Lecture 21: Benefits and Costs of Government Intervention
Outline:
1. The case for the market system
i. flexible and automatic coordination
ii. stimulus to innovation and growth
iii. relative prices reflecting relative costs
iv. self-correcting mechanism
v. decentralization of power
2. The case for government intervention
i. market failure
ii. failure to achieve social goals
3. A benefit-cost analysis of government intervention
i. tools of government intervention
ii. costs of government intervention
iii. government failure
iv. how much should the government intervene?
4. Dollars and Sense Article 10
5. The New Field Guide: 6.9, 6.13, 6.14, 6.15, 6.16.
1. The issue of government intervention in a market economy:
* What is the optimal mix of markets and government intervention in markets that suits people's hopes and needs.
* Markets can work and markets can fail, just as government intervention can work and government intervention can fail.
2. The case for the market system:
For the most part the market system as an effective coordinator of decentralized decision making.
Under certain conditions all of the following are advantages of the market system:
* flexible and automatic coordination
As long a prices can move freely they carry information to economic agents about changing economic conditions. Agents respond to these price changes and decision making is coordinated in a simple decentralized manner.
* stimulus to innovation and growth
In response to changing tastes, technology and resource availability, people risk their time and money to make profits, and the result is new products and processes.
* relative prices reflect relative costs
Even in the case of imperfectly competitive markets there are tendencies for market prices to be driven close to the average cost of production, such as new products, new processes, and the drive for profits in the face of some competition.
* self-correction mechanism
In response to change there is a tendency of the market to move toward equilibrium and to correct disequilibrium, as prices move to eliminated excess demand and excess supply.
* decentralization of power
Markets tend to diffuse power and work against coercion. Even with the market power of large firms and unions/other organization, any firm/organization tends to be small relative to the economy as a whole.
3. The case for government intervention:
Efficient allocation of resources requires that in every market:
MSB = MSC
MSB = the marginal social benefit of producing the last unit of the good (Extra benefit to society of the good).
MSC = the marginal social cost of producing the last unit of the good (Extra cost to society of the good).
Markets produce an efficient allocation of resources when:
i. P=MSB
* The price of the good reflects all of the extra benefits to society of the good
ii. MC=MSC
* The extra cost of producing the good for the firm reflects all the extra costs to society of the good
iii. And if P=MC
Then MSB = MSC
* The decisions of consumers and firms based on market prices and firms' costs reflect the underlying social benefits and costs of goods and services.
4. Market Failure:
There are various ways that markets fail to achieve the efficient outcome.
The following are examples of what economists call, market failures:
* monopoly power
i. P=MSB There is no problem with price as an indicator of MSB
ii. MC=MSC There is no problem with the firm's marginal costs as an indicator of MSC
iii. But since P > MC
Then MSB > MSC
The problem with monopoly is that the firm produces a level of output that is too low from the point of view of society.
GRAPH
The market failure: Less than the efficient level of output is produced in a monopoly market.
* externalities
Definition:
Externalities are benefits or costs of a transaction that are incurred or received by members of society but are not taken into account by the parties to the transaction.
Also called spill-over effects or third-party effects.
Negative externalities:
These involve cases where the buyers and/or sellers in a market fail to take into costs associated with their transaction and these costs are imposed on parties not involved in the transaction.
These are called external costs.
Examples: pollution, drunk driving
i. MC < MSC The problem is that there are costs to society that firms are not taking into account -- so the firm's marginal costs are not a good indicator of MSC .
ii. P=MSB There is no problem with price as an indicator of MSB
iii. Therefore P=MC
Implies MSB < MSC
The problem is that too much of the good is being produced in this market when one takes into account the external costs of production that society has to bear.
Market failure: More than the efficient level of output is produced in a market where there is a negative externality.
GRAPH
Question: What policies could the government use to deal with the problem of negative externalities?
Positive externalities:
These involve cases where the buyers and/or sellers in a market fail to take into benefits associated with their transaction and these benefits are received by parties not involved in the transaction.
These are called external benefits.
Examples: education, medical research, parks and gardens, child immunization.
i. P < MSB The problem is that the market price does not capture all of the benefits that are generated by this good - so the decisions of consumers based on price are not a good indicator of MSB.
ii. MC = MSC There is no problem with the firm's marginal costs as an indicator of MSC
iii. Therefore P = MC
Implies MSB > MSC
The problem is that too little of the good is being produced in a market where there are benefits that are not captured in the decision making of consumers and firms.
Market Failure: Less than the efficient level of output is produced in a market where there is a positive externality.
GRAPH
Question: What kind of government policies could be used to deal with the problem of positive externalities?
* public goods
Definition:
A public good is a good for which the total cost of providing the good does not increase with the total number of consumers, and it is difficult or impossible to charge a price for the good that depends on how much a person consumes.
These are goods that private firms have little interest in providing - since once the good is provided it is difficult for the firm to restrict people's consumption of it and thus force them to pay for how much they consume.
Unlike private goods they have the characteristics of non-excludability and non-depletability.
Examples: national defense, public radio, public TV, public parks and gardens.
i. P < MSB The problem is that the price is not a good indicator of the MSB of the good since people can receive benefits of consuming the good without paying for it.
ii. MC= MSC There is no problem with the firm's marginal costs as an indicator of MSC.
iii. If P=MC
Then MSB > MSC
The problem is that there is too little output of the good produced in the market since consumers and firms are basing their decisions on market price rather than on MSB.
Market failure: Less than the efficient level of output will be produced in markets for public goods.
GRAPH
There is what is called a FREE-RIDER problem associated with public goods. Since people cannot be forced to pay for what they consume, as long as the good is provided some people will be able to consume it without paying for how much they really value the good.
Example: Public radio and fund drives.
Question: What kinds of government policies may be used to increase the production of public goods in the economy?
5. The market can fail to achieve social goals:
* income distribution
An efficient allocation of resources says nothing about the distribution of income. It is entirely possible that resources are allocated efficiently in a society with one person holding all the resources and the rest of the people holding none.
Greater equality in the distribution of income is often a goal of a society, to promote social cohesion. It can be a goal that conflicts with the goal of efficiency.
Extension 18-1 Okun's Leaky Bucket
* There is often a case for trading-off some efficiency for greater equity.
* preferences for public provision
There are some goods that we don't want provided through markets - for example: police, the judicial system, the right to vote. There are some goods that we think people should have access to regardless of whether or not they can afford them.
* paternalism
There are cases where society wants some people to be protected from themselves. In these cases there are laws such as seat belt laws, anti drug laws, helmet laws for motor cyclists.
* social obligations
There are some obligations that society thinks people should not be able to buy their way out of - for example, military service, or jury duty. These obligations must be met in some way that is not determined by a person's ability or lack of to pay.
6. Benefit-cost analysis of government intervention:
* Policies can create benefits but they also generally impose costs.
* To decide whether or not a policy should be implemented it is necessary to weigh the benefits and costs.
*If the benefits outweigh the costs the policy should be implemented.
Difficulties of making this calculation in practice:
1. Often difficult to predict all of the possible outcomes of a policy.
2. Costs and benefits may not appear until some time in the future
3. Costs and benefits may be difficult to quantify.
7. Tools of government intervention:
1. public provision - using tax revenues to pay for publically provided goods.
2. redistribution and social insurance - using taxes and spending to effect the distribution of income.
3. regulation - public rules that effect the behavior of private firms and consumers.
4. structuring incentives - using taxes and subsides to discourage or encourage certain behaviors.
What are the costs of government intervention?
1. It uses real resources.
2. The intervention itself may be imperfect - there may be government failure
3. The process of determining the nature of government intervention is costly and imperfect.
What are the causes of government failure?
1. Special interests - can often get their interests served and have someone else pay the price.
2. Government as a monopoly - doesn't have incentives to keep costs down since it doesn't face any competition.
3. Political interests can differ from the public's interest - politicians are often motivated by their own interests rather than the public's interests.
How much should the government intervene?
Realistically we must compare the workings of the market system in practice with the workings of government intervention in practice.
This requires being realistic about the benefits and costs of both.
Conservatives tend to dogmatically glorify the hypothetical free market.
Liberals tend to dogmatically glorify hypothetical government intervention in the market.
Neither tells the real story.