“The Economic
Way of Thinking”
11th Edition
© 2006 Prentice Hall Business Publishing
Chapter 13:
Markets and
Government
The Economic Way of Thinking, 11/e
Heyne/Boettke/Prychitko
Chapter 13 Outline
• Introduction
• Private Versus Public?
• Competition and Individualism
• Economic Theory and Government Action
• The Right to Use Coercion
• Is Government Necessary?
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Chapter 13 Outline
• Excluding Nonpayers
• The Free-Ride Problem
• Positive Externalities and Free-Riders
• Law and Order
• National Defense
• Roads and Schools
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Chapter 13 Outline
• Income Redistribution
• The Regulation of Voluntary Exchange
• Government and the Public Interest
• Information and Democratic Governments
• The Interests of Elected Officials
• Concentrated Benefits, Dispersed Costs
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Chapter 13 Outline
• Positive Externalities and Government Policies
• How Do People Identify the Public Interest?
• The Prisoner’s Dilemma
• The Limits of Political Institutions
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Introduction
• Key questions in constitutional political economy
– What should be left to the market?
– What are the appropriate tasks for government?
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Private Versus Public?
• The market usually characterizes the private
sector.
• Government agencies and officials comprise the
public sector.
• Question
– Does individual self-interest play a role in the public
sector?
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Competition and Individualism
• The market sector is often referred to as the
competitive sector.
• Question
– Is there competition in the government?
• Competition in the public sector
– Elections
– Government agencies
– Passing legislation
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Economic Theory and
Government Action
• Economic Theory
– All participants are concerned with self-interest and
behave rationally.
– If the marginal revenue of an activity exceeds the
marginal cost, the activity should be expanded.
– If the marginal cost of an activity exceeds the
marginal revenue, the activity should be contracted.
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Economic Theory and
Government Action
• Question
– Does the government make decisions in the same
way?
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Economic Theory and
Government Action
• Governments:
–
–
–
–
Have limited resources.
Wants exceed the capacity of the resources.
Must allocate their resources.
Will use incentives to determine the optimal
allocation.
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Economic Theory and
Government Action
• What is the role of property rights in government
behavior?
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The Right to Use Coercion
• Government possesses a generally conceded
and exclusive right to coerce adults.
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The Right to Use Coercion
• Coercion
– To induce cooperation by threatening to reduce
people’s options.
• Persuasion
– To induce cooperation by promising to expand
people’s options.
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The Right to Use Coercion
• Examples of Coercion
– Traffic laws
– Easements
– Code enforcement
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The Right to Use Coercion
• We may be able to achieve greater freedom and
expanded options if we all accept some
limitations of our freedom and some reduction in
our options.
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Is Government Necessary?
• How much police protection did you consume
last month?
• Would police protection be available without
government?
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Excluding Nonpayers
• Without government
– People who wanted police and/or fire protection could
pay for it.
– Could their neighbors be excluded?
– How does this impact a person’s willingness to pay for
protection?
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Excluding Nonpayers
• Positive Externalities and Free-Riders
– Spillover benefits reduce the incentive to produce
certain goods.
• Positive Externalities and Free-Riders
– Government can create an incentive to produce
goods through coercion which reduces the
transaction cost.
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The Free-Rider Problem
• Free-Riders
– People who accept benefits without paying their share
of the cost of providing those benefits.
• Question
– Why don’t people do what would clearly make
themselves and others better off?
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The Free-Rider Problem
People are guided by the costs they expect
to bear and benefits they expect to receive.
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Positive Externalities and Free-Riders
• Positive Externalities
– Exist alongside negative externalities.
– Create a disincentive to produce.
– Probably more prevalent than spillover costs.
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Positive Externalities and Free-Riders
• Exchange entails transaction costs.
• Transaction Costs
– Reduce exchanges if they exceed marginal benefits.
• Government Coercion
– Reduces transaction costs.
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Law and Order
• High transaction costs make it difficult to exclude
free-riders.
• Government coercion forces everyone to pay
involuntary contributions (taxes).
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Law and Order
• Uniform and Consistent Rules
– Increase planning confidence
– Contribute to cooperating society
• Examples
– Defining property rights
– Enforcement of contracts
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National Defense
• National Defense
– A public good
– A traditional role of government
– Can’t be provided privately due to the free-rider
problem.
– Does not have to be solely provided through coercion.
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Roads and Schools
• Question
– Would the quantity and quality of roads be the same if
coercion was not used to finance them?
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Roads and Schools
• Transaction Costs
– Would be high if tolls were relied on to finance roads.
• Question
– Do others benefit from road development?
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Roads and Schools
• Education
– People acquire education only as long as the
marginal benefit exceeds the marginal cost.
– Positive externalities result.
• Education
– Less than optimal will be obtained when external
benefits are not considered.
– Taxes to finance education lowers the cost and
increases the demand.
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Income Redistribution
• The government provides special benefits to the
impoverished.
• Question
– Why not rely on private philanthropy?
• Hint: Free-riders
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The Regulation of Voluntary Exchange
• Reducing Transaction Costs
– Licensing
– Certification
– Setting standards
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Government and the Public Interest
• Government attempts to address sources of
market failure.
– Transaction costs
– Positive externalities
– Free-riders
• Question
– How would the lack of perfect information and
incentives impact the government’s ability to act in the
public interest?
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Government and the Public Interest
• Why are government policies dominated by
special interests?
• Why are governments more likely to oversupply
than undersupply a public good?
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Information and
Democratic Governments
• Question
– Why don’t you take the time to learn more about the
candidates running for various offices?
• Question
– Is an interest in being re-elected likely to lead elected
officials to vote and act in the public interest?
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The Interests of Elected Officials
• Observation
– The few who have much to gain invest vast resources
in trying to influence the political process.
• Observation
– The many with more to gain in total, but less to gain
individually, invest almost nothing.
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Concentrated Benefits, Dispersed Costs
• Democratic political process
– Concentrate benefits on the
• Well organized
• Well informed
• Who gain the most
– Disperse costs on
• Unorganized
• Ill-informed
• With little to gain individually
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Positive Externalities
and Government Policies
• Government policies
– tend to be dominated by special interests.
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How Do People Identify
the Public Interest?
• Scenario
– How long should a new drug be tested by the FDA?
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How Do People Identify
the Public Interest?
Costs
and
Benefits
Benefits to patients
of additional testing
Costs to patients
of additional testing
Cost =
Benefit
Cost to the FDA
for testing
T1
Time Spent in Testing
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T2
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The Prisoner’s Dilemma
• The Dilemma
– Choosing whether to spend two hours/week working
on a public policy issue or go bowling.
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The Prisoner’s Dilemma
Duty
Each
Chooses
Good
Government
Bad
Government
Recreation
Others Choose
Duty
Recreation
Good
Government
Plus
Bowling
Bad
Government
Plus
Bowling
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The Limits of Political Institutions
• What do you think?
– Are there limits to what political institutions can
accomplish?
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Once Over Lightly
• Government actions follow decisions of citizens
and government officials.
• They compare marginal costs and benefits of
alternative actions.
• Governments have the right to use coercion.
• Thru coercion it is sometimes possible to secure
goods not available thru voluntary cooperation.
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Once Over Lightly
• Coercion may secure the supply thru lowering
transaction costs.
• Government actions reduce transaction costs
and overcome free-rider problems.
• Government coercion presupposes voluntary
cooperation.
• Positive externalities permeate the political
process in a democratic government.
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End of Chapter 13
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