government intervention. (If you are an economist, I recommend these two classic articles by my late Nobel-laureate colleague James Buchanan: “Externality [3]” and “The Relevance of Pareto Optimality [4].” The wisdom and insights in these articles – as well as those of another Nobel laureate, Ronald Coase [5] – seem unknown by economists who today assert that mandated paid-leave is justified because it internalizes a positive externality.)

It’s easy to toss out terms such as “market failure” and “externality” and then leap to the conclusion that a credible case is thereby made for government intervention. Advocates of mandated paid leave have mastered this trick of leaping to conclusions based on carelessly tossed-out terms. But to prove the frivolousness with which these paid-leave advocates reason, all one need do is to play the same game, such as by arguing thusly: ‘Society benefits when families, to reduce their likelihood of ever using government welfare, save for rainy days. But the market – by supplying many workers with fringe benefits such as paid leave – inefficiently discourages such saving by paying workers too little in the form of take-home pay. Families thus save socially sub-optimal amounts. Because the market fails to internalize the positive externality of families saving more, the government should correct this market failure by mandating that all compensation for workers come in the form of take-home pay.’

There, I’ve made what appears to be a scientific argument for government to prohibit paid leave. Are you convinced? I hope not. Yet for the very same reason you should not be convinced by arguments for government to mandate paid leave.

Donald J. Boudreaux
Professor of Economics
Martha and Nelson Getchell Chair for the Study of Free Market Capitalism at the Mercatus Center
George Mason University
Fairfax, VA 22030