McConnell Macroeconomics 18th edition - Chapter 4

The Public Sector: Government's Role

The economic activities of the public sector—Federal, state, and local government—are extensive. We
begin by discussing the economic functions of governments. What is government's role in the
economy?

Providing the Legal Structure

Maintaining Competition
Redistributing Income
Reallocating Resources
Promoting Stability

Providing the Legal Structure

Government provides the legal framework and the services needed for a market economy to operate
effectively. The legal framework sets the legal status of business enterprises, ensures the rights of
private ownership, and allows the making and enforcement of contracts. Government also establishes
the legal “rules of the game” that control relationships among businesses, resource suppliers, and
consumers. Discrete units of government referee economic relationships, seek out foul play, and
impose penalties.

Government intervention is presumed to improve the allocation of resources. By supplying a medium

of exchange, ensuring product quality, defining ownership rights, and enforcing contracts, the
government increases the volume and safety of exchange. This widens the market and fosters greater
specialization in the use of land, labor, capital, and entrepreneurial resources. Such specialization
promotes a more efficient allocation of resources.

Like the optimal amount of any “good,” the optimal amount of regulation is that at which the marginal
benefit and marginal cost are equal. Thus, there can be either too little regulation (MB exceeds MC) or
too much regulation (MB is less than MC). The task is to decide wisely on the right amount.

Maintaining Competition

Competition is the basic regulatory mechanism in the market system. It is the force that subjects
producers and resource suppliers to the dictates of consumer sovereignty. With competition, buyers
are the boss, the market is their agent, and businesses are their servants.

It is a different story where a single seller—a monopoly

A market structure in which the number of sellers is so small that each seller is able to influence the
total supply and the price of the good or service. (Also see pure monopoly.)

—controls an industry. By controlling supply, a monopolist can charge a higher-than-competitive price.

Producer sovereignty then supplants consumer sovereignty. In the United States, government has
attempted to control monopoly through regulation and through antitrust.

A few industries are natural monopolies—industries in which technology is such that only a single
seller can achieve the lowest possible costs. In some cases government has allowed these
monopolies to exist but has also created public commissions to regulate their prices and set their
service standards. Examples of regulated monopolies are some firms that provide local electricity,
telephone, and transportation services.
In nearly all markets, however, efficient production can best be attained with a high degree of
competition. The Federal government has therefore enacted a series of antitrust (antimonopoly) laws,
beginning with the Sherman Act of 1890, to prohibit certain monopoly abuses and, if necessary, break
monopolists up into competing firms. Under these laws, for example, in 2000 Microsoft was found
guilty of monopolizing the market for operating systems for personal computers. Rather than breaking
up Microsoft, however, the government imposed a series of prohibitions and requirements that
collectively limited Microsoft's ability to engage in anticompetitive actions.

Redistributing Income

The market system is impersonal and may distribute income more inequitably than society desires. It
yields very large incomes to those whose labor, by virtue of inherent ability and acquired education
and skills, commands high wages. Similarly, those who, through hard work or inheritance, possess
valuable capital and land receive large property incomes.

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But many other members of society have less productive ability, have received only modest amounts
of education and training, and have accumulated or inherited no property resources. Moreover, some
of the elderly, the physically and mentally disabled, and the poorly educated earn small incomes or,
like the unemployed, no income at all. Thus society chooses to redistribute a part of total income
through a variety of government policies and programs. They are:

Transfer payments Transfer payments, for example, in the form of welfare checks and food stamps,
provide relief to the destitute, the dependent, the disabled, and older citizens; unemployment
compensation payments provide aid to the unemployed.

Market intervention Government also alters the distribution of income through market intervention, that
is, by acting to modify the prices that are or would be established by market forces. Providing farmers
with above-market prices for their output and requiring that firms pay minimum wages are illustrations
of government interventions designed to raise the income of specific groups.

Taxation The government uses the personal income tax to take a larger proportion of the income of
the rich than of the poor, thus narrowing the after-tax income difference between high-income and low-
income earners.

The extent to which government should redistribute income is subject to lively debate. Redistribution
involves both benefits and costs. The purported benefits are greater “fairness” or “economic justice”;
the purported costs are reduced incentives to work, save, invest, and produce, and therefore a loss of
total output and income.

Reallocating Resources

Market failure occurs when the competitive market system (1) produces the “wrong” amounts of
certain goods and services or (2) fails to allocate any resources whatsoever to the production of
certain goods and services whose output is economically justified. The first type of failure results from
what economists call externalities or spillovers and the second type involves public goods.
Government can take actions to try to address both kinds of market failure.

Externalities When we say that competitive markets automatically bring about the efficient use of
resources, we assume that all the benefits and costs for each product are fully reflected in the market
demand and supply curves. That is not always the case. In some markets certain benefits or costs
may escape the buyer or seller
An externality is a cost or benefit from production or consumption, accruing without
compensation to someone other than the buyers and sellers of the product (see negative
externality and positive externality).

Externalities occur when some of the costs or the benefits of a good are passed on to or
“spill over to” someone other than the immediate buyer or seller. Such spillovers are called
externalities because they are benefits or costs that accrue to some third party that is
external to the market transaction.

Negative Externalities Production or consumption costs inflicted on a third party without

compensation are called negative externalities

A cost imposed without compensation on third parties by the production or consumption of

sellers or buyers. Example: A manufacturer dumps toxic chemicals into a river, killing the
fish sought by sports fishers; an external cost or a spillover cost.

. Environmental pollution is an example. When a chemical manufacturer or a meatpacking

plant dumps its wastes into a lake or river, swimmers, fishers, and boaters—and perhaps
those who drink the water—suffer external costs. When a petroleum refinery pollutes the
air with smoke or a paper mill creates obnoxious odors, the community experiences
external costs for which it is not compensated.

What are the economic effects? Recall that costs determine the position of the firm's
supply curve. When a firm avoids some costs by polluting, its supply curve lies farther to
the right than it does when the firm bears the full costs of production. As a result, the price
of the product is too low and the output of the product is too large to achieve allocative
efficiency. A market failure occurs in the form of an overallocation of resources to the
production of the good.

Correcting for Negative Externalities Some externalities get resolved via private
negotiations between those creating the externalities and those affected by them. But
when the externalities are widespread and negotiation between parties is unrealistic,
government can play an important role. For example, it can do two things to correct the
overallocation of resources associated with negative externalities. Both solutions are
designed to internalize external costs, that is, to make the offending firm pay the costs
rather than shift them to others:

Legislation In cases of air and water pollution, the most direct action is legislation
prohibiting or limiting the pollution. Such legislation forces potential polluters to pay for the
proper disposal of industrial wastes—here, by installing smoke-abatement equipment or
water-purification facilities. The idea is to force potential offenders, under the threat of legal
action, to bear all the costs associated with production.

Specific taxes A less direct action is based on the fact that taxes are a cost and therefore a
determinant of a firm's supply curve. Government might levy a specific tax—that is, a tax
confined to a particular product—on each unit of the polluting firm's output. The amount of
this tax would roughly equal the estimated dollar value of the negative externality arising
from the production of each unit of output. Through this tax, government would impose a
cost on the offending firm equivalent to the spillover cost the firm is avoiding. This would
shift the firm's supply curve to the left, reducing equilibrium output and eliminating the
overallocation of resources.

Positive Externalities Sometimes externalities appear as benefits to other producers or

consumers. These uncompensated spillovers accruing to third parties or the community at
large are called positive externalities
 A benefit obtained without compensation by third parties from the production or
consumption of sellers or buyers. Example: A beekeeper benefits when a neighboring
farmer plants clover. An external benefit or a spillover benefit.

. Immunization against measles and polio results in direct benefits to the immediate
consumer of those vaccines. But it also results in widespread substantial external benefits
to the entire community.

Education is another example of positive externalities. Education benefits individual

consumers: Better-educated people generally achieve higher incomes than less-well-
educated people. But education also provides benefits to society, in the form of a more
versatile and more productive labor force, on the one hand, and smaller outlays for crime
prevention, law enforcement, and welfare programs, on the other.

External benefits mean that the market demand curve, which reflects only private benefits,
understates total benefits. The demand curve for the product lies farther to the left than it
would if the market took all benefits into account. As a result, a smaller amount of the
product will be produced, or, alternatively, there will be an underallocation of resources to
the product—again a market failure.

Correcting for Positive Externalities How might government deal with the underrallocation
of resources resulting from positive externalities? The answer is either to subsidize
consumers (to increase demand), to subsidize producers (to increase supply), or, in the
extreme, to have government produce the product:

Subsidize consumers To correct the underallocation of resources to higher education, the

U.S. government provides low-interest loans to students so that they can afford more
education. Those loans increase the demand for higher education.

Subsidize suppliers In some cases government finds it more convenient and

administratively simpler to correct an underallocation by subsidizing suppliers. For
example, in higher education, state governments provide substantial portions of the
budgets of public colleges and universities. Such subsidies lower the costs of producing
higher education and increase its supply. Publicly subsidized immunization programs,
hospitals, and medical research are other examples.

Provide goods via government A third policy option may be appropriate where positive
externalities are extremely large: Government may finance or, in the extreme, own and
operate the industry that is involved. Examples are the U.S. Postal Service and Federal air
traffic control systems.

Public Goods and Services Certain goods called private goods are produced through the competitive
market system. Examples are the wide variety of items sold in stores. Private goods have two
characteristics—rivalry and excludability. “Rivalry” means that when one person buys and consumes a
product, it is not available for purchase and consumption by another person. What Joan gets, Jane
cannot have. Excludability means that buyers who are willing and able to pay the market price for the
product obtain its benefits, but those unable or unwilling to pay that price do not. This characteristic
enables profitable production by a private firm.

Certain other goods and services called public goods

A good or service that is characterized by nonrivalry and nonexcludability; a good or

service with these characteristics provided by government.
have the opposite characteristics—nonrivalry and nonexcludability. Everyone can
simultaneously obtain the benefit from a public good such as a global positioning system,
national defense, street lighting, and environmental protection. One person's benefit does
not reduce the benefit available to others. More important, there is no effective way of
excluding individuals from the benefit of the good once it comes into existence. The
inability to exclude creates a free-rider problem

The inability of potential providers of an economically desirable good or service to obtain

payment from those who benefit, because of nonexcludability.

, in which people can receive benefits from a public good without having to pay for it. As a
result, goods and services subject to free riding will typically be unprofitable for any private
firm that decides to produce and sell them.

An example of a public good is the war on terrorism. This public good is thought to be
economically justified by the majority of Americans because the benefits are perceived as
exceeding the costs. Once the war efforts are undertaken, however, the benefits accrue to
all Americans (nonrivalry). And there is no practical way to exclude any American from
receiving those benefits (nonexcludability).

No private firm will undertake the war on terrorism because the benefits cannot be
profitably sold (due to the free-rider problem). So here we have a service that yields
substantial benefits but to which the market system will not allocate sufficient resources.
Like national defense in general, the pursuit of the war on terrorism is a public good.
Society signals its desire for such goods by voting for particular political candidates who
support their provision. Because of the free-rider problem, the public sector provides these
goods and finances them through compulsory charges in the form of taxes.

Quasi-Public Goods Government provides many goods that fit the economist's definition of
a public good. However, it also provides other goods and services that could be produced
and delivered in such a way that exclusion would be possible. Such goods, called quasi-
public goods

A good or service to which excludability could apply but that has such a large positive
externality that government sponsors its production to prevent an underallocation of
resources.

, include education, streets and highways, police and fire protection, libraries and
museums, preventive medicine, and sewage disposal. They could all be priced and
provided by private firms through the market system. But, as we noted earlier, because
they all have substantial positive externalities, they would be underproduced by the market
system. Therefore, government often provides them to avoid the underallocation of
resources that would otherwise occur.

The Reallocation Process How are resources reallocated from the production of private
goods to the production of public and quasi-public goods? If the resources of the economy
are fully employed, government must free up resources from the production of private
goods and make them available for producing public and quasi-public goods. It does so by
reducing private demand for them. And it does that by levying taxes on households and
businesses, taking some of their income out of the circular flow. With lower incomes and
hence less purchasing power, households and businesses must curtail their consumption
and investment spending. As a result, the private demand for goods and services declines,
as does the private demand for resources. So by diverting purchasing power from private
spenders to government, taxes remove resources from private use.
 Government then spends the tax proceeds to provide public and quasi-public goods and
services. Taxation releases resources from the production of private consumer goods
(food, clothing, television sets) and private investment goods (printing presses, boxcars,
warehouses). Government shifts those resources to the production of public and quasi-
public goods (post offices, submarines, parks), changing the composition of the economy's
total output. (Key Questions 9 and 10)

CONSIDER THIS …

Street Entertainers

Street entertainers are often found in tourist areas of major cities. Some
entertainers are highly creative and talented; others “need more practice.” But,
regardless of talent level, these entertainers illuminate the concepts of free
riders and public goods.

Most street entertainers have a hard time earning a living from their activities
(unless event organizers pay them) because they have no way of excluding
nonpayers from the benefits of their entertainment. They essentially are
providing public, not private, goods and must rely on voluntary payments.

The result is a significant free-rider problem. Only a few in the audience put
money in the container or instrument case, and many who do so contribute only
token amounts. The rest are free riders who obtain the benefits of the street
entertainment and retain their money for purchases that they initiate.

Street entertainers are acutely aware of the free-rider problem, and some have
found creative ways to lessen it. For example, some entertainers involve the
audience directly in the act. This usually creates a greater sense of audience
willingness (or obligation) to contribute money at the end of the performance.

“Pay for performance” is another creative approach to lessening the free-rider

problem. A good example is the street entertainer painted up to look like a
statue. When people drop coins into the container, the “statue” makes a slight
movement. The greater the contributions, the greater the movement. But these
human “statues” still face a free-rider problem: Nonpayers also get to enjoy the
acts.

Finally, because talented street entertainers create a festive street environment,

cities or retailers sometimes hire them to perform. The “free entertainment”
attracts crowds of shoppers, who buy goods from nearby retailers. In these
instances the cities or retailers use tax revenue or commercial funds to pay the
entertainers, in the former case validating them as public goods.

Promoting Stability

Macroeconomic stability is said to exist when an economy's output matches its production capacity, its
labor resources are fully employed, and inflation is low and stable. (Inflation is a general increase in
the level of prices.) In such circumstances, the economy's total spending matches its production
capacity. Government and the nation's central bank (the Federal Reserve in the United States)
promote full employment and price stability through prudent fiscal policy (government taxing and
spending policy) and monetary policy (central bank interest rate policy). But sometimes unexpected
shocks occur to the economy that cause total spending either to fall far below production capacity or to
surge way above it, resulting in widespread unemployment or inflation. Government may try to
address these problems by altering its fiscal policy or monetary policy.
Unemployment When private sector spending is too low, resulting in unemployment, government may
try to increase total spending (private + public) by raising its own spending or by lowering tax rates to
encourage greater private spending. Also, the nation's central bank may take monetary actions to
lower interest rates, thereby encouraging more private borrowing and spending.

Inflation Inflation is a general increase in the level of prices. Prices of goods and services rise when
the amount of spending in the economy expands more rapidly than the supply of goods and services.
This can happen when the nation's central bank allows interest rates to remain too low for the
economic circumstances. In such situations, the central bank can act to lower inflation by increasing
the interest rate so as to dampen private borrowing and spending. The government may also try to
reduce total spending by cutting its own expenditures or boosting tax rates to reduce private spending.

Government's Role: A Qualification

Government does not have an easy task in performing the aforementioned economic functions. In a
democracy, government undertakes its economic role in the context of politics. To serve the public,
politicians need to get elected. To stay elected, officials (presidents, senators, representatives,
mayors, council members, school board members) need to satisfy their particular constituencies. At
best, the political realities complicate government's role in the economy; at worst, they produce
undesirable economic outcomes.

In the political context, overregulation can occur in some cases; underregulation, in others. Income
can be redistributed to such an extent that incentives to work, save, and invest suffer. Some public
goods and quasi-public goods can be produced not because their benefits exceed their costs but
because their benefits accrue to firms located in states served by powerful elected officials.
Inefficiency can easily creep into government activities because of the lack of a profit incentive to hold
down costs. Policies to correct negative externalities can be politically blocked by the very parties that
are producing the spillovers. In short, the economic role of government, although critical to a well-
functioning economy, is not always perfectly carried out.

QUICK REVIEW 4.3

Government enhances the operation of the market system by providing an appropriate legal
foundation and promoting competition.

Transfer payments, direct market intervention, and taxation are among the ways in which government
can lessen income inequality.

Government can correct for the overallocation of resources associated with negative externalities
through legislation or taxes; it can offset the underallocation of resources associated with positive
externalities by granting government subsidies.

Government provides certain public goods for which there is nonrivalry in consumption and
nonexcludability of benefits; government also provides many quasi-public goods because of their large
external benefits.

A nation's government and central bank promote economic stability by engaging in prudent fiscal and
monetary policies.

Summary: Economic Functions of Government

1. Maintain legal and social framework

a. Create laws and provide courts

b. Provide information and services to help the economy function better

 c. Establish a system of money

d. Define and enforce property rights

e. Regulate contracts

f. This function helps ensure innovation and, as a result, economic growth

2. Maintain Competition

a. Create and enforce antitrust laws

i. Antitrust laws – rules that prevent businesses from working

together to control too much of an industry or set prices

ii. Note: It is difficult and expensive to detect unfair competition

b. Regulate natural monopolies

i. Natural monopoly – an industry in which there are not enough

consumers to support more than one producer or an industry where
one producer can provide all that is demanded at a lower cost tan if
there were several competing producers

ii. Example: Electricity and natural gas distribution or water

c. This function keeps producers responsive to consumers

d. This function improves efficiency and competition, and as a result, innovation

and economic growth

3. Providing Public Goods and Services

a. Providing goods or services that markets are unwilling or unable to provide –

Example: National defense, roads

b. There are costs and benefits of all government actions

c. Problems of free riders – people who use the product but don’t pay for it

4. Redistributing Income

a. Taking taxes money and giving it back out in the form of services, safety
nets, and public goods

b. Higher income tax rates for those who make more money

c. Social Security

d. Aid for dependent children

e. Medicare and Medicaid

5. Correcting for Externalities

a. Externality – a spill over – something that occurs as a result of the production

process that effects those outside of the market
 b. Taxes collected to pay for cleanup such as environmental cleanup

c. Subsidies to encourage positive externalities such as education

d. Subsidy – A government payment that supports a business or market

6. Stabilizing the Economy

a. The gov’t plans it taxing and spending plans and controls the money supply
to try and influence the rate of inflation, reduce unemployment, and promote
economic growth

b. If there is high unemployment the government might increase government

spending, reduce taxes, and/or increase the money supply

c. If there is high inflation the government may decrease government spending,

raise taxes, and/or reduce the money supply