2. Describe specifically how your economic thinking has been affected by this course and how you can best make use [apply] the central principles and theories which were studied. What is the main outcome(s) from the course for you? (~ 2 pages)

Learning Objectives – After reading the chapter, students should be able to:

Describe how government's power to coerce can be economically beneficial and list some of the difficulties associated with managing and directing the government.

Discuss "government failure" and explain why it happens.

(Appendix) Explain the difficulties of conveying economic preferences through majority voting.

Government's Economic Role

0. Although the U.S. economy is primarily a market system where markets and prices coordinate and direct economic activity, there is still a prominent role for government in determining how the economy functions.

Government's Right to Coerce: One key difference between the economic activities of government and those of private firms and individuals is that government possesses the legal right to force people to do things. In many cases this can improve economic efficiency.

Force and Economic Efficiency: The government can correct for market failure by providing public goods and by providing the appropriate incentives to firms (or households) in the presence of externalities. This will most likely increase economic efficiency. The government can also reduce private-sector economic risks by enforcing property rights and enforcing contracts. This will also most likely increase economic efficiency.

The Problem of Directing and Managing Government

The government can substantially improve allocative and productive efficiency if it directs its coercive powers toward rectifying market failures and providing a low-risk economic environment for the private sector. However, governments face the daunting challenge of organizing millions of employees to carry out thousands of tasks. An understanding of these challenges and complexities will give you a better sense of how well most governments manage to do despite all of the problems associated with government failure.

No Invisible Hand: Government economic policies are not self-correcting. If a government program is inefficient there is no pressure forcing this program to become more efficient or forcing it "out-of-business".

Massive size and scope: The size and scope of government makes it difficult to identify and fix economic inefficiencies.

The need for bureaucracy: Given the size of government, elected officials must rely upon many layers of supervisors to run and manage government programs.

The need for paperwork and inflexibility: To make sure that laws are uniformly enforced, the bureaucracy is regulated by detailed rules and regulations governing nearly every possible action that any individual bureaucrat might be called upon to make.

The information aggregation problem: Because of their massive size and scope, bureaucracies have difficulty with effectively aggregating and conveying information from their bottom layers to their top layers. As a result, top officials will tend to make inefficient choices.

Lack of accountability: Democratic elections do take place, but because the government undertakes so many activities, it is difficult for the electorate to know the details of even a small fraction of what the government is up to at any particular time. As a result, many programs are run poorly without affecting the reelection chances of the incumbent politicians.

Consider This … Does Big Government Equal Bad Government?

The actual size of the government is not necessarily "good" or "bad". It is whether or not the marginal benefit of a government program exceeds the marginal cost of the program. Thus, the debate over "large" or "small" government is misplaced. It is really a debate about the marginal benefit and marginal cost of government programs.

Government Failure

0. Government can fail despite knowing the preferences of voters (as discussed in the appendix) because government puts their own interests ahead of the voters’ interests and/or government chooses policies that create large benefits for a small group while creating small losses for the majority.

Representative Democracy and the Principal-Agent Problem

The principal-agent problem occurs because conflicts arise when tasks are delegated by one group of people (principal) to another group of people (agents).

In a democracy, elected officials (agents) have goals like reelection which conflict with the interests of the voters.

Special interests may promote the interests of a small group at the expense of society at large.

The special-interest effect refers to the situation where a small number of people will receive large gains at the expense of a much larger number of people who individually suffer small losses. The small group will be well informed and highly vocal on the issue and press politicians for approval. The large numbers who will each suffer small losses will not have the incentive to be informed or feel strongly. The result is that the politician will support the specialinterest program, whose supporters will notice the vote in their favor, and ignore the majority who don’t feel strongly.

Pork-barrel politics is an example of the special-interest effect. In this case, the benefit goes to a single political district and to the politician from that political district. The cost of the project is spread out to many individuals who will never receive the benefits. Pork-barrel politics is often combined with logrolling.

Rent-seeking behavior occurs when a transfer of wealth at someone else’s or society’s expense occurs through government action. Here the term “rent” means any payment to a resource supplier, business, or other organization above that which would accrue under competitive market conditions. Examples include tax loopholes that benefit only certain groups; public works projects that cost more than the benefits they yield; and occupational licensing that requires more than is necessary to protect consumers.

Clear benefits, hidden costs (or the reverse, immediate costs and future more vague benefits) are another dilemma for politicians trying to decide on public programs. Where the benefits are recognizable and popular, the politician may vote for the program even if the costs exceed these benefits if the costs are diffuse or hidden.

Unfunded Liabilities: The political tendency to favor priorities that have immediate payouts but deferred costs also leads to many government programs having unfunded liabilities. An unfunded liability occurs when the government commits to future expenditures without simultaneously committing to collect enough tax revenues to pay for those expenditures (unfunded liability = present value of projected expenditures on the program - present value of projected tax revenue for the program).

Social Security is one of the largest programs with an unfunded liability.

Medicare also has a large unfunded liability component.

Chronic Budget Deficits: A budget deficit occurs whenever tax revenues are less than spending in a particular year.

Deficits might result in economic inefficiency by allowing the government to control and direct a large fraction of the economy's resources.

A Debt Crisis might occur because the government has accumulated so much debt that creditors are no longer willing to lend to the government. This can result in a major "shock" to the economy as the government raises taxes and cuts spending at unprecedented levels. It is better to gradually raise taxes and phase out programs (spending) rather than to implement a drastic adjustment to an economy.

Misdirection of Stabilization Policy: Stabilization policy attempts to use fiscal and monetary policy to "smooth-out" business cycle fluctuations.

Fiscal policy attempts to stimulate spending by changing tax rates and spending levels.

Monetary policy attempts to stimulate spending by changing interest rates.

The problem is that the politicization of fiscal and monetary policy might result in abuse and inefficiency by government officials. For example, the government might direct expenditures to specific companies in their district. Or might attempt to change interest rates before an election (an independent Federal Reserve reduces this possibility).

Limited and bundled choice is another problem with public goods. The voter must choose between a few candidates who will have the power to select the public goods and services to be financed by the voter’s tax money. The choices are “bundled” in that the limited set of candidates will govern over a variety of issues, and the voter’s preferences may not perfectly align with any candidate. In the private sector, the consumer has a multitude of choices available, and can generally separate out those goods and services not desired.

Consider This … Government, Scofflaw

An interesting example of government failure occurs when public companies operated by the government violate the law at higher rates than private companies.

A 2015 study found that public companies were substantially more likely than private companies to violate health and safety laws.

One explanation is that public companies may have a difficult time getting the tax revenue, or funding, that would be needed to comply with the law.

Another explanation is that the law appears to be applied much more leniently against public companies.

Bureaucracy and inefficiency can be another problem in the public sector because the profit motive or competitive pressure to perform efficiently is not present. Ironically, a potential response of government to a program’s failure is to increase its budget and staff.

Government employees, together with the special-interest groups they serve, often have the political clout to block attempts to pare down or eliminate their agencies.

There is a tendency for government bureaucracy to justify continued employment by looking for and eventually finding new problems to solve.

Inefficient Regulation and Intervention: Governments regulate many aspects of the economy with the hope that these regulations improve economic outcomes. Examples include the environmental laws and banking supervision.

Regulatory Capture occurs when the government agency that is supposed to supervise a particular industry becomes heavily influenced by the industry that it is supposed to be regulating.

Some argue that regulatory capture has occurred in the FDA with respect to the pharmaceutical industry.

Deregulation as an alternative to regulation will reduce (or eliminate) regulatory capture, but this might result in other inefficiencies, such as monopolies, false claims and unsafe drugs, and potential negative externalities from pollution.

Government's poor investment track record

Loan guarantees reduce downside risk and result in potentially inefficient investments.

Loan guarantees also socialize losses and privatize gains. If the project fails then the taxpayer picks up the tab. If project succeeds then the private investors reap the reward.

Corruption often occurs in government when officials abuse their power.

A government official is bribed to do what he should already be doing.

A government official accepts a bribe to do something he does not have the legal authority to do.

An interesting debate is whether or not campaign contributions constitute a bribe.

Imperfect institutions exist in both the public and private sectors, which often makes it difficult to decide which institutions would perform best in the production of certain goods and services.

LAST WORD: “Government Failure” in the News

0. Despite Disney making a profit of over $2 billion per year running nine of the world's 10 largest amusement parks, two Disney contractors received $1.4 million of federal loan guarantees in 2014.

The $878 billion American Recovery and Reinvestment Act of 2009 had many questionable spending projects. For example, $10 million was set aside to renovate a train station in Elizabethtown, PA that hadn't been used in 30 years.

Between 2009 and 2014, the U.S. Department of Agriculture spent $34 million on a program to encourage Afghanis to cultivate and consume soybeans—despite soybeans growing poorly in Afghanistan.

The government paid out funds on over 900,000 false claims for disaster relief from Hurricane Katrina.

APPENDIX TO CHAPTER 5: PUBLIC CHOICE THEORY AND VOTING PARADOXES

1. Public Choice Theory

0. Economic analysis of government decision making, politics, and elections.

Understanding government failures highlights how changes in government processes can lead to greater efficiency.

Revealing Preferences through Majority Voting

0. Majority voting can lead to inefficient outcomes; that is, the majority can defeat a proposal that would have provided greater benefits than costs and adopt one that costs more than the benefits it provides (Figure 1).

Illustration of an inefficient “no” vote result: Suppose there are 3 voters who each will have to pay $300 in tax if a proposal is adopted. It is worth $700 to one, $250 to the second and $200 to the third. The second and third voters will vote “no” and defeat the proposal despite the fact that the total benefits ($1150) exceed the $900 cost.

Illustration of an inefficient “yes” vote result: Take the same three voters as above and the same level of taxation. Now the proposal is worth $100 to the first voter and $350 to each of the others. The vote will be 2 to 1 in favor of the proposal even though the total benefit of $800 is less than the $900 cost.

Conclusion: The problem is that the oneperson onevote rule does not measure intensity of preferences, so the result may not be economically efficient. Too much or too little of the good is produced.

Interest groups may improve the economic efficiency of results by registering intense feelings with elected representatives or by organizing major efforts to get the vote to go their way.

Logrolling or vote trading may also secure favorable decisions for those who feel strongly about certain issues, but it may also negate an efficient outcome in favor of a special interest group where the value of the benefits received does not justify the cost. The efficiency of the outcome will depend on the circumstances.

The paradox of voting is that society may not be able to rank its preferences consistently through majority voting.

Table 1 demonstrates a situation in which three voters have expressed their rankings of three public projects; each has a different ranking. If voting is done on pairs of projects, it can be shown that national defense will win over roads, and roads will win over weather warning systems. But the logical conclusion that the community prefers national defense to weather warning systems is not the case—they would each get the same number of points (if points were awarded for a 1st, 2nd, and 3rd choice). In other words, if one choice must receive a majority of the votes, there will not be a consistent outcome in this case unless somehow the strengths of the rankings can be measured.

Government might find it difficult to provide the “correct” public goods by acting in accordance with majority voting.

Consider This … Voter Failure

The median-voter model suggests that under majority rule the median voter will in a sense determine the outcomes of elections. The median voter is the person holding the middle position on an issue.

The textbook example has three voters deciding among three types of weather warning systems. The first is willing to spend $400; the second, $800; the third, $300. The median-voter model suggests that the $400 proposal will win. In a choice between the $400 and $800 proposal, the first and third will vote for the $400 type. In a choice between the $400 and $300, the first and second will vote for the $400 type. In other words, both extreme voters prefer the median choice rather than the other extreme, so the median voter will tend to predominate.

Real-world examples occur in political positions where candidates seem to aim their appeal at the median voters within each party to get the nomination and later at the middle of the population in an effort to win the election.

Implications of the median-voter model:

Many people will be dissatisfied by the extent of government involvement in the economy.

Some people may “vote with their feet” by moving into political jurisdictions where the median voter’s preferences are closer to their own.

Median preferences can change over time.

QUIZ

1. Which of the following are potential problems with directing and managing government?

The government's massive size and scope

Politicians aren't as intelligent as the rest of society

It is difficult for the government to effectively aggregate information from bottom to top

Answer A and C are correct

Answer: D

What is the correct criterion in evaluating government programs?

1. The size of government: A larger government provides more goods.

The size of government: A smaller government has lower taxes.

By comparing the marginal benefit to the marginal cost of the government program. If the marginal benefit exceeds the marginal cost this is an efficient program.

By comparing the marginal benefit to the marginal cost of the government program. If the marginal cost exceeds the marginal benefit this is an efficient program.

Answer: C

An unfunded liability for a government program implies that:

1. projected government expenditure exceeds projected government revenue for the program.

the government program is self-sustaining.

projected government revenue exceeds projected government expenditure for the program.

the government has yet to establish the program.

Answer: A

A special-interest issue is one whose passage yields:

1. large private benefits compared to external benefits.

large external benefits compared to private benefits.

small economic losses to a small number of people and large economic losses to a large number of people.

large economic gains to a small number of people and small economic losses to a large number of people.

Answer: D

Politicization of fiscal and monetary policy:

1. Refers to the use of fiscal and monetary policy to help foreign governments.

Is the primary reason for public sector efficiency.

Refers to the use of fiscal and monetary policy to help politicians before an election.

Creates the opportunity for the fallacy of limited decisions.

Answer: C

Which of the following is the most likely cause of unfunded liabilities?

1. The cost of the program is immediate while the benefit is in the distant future.

The benefit of the program is immediate while the cost is in the distant future.

Politicians are helping as many people as they can.

Voters prefer taxes now rather than in the future.

Answer: B

It is often argued that government laws and regulations have unintended consequences. Which of the following is an unintended consequence of the 2010 healthcare reform law?

1. Everyone will now have insurance.

Companies are now willing to employ more full-time workers.

Companies are reducing full-time employees to part-time employees.

Insurance markets are now more efficient.

Answer: C

The concept of limited choices, as used in public choice theory, refers to the fact that:

1. Politicians may not be objective in evaluating economic policy programs.

Because of the importance of television and other modern communication techniques, the best and brightest candidates may not be selected by voters.

Voters must select a candidate who represents a "bundle" of various public policy programs and who can't register support or opposition for specific programs.

The most economically efficient public policy programs may not be selected because political leaders do not know enough about economics.

Answer: C

Public choice theory focuses on the economics of:

1. fiscal and monetary policy.

the behavior of business firms.

antitrust and regulatory policy.

government decision making, politics, and elections.

Answer: D

Regulatory capture is problematic for which of the following reasons?

1. The government collects less tax revenue.

The regulations governing an industry are set by the industry itself.

Monetary policy is likely to influence the election outcome.

There is excess spending on politician salaries.

Answer: B

387

2

5-2

Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.