Chapter 3 – The Economic Roles of
Government
• In Chapter 2 we learned that if the assumptions
of the First Fundamental Theorem of Welfare
Economics hold, then resource allocation is
efficient in an economy and the government
interferes for reasons of equity
• In Chapter 3 we will cover failures of
Chapter 2’s assumptions and further reasons
for government involvement in the economy
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Chapter 3 – The Economic Roles of
Government
• In this chapter we will study:
Market Failure
Government Redistribution
Government Stabilization
Financing Government Spending
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Theory - Market Failure
• First Fundamental Theorem of Welfare
Economics assumptions (chapter 2):
1) All consumers and producers act as perfect
competitors (no one has market power)
and
2) A market exists for each and every
commodity
If either fail,
-Pareto efficiency isn’t reached
-there is room for more government
involvement
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Failure 1 - Market Power
• Microeconomics shows that under perfect
competition (no firm has market power),
P=MC
• However, if any firm has market power (is a
price maker, not a price taker), we have a
situation were
P>MC
• And efficiency no longer holds
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Failure 1 - Market Power
• Market Power can arise in a variety of
economies. Examples include:
a) Monopoly – one firm supplies all of a product
and has no competition (entry is blocked)
-It can be the case that a firm has a decreasing
average cost, and is therefore a NATURAL
MONOPOLY
-This often happens with utilities
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Market Power
b) Oligopoly – few firms supply a product
-Often each firm has enough market power to
charge P>MC
c) Monopolistic Competition – although there are
many firms, each firm has enough of a
differentiated product to wield some market
power (ie: brand loyalty – Ipods and MP3
players, some breakfast cereals)
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Failure 2 -Nonexistence of Markets
The First Fundamental Theorem of Welfare
Economics also fails if a market doesn’t exist.
Three things that could cause a market not to
exist are
a) insurance failure
b) externalities
c) public goods
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Failure 2a) Insurance Failure
Insurance isn’t offered, or is offered inefficiently,
in many markets due to ASYMMETRIC
INFORMATION – one party (usually the buyer)
has more information that the other
Insurance failure commonly occurs for 2 reasons:
1) Adverse Selection
2) Moral Hazard
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Insurance Failure Example
In hockey, assume a team can win (best case),
tie, or lose (worst case).
Assume, however, that a team could buy “loss”
insurance, that would change any loss into a
tie on their record. Assume that fair insurance
would cost $20,000 a game.
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Adverse Selection Example
ADVERSE SELECTION – people most likely to
receive benefits from insurance are most likely
to buy it.
Good teams (with few potential claims) would
avoid this insurance.
Bad teams (Calgary Flames – with many potential
claims) would buy it every game.
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Adverse Selection
The insurance would pay out MORE often than
average, requiring a higher premium (ie:
$50,000)
At this new, higher premium, average teams
(Ottawa Senators) also pass up the insurance,
pushing the premium up even higher.
This is one reason auto insurance is mandatory.
If it wasn’t it would cost much, much more.
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Moral Hazard
MORAL HAZARD – arises when an individual
can influence the probability or magnitude of a
loss through an action the insurance company
can’t observe.
Assume however that the Edmonton Oilers buy
the insurance, and near the end of the game
there is a tie. Players are tired and may give
up the game, knowing that they won’t get a
loss.
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Moral Hazard and University
Many scholarships are offered to help pay for
University, as an attempt to reward or attract
successful students and encourage them to
continue succeeding.
However, some studies have shown some
scholarships NEGATIVELY affecting a
student’s success.
This may be related to Moral Hazard – if the cost
of going to University is low, the student has
more incentive to “slack off”, since the last
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year cost him or her little.
Failure 2b) Externalities
An EXTERNALITY exists when the activity of one
agent affects the welfare of another agent in a
way that is outside existing markets.
For example, a smoker pollutes the air, but no
market exists for polluted (clean) air.
-the smoker is not forced to pay for his polluted
air in an air market
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Externality Example
A barking dog increases the security (and
sleeplessness) of your neighbour, yet no
market exists for these.
-a neighbour is not paid for protecting your
house in a neighbourhood security market
-your neighbour is not charged for keeping you
awake in a neighbourhood sleep market
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Externality Violation
In cases of negative externalities, SOCIAL
marginal cost is greater than PRIVATE
marginal cost:
SMC>MC
Therefore
SMC > P
The First Fundamental Theorem of Welfare
Economics fails, inefficiency exists, there is
room for government intervention. 16
Externality Violation
In cases of positive externalities, the SOCIAL
BENEFIT provided is inefficiently small.
Ie: Although a dog next door may make your
house safer, it is no substitute to locking your
doors at night.
Rarely will there be enough guard dogs in a
neighbourhood to leave your door unlocked.
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Failure 2c) Public Good
A PUBLIC GOOD is any commodity that is
nonrival in consumption – one consumer
consuming does not prevent another
consumer from consuming – and
nonexcludable – impossible or expensive to
exclude someone from consuming.
Examples: lighthouse, fireworks, city park, city
road, city alley, simple radio stations, public TV
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Free Riding
In the case of public goods, there is an incentive
to FREE RIDE, or enjoy the public good while
others pay for it.
-Citizens often will claim that a public good
benefits them less than it actually does, hoping
that others will cover the cost
As a result, public goods tend to be underprovided in a free market, therefore the market
is acting inefficiently without government
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intervention forcing fair payment for the good
Free Riding Example
When a mathematical problem goes up on the
board at university, its solution is a public good
– all students in the class benefit from it.
However, solving the problem requires work (and
actually taking one’s calculator out), so some
students try to look:
a) bored
b) uninterested, or
c) so intrigued that they are too busy to pull out
their calculator, while at the same time
glancing around, hoping someone else is 20
solving the problem.
Theory - Government and Efficiency?
When the discussed assumptions fail, the
allocation of goods is no longer Pareto
efficient, and there is the opportunity for the
government to intervene to enhance efficiency.
However, the government does not always
intervene, and in some cases should not, for
two main reasons:
1) Cost – the cost of intervening may be higher
than the efficiency gained
2) Mistakes – if the government intervenes
incorrectly, they may fail or make things worse
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Theory - Government Redistribution
The Second Fundamental Theorem of Welfare
Economics argues for government
redistribution.
But WHY should government be involved in
social programs?
1)
2)
3)
4)
Alturism is too small and inefficient
Social Stability
Poverty Insurance
Basic Human Rights
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1) Insufficient Altruism
Many economic agents – churches, clubs,
individuals, food banks – voluntarily provide
social programs.
Charitable organizations therefore have a positive
externality.
-however, positive externalities are rarely by
themselves sufficient
If a rich person feeds one poor person, SMC
(very little)<SMB (someone doesn’t die),
therefore there is under-provision
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1) Insufficient Altruism
Assume that a church puts on a big, free
community meal for Christmas, and feeds the
community. That’s great and a great social
program, but the next day all those people are
hungry again, and the day after, and the day
after.
Charitable organizations are good, but rarely
sufficient to the need, therefore the
government either needs to subsidize charities
or provide its own social programs.
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2) Social Stability
High disparity in distribution of income can lead to
strife and lack of teamwork in society.
-The poor become envious and negative
towards the rich
-The rich become afraid of losing what they
have to the poor
A social net is the “glue” that holds a society
together and guarantees property rights and
the opportunity for an efficient market.
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3) Poverty Insurance
Government social programs can be seen as
poverty insurance – insurance against being
poor.
Some people (such as those with severe mental
or physical challenges) have an almost
certainty of being poor.
Insurance can’t insure against the certain,
therefore private poverty insurance is
impossible.
Only the government can fully insure against
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poverty.
4) Basic Human Rights
Many people support social programs as a part of
their support for Basic Human Rights.
Article 25 of the United Nations Universal
Declaration of Human Rights states,
“Everyone has the right to a standard of living
adequate for the health and well-being of
himself and his family.”
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Basic Human Rights
Similarly, the Canadian Constitution Act, 1982
states,
the government of Canada and the provincial
governments, are committed to
a) promoting equal opportunities for the wellbeing of Canadians
b) furthering economic development to reduce
disparity in opportunities; and
c) providing essential public services of
reasonable quality to all Canadians
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Redistribution Issues
The First Fundamental Theorem of Welfare
Economics states that a perfectly functioning
market is Pareto Efficient.
The Second Fundamental Theorem of Welfare
Economics states that lump sum transfers can
efficiently redistribute wealth.
Observe the following Utility Possibility Frontier
and Social Indifference Curves:
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Redistribution Issues
If the initial endowment
resulted in point i, the ideal
lump-sum transfer would
move society to point ii
Maka’s Utility
i
O
Maka
ii
W```
W`
Susan’s Utility
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Redistribution Issues
In practice, lump-sum transfers can be difficult
due to asymmetric information
-Even if the government can observe income,
that income could be misleading – it doesn`t
take into account time and effort spent on the
income
-If lump-sum fees and transfers are related to
income, they are an income tax
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Income Tax
If the government imposes an proportional
income tax and gives equal payments to
everyone, it would act as a lump-sum transfer,
as the rich will pay more, yet everyone
receives the same amount
This creates a disincentive to work, and shifts the
Utility Possibility Curve inwards
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Income Tax
Generally, at low tax levels increases the tax
brings in more tax revenue, regardless of
increased disincentive to work.
Eventually, however, an increase in tax creates
such a disincentive to work that it reduces tax
revenue. This is point C* on the next graph.
We then see the reduced Utility Possibility Curve
and new social optimum under asymmetric
information:
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Asymmetric Issues
Due to imperfect
information, government
intervention may achieve iii
instead of ii
Maka’s Utility
i
O
Maka
ii
iii
W```
C*
W`
W``
Note that at
point C*, the
slope of the
new Utility
Possibility
Frontier is
vertical.
Susan’s Utility
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Equity-Efficiency Trade-Off
Notice that the new Utility Possibility Curve
deviates more and more from the original the
farther away one moves from the initial
endowment.
This illustrates the fact that with distortionary
taxes, the rate at which one person loses to
benefit the other is higher.
The equity-efficiency trade-off of distortionary
taxes is a subject of much debate. Different
tax-transfer mechanisms also have different
trade-off rates.
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Sidenote: Government Stabilization
Keynesian Macroeconomics states that private
investment or exports can cause fluctuations in
aggregate output; fluctuations that the
government is responsible to “smooth out”
One could argue that the bailouts following the
economic collapse was the US government’s
attempt to increase expenditure to “smooth
out” the economy and keep it stable.
This is a largely Macroeconomic issue touched
upon in Chapter 11.
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Theory - Financing Government
Spending
Government services must be funded
Most people hate taxes, but the alternatives:
a) Borrowing
b) Printing Money
c) Conscription
d) Government fees
prove to be inadequate
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a) Borrowing
Government can borrow to fund certain projects
(large capital expenditures, war, etc).
Borrowed money must be paid back with
INTEREST.
Borrowing ≠ income
Borrowing => lower future income
Borrowing/debt today is a tax hike tomorrow. 38
b) Printing Money/Increasing Money
Supply
In extreme cases, the government can “print
money” as a method of finance.
↑Money Supply => ↓ value of money, therefore
↑Money Supply => inflation (inflation tax)
Inflation
a) is bad for society
b) increases the cost of government
Eventually the monetary system can break down
entirely.
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c) Conscription
In Western Democratic Countries, conscripting
workers or expropriating resources is rare, but
does happen (US draft, Edmonton snow
shovelling by-law).
Conscription is inequitable and inefficient:
-it targets those citizens most valuable for the
job (ie: engineers) and makes those jobs less
attractive
-citizens would try to avoid conscription and do
a poor job once conscripted
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Plus, how do you pay for the conscription police?
d) Government Fees
Government fees can fund SOME PROGRAMS,
BUT can’t fund PUBLIC or quasi-public
GOODS:
-Some public goods (national defence) are
available to all. Who do you charge? What do
you do if someone doesn’t want it?
-Exclusion may be costly (ie: public roads)
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d) Government Fees
-Exclusion may be inappropriate if goods are
nonrival (ie: park with plenty of room)
-User charges don’t work for welfare services or
income redistribution (ie: charging the poor to
give money to the poor)
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Tax Truth
No alternative to Taxes can raise the funds
needed to provide government services.
Wanting the services that government provides
indirectly means wanting taxes.
(Similar to how wanting more from the University
can indirectly mean wanting higher tuition.)
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Brief Theory - Tax Evaluation
Economics of taxation is another course, but
briefly, the TYPE of tax charged is evaluated
on 4 areas:
1) Equity – does the tax tax those who benefit?
-is taxation related to ability to pay?
2) Efficiency – does the tax have a large negative
impact on the economy?
3) Administration – how high are the tax’s
compliance and administration costs?
4) Visibility – is the tax visible enough to make
people aware of the costs of government
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programs?
Chapter 3 Summary
Government involvement includes:
1) Protecting property rights
2) Stepping in when the market fails (market
power, insurance, externalities and public
goods)
3) Redistribution
4) Stabilization
5) Taxation
-Asymmetric information causes problems with
redistribution of income
-Taxes are necessary to fund government 45
programs, but must be evaluated