The proper role of government in a market economy is a perennial subject of heated debate, providing us the frequent irony of people arguing, on the one hand, that government should “do something,” even as they complain, on the other hand, that government should “get off their backs.” How do we approach the subject of government’s role with some measure of objectivity? Economic reasoning provides positive tools for evaluating the normative choices of individuals who hold a variety of perspectives on the proper level of government involvement in the economy. Economic analysis helps us identify both the costs and benefits of various levels of government involvement, and the individuals and groups who bear the costs and reap the benefits.
This topic offers a model or framework for classroom lessons that address the question of which aspects of the economy should be left to the invisible hand of the market, and which should be subject to direct or indirect government involvement. Common instances of market misallocation are identified and various types of government response evaluated. The lesson takes incentive analysis and economic reasoning into the political arena by introducing the theory of public choice. Data and historical examples tie micro-economics – decision-making constrained by scarcity, incentives, and marginal analysis – to the macro-economic arena where government adopts policies that shape the national economy.
Finally, using contemporary data and historical examples, this lesson demonstrates how economics education can be an effective vehicle for learning in many disciplines and contexts.
|marginal cost / marginal benefit
|theory of public choice
Standard 2: Students will understand that: Effective decision making requires comparing the additional costs of alternatives with the additional benefits. Most choices involve doing a little more or a little less of something; few choices are all-or-nothing decisions.
- To determine the optimal level of a public policy program, voters and government officials must compare the marginal benefits and marginal costs of providing a little more or a little less of the programs services.
Standard 16: Students will understand that: There is an economic role for government to play in a market economy whenever the benefits of a government policy outweigh its costs. Governments often provide for national defense, address environmental concerns, define and protect property rights, and attempt to make markets more competitive. Most government policies also redistribute income.
- Public goods and services provide benefits to more than one person at the same time, and their use cannot be restricted only to those people who have paid to use them.
- If a good or service cannot be withheld from those who do not pay for it, providers expect to be unable to sell it and therefore will not produce it. In market economies, governments provide some of these goods and services.
- Markets do not allocate resources effectively if (1) property rights are not clearly defined or enforced, (2) externalities (spillover effects) affecting large numbers of people are associated with production or consumption of a product, or (3) markets are not competitive.
- An important role for government in the economy is to define, establish, and enforce property rights. Full property rights to a good or service includes the right to exclude others from using the good or service and the right to transfer the ownership or use of the resource to others.
- Externalities exist when some of the costs and benefits associated with production and consumption fall on someone other than the producers or consumers of the product.
- When one producer can supply total output in a market at a cost that is lower than the cost incurred when two or more producers divide production, competition may be impossible. In the absence of competition, government regulations may then be used to control price, output, and quality.
- Governments provide an alternative method to markets for supplying goods and services when it appears that the benefits to society of doing so outweigh the costs. Not all individuals will bear the same costs or share the same benefits of such policies.
- A government policy to correct a market imperfection is not justified economically if its expected costs exceed its expected benefits.
Standard 17: Students will understand that: Costs of government policies sometimes exceed benefits. This may occur because of incentives facing voters, government officials, and government employees, because of actions by special interest groups that can impose costs on the general public, or because social goals other than economic efficiency are being pursued.
- Citizens, government employees, and elected officials do not always directly bear the costs of their political decisions. This often leads to policies whose costs outweigh their benefits for society.
- Incentives exist for political leaders to implement policies that disperse costs widely over large groups of people and benefit relatively small, politically powerful groups of people.
- Incentives exist for political leaders to favor programs that entail immediate benefits and deferred costs. Few incentives favor programs promising immediate costs and deferred benefits, even though the latter programs are sometimes economically more effective than the former programs.
- Referencing the National Economic Goals session (topic 6), discuss the question of the proper role for government in the economy. Differentiate between the positive perspective of economics and the normative perspective of politics.
- Review the foundations necessary for a market economy to work properly – that is, to direct resources to their most valuable uses.
- Identify “market failure” as the condition that exists when resources are not drawn to their most valuable uses.
- Provide examples in which market outcomes are not efficient, and identify the conditions in which market failure occurs.
- Distinguish between private and public goods and discuss the difference between true public goods and services, and goods and services that are paid for publicly. Discuss the “free rider” problem.
- Define and provide examples of externalities, and discuss options for preventing, eliminating, or dealing with externalities. Explain and exemplify how clear definition of property rights facilitates the reduction of externalities.
- Identify and provide examples of other common areas of market imperfection, including lack of competition and discrimination. Discuss methods for dealing with the imperfections and criteria for evaluating success in dealing with them.
- Explain and illustrate how we can use marginal analysis to evaluate government policies and the actions of government officials, government workers, voters, and citizens.
- Discuss how the incentives facing government workers differ from the incentives facing those who operate in the competitive market. Explain public choice theory.
- Use incentive analysis to explain why good politics is often bad economics.
- Decision-making by government officials is fundamentally similar to decision-making by individuals and firms in that it is constrained by scarcity.
- The benefits of government involvement in the economy are most likely to outweigh the costs when public goods and common resources are involved, or when market power or externalities exist.
- Public goods differ from private goods in that they are non-rivalrous and non-exclusive.
- Private firms will only provide goods and services when they can exclude non-payers.
- Externalities exist when costs (or benefits) are not captured in an exchange and spill over onto people other than those who participated in the exchange.
- Externalities occur when property rights are not clearly defined or cannot be enforced. An important function of government is the definition and enforcement of property rights.
- When there is insufficient competition, firm(s) may wield market power, acting as price-setters instead of price-takers. Regulation of such markets by government may be used to correct or prevent socially inefficient output decisions.
- Public choice theory is the application of cost-benefit analysis to the decision-making activities of public officials who can only achieve their goals by getting to and remaining in office. The incentives within the system favor: well-organized interest groups whose members can affect election outcomes; programs with diffuse costs and concentrated benefits, and policies with long-term costs and short-term benefits.
- Firms and consumers in private markets face scarcity, but government does not.
- If politicians were honest and governments made careful decisions, we could accomplish all of our national economic goals.
- All goods and services paid for by taxes are true public goods.
- Government actions / policies are free and have no opportunity cost.
- Unlike consumers and business people, politicians do not attempt to maximize their utility.
- Markets allocate resources perfectly.
- Government’s role in the economy should be extremely limited.
Frequently Asked Questions:
- What is market failure and why does it happen?
- What should government(s) be involved in and why? (When it comes to the economy, is there such a thing as “government failure”?)
- Why are some businesses able to charge more than would be necessary to keep them in business?
- What are entitlements and how do they affect behavior and markets?
- Why does it seem to be so difficult to stop/prevent pollution?
- Doesn’t the market punish discrimination?
- Why don’t politicians just do what is fair?
- Why do so many politicians fail to follow through on their campaign promises?
- Why should I vote?
Classroom Activity Option
- Review the foundations of the market: competition, private property, rule of law, perfect information, freedom, sovereignty, price stability, and efficiency. Discuss how/how well the United States keeps these foundations in place.
- Link the principles of economic reasoning used in individual decision-making to decision-making in the public sector. Describe public choice theory and how citizens, politicians, and bureaucrats weigh expected costs with expected benefits when creating or voting on policies.
- Apply public choice theory to the question of why voter turn-out is generally low in the U.S. Discuss the incentives to become informed and to vote, and the expected benefits and costs of those actions. Challenge students to create a plan to increase voting percentages.
- Public goods, free riders, and common resources all create issues that might be better understood and resolved through government involvement. In these situations, overuse is common. Discuss the issues and provide examples. Include: tragedy of the commons; public trash, police protection. Provide historical and contemporary examples (light houses, bridges, roads etc.) where allocation cannot be made on the basis of price so government provides the good or service and taxes all citizens.
- Distribute copies of the U.S. Constitution. Direct students to highlight the parts of the Constitution that they think relate (either positively or negatively) to economics. Discuss how the document could be viewed as economic rather than political.
- Review the current or proposed federal budget and identify expenditures that reveal national economic goal priorities. Follow the news as a piece of legislation goes through the approval process; look for the differing economic goal priorities of supporters and opponents.
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