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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 FailureGovernment RedistributionGovernment StabilizationFinancing 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)

and2)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 Selection2) 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 UniversityMany 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 year cost him or her little.

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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>MCThereforeSMC > P

The First Fundamental Theorem of Welfare Economics fails, inefficiency exists, there is

room for government intervention.

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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 under-provided in a free market, therefore the market is acting inefficiently without government intervention forcing fair payment for the good

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Free Riding ExampleWhen 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) boredb) 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 solving the problem.

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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 RedistributionThe Second Fundamental Theorem of Welfare

Economics argues for government redistribution.

But WHY should government be involved in social programs?

1) Alturism is too small and inefficient2) Social Stability3) Poverty Insurance4) 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 poverty.

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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 RightsSimilarly, the Canadian Constitution Act, 1982

states,

the government of Canada and the provincial governments, are committed toa) promoting equal opportunities for the well-being of Canadiansb) furthering economic development to reduce disparity in opportunities; andc) 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

Susan’s Utility

Mak

a’s

Util

ity

OMaka

If the initial endowment resulted in point i, the ideal lump-sum transfer would move society to point ii

i

ii

W```

W`

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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

Susan’s Utility

Mak

a’s

Util

ity

OMaka

Due to imperfect information, government intervention may achieve iii instead of ii

i

ii

W```

W`

iii

W``C*

Note that at point C*, the slope of the new Utility Possibility Frontier is vertical.

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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 fundedMost people hate taxes, but the alternatives:

a) Borrowingb) Printing Moneyc) Conscriptiond) 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 ≠ incomeBorrowing => lower future income

Borrowing/debt today is a tax hike tomorrow.

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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 societyb) increases the cost of government

Eventually the monetary system can break down entirely.

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c) ConscriptionIn 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

Plus, how do you pay for the conscription police?

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d) Government FeesGovernment 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 EvaluationEconomics 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 programs?

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Chapter 3 SummaryGovernment involvement includes:1) Protecting property rights2) Stepping in when the market fails (market power,

insurance, externalities and public goods)3) Redistribution4) Stabilization5) Taxation-Asymmetric information causes problems with

redistribution of income-Taxes are necessary to fund government

programs, but must be evaluated