The mixed economy and the role of government P1Sessions11-12 The mixed economy and the role of government

The Economic Theory of Government The economic theory of government explains why governments exist, the economic choices they make and the consequences of those choices. Governments exist for three main economic reasons: To establish property rights To provide a non-market mechanism for allocating scarce resources To redistribute income and wealth

The Economic Theory of Government The market economy sometimes brings inefficiency—a situation called a market failure. Some government intervention seeks to correct market failure. The market economy also brings inequality that most people think unfair. Achieving an equitable distribution requires some redistribution. A free mkt economy cannot function properly without the pursuit of self-seeking individuals (self-interest). The pursuit of self-interest when taken too far, results in mkt failure. Therein the dichotomy since the mkt economy owes its existence to the self-seeking motive of individuals in society.

The Economic Theory of Government You will study the economic roles of government in five areas: Monopoly and oligopoly regulation Externalities regulation Provision of public goods Use of common resources Income redistribution

The Economic Theory of Government Monopoly and Oligopoly Regulation Monopoly (single producer) and oligopoly (few producers), and the rent seeking (seeking abnormal/economic profits) to which they give rise, prevent the allocation of resources from being efficient and redistribute the consumer surplus (benefit) to producers. The economic theory of monopoly and oligopoly regulation is an application of the broader theory of public choice. Regulation is influenced by the demands of voters and firms, the supply by politicians and civil servants, and the equilibrium that balances the two sides of the political market place. Government regulation is needed to curb this rent seeking behaviour.

The Economic Theory of Government Externalities Regulation External costs and benefits are consequences of an economic transaction between two parties that are borne or enjoyed by a third party. A chemical factory that dumps waste into a river that kills the fish imposes an external cost. A bank that builds a beautiful office building creates an external benefit. Externalities create inefficiency.

The Economic Theory of Government Provision of Public Goods Public goods are goods that are consumed by everyone and from which no one can be excluded Examples are national defence, law and order, and sewage and waste disposal services. The market economy under produces these goods because it is impossible to exclude non-payers from enjoying them—called the free-rider problem.

The Economic Theory of Government Income Redistribution The market economy delivers an unequal distribution of income and wealth. Progressive income taxes pay for public goods and redistribute income. Social programs and welfare benefits also redistribute income.

The Economic Theory of Government Use of Common Resources Some resources are owned by no one and used by everyone. Examples are fish in the ocean and the lakes and rivers. The market economy over uses these resources because no one has an incentive to conserve them—called the problem of the commons.

The Economic Theory of Government Alternative Intervention Methods Government intervenes in monopoly and oligopoly markets to influence prices, quantities produced, and the distribution of the gains from economic activity. It intervenes in three main ways: Regulation Monopoly control laws Public ownership

The Economic Theory of Government Regulation consists of rules administered by government agency to influence economic activity by determining prices, product standards and types, and the conditions under which new firms may enter an industry. Deregulation is the process of reversing previous regulation.

The Economic Theory of Government Monopoly control laws are laws that regulate or prohibits certain kinds of market behaviour, such as monopoly and monopolistic practices. These laws cover practices that create barriers to entry, collusion over prices, restriction of consumer choice and mergers to enhance market power.

The Economic Theory of Government Public ownership is the ownership (and sometimes operation) of a firm or an industry by a government department or a government controlled agency. Public ownership was at its peak during the 1940s and 1950s. Privatization is the sale of government-owned firms and industries.

Externalities in Our Lives An externality is a cost or benefit that arises from production and falls on someone other than the producer, or a cost or benefit that arises from consumption and falls on someone other than the consumer. A negative externality imposes an external cost and a positive externality creates an external benefit. No man (or woman) is an island. The main theme in this chapter is how to analyze the impact of negative or positive externality on the market allocation of resources, as well as the government’s ability to enhance efficiency: Cost externalities cause social costs to be under appreciated by resource allocation decision makers in the market, creating too much of the activity creating the externality to be produced. Benefit externalities cause social benefits to be under appreciated by resource allocation decision makers in the market, creating too little of the activity creating the externality to be produced. There are some correcting policies that the government can use to increase efficiency, but some are more effective than others.

Externalities in Our Lives So the four possible types of externality are: Negative production externalities Positive production externalities Negative consumption externalities Positive consumption externalities

Externalities in Our Lives Negative Production Externalities Negative production externalities are common. Some examples are noise from aircraft and trucks, polluted rivers and lakes, the destruction of animal habitat and air pollution in major cities from car exhaust.

Externalities in Our Lives Positive Production Externalities Positive production externalities are less common than negative externalities. Two examples arise in honey and fruit production. By locating honeybees next to a fruit orchard, fruit production gets an external benefit from the bees, which pollinate the fruit orchards boost fruit output; and honey production gets an external benefit from the orchards.

Externalities in Our Lives Positive Consumption Externalities Positive consumption externalities are also common. When you get a flu vaccination, everyone you come into contact with benefits. When the owner of an historic building restores it, everyone who sees the building gets pleasure.

Externalities in Our Lives Negative Consumption Externalities Negative consumption externalities are a common part of everyday life. Smoking in a confined space poses a health risk to others; noisy parties or loud car stereos disturb others.

Negative Externalities: Pollution The Demand for a Pollution-free Environment The demand for a pollution-free environment is greater today than it has ever been. Demand has increased for two reasons: Higher incomes: A high-quality environment is a “normal good”, the demand for which increases with income. Greater awareness: Greater knowledge about the causes of environmental problems raise understanding of environmental issues.

Negative Externalities: Pollution Pollution is an old problem and is faced by both rich industrial countries and poor developing countries. It is an economic problem that is coped with by balancing benefits and costs.

Negative Externalities: Pollution The Sources of Pollution There are three sources of environmental pollution problems: Air pollution Water pollution Land pollution

Negative Externalities: Pollution Air Pollution 60% of air pollution comes from road transportation and industrial processes; 16% from electric power generation. There is lot of disagreement about the effects of air pollution. The least controversial is acid rain which causes water pollution and damages vegetation. More controversial are airborne substances such as lead that may cause cancer or life-threatening conditions. Other controversies include global warming(avg temperatures increasing due carbon dioxide emissions); ozone layer depletion (causes not clearly understood)

Negative Externalities: Pollution Air Pollution Figure 15.1 shows the emissions of carbon dioxide in the United Kingdom from 1970 to 2004 with projection to 2020.

Negative Externalities: Pollution Water Pollution The largest source of water pollution is the dumping of industrial waste and treated sewerage into lakes and rivers and run-off from fertilizers. Marginal private cost, marginal external cost, and marginal social cost increase with output. Land Pollution Land pollution arises from dumping toxic waste products.

Private versus Public Goods Excludable A good, service or resource is excludable if it is possible to prevent a person from enjoying its benefits.(Cinema, ice cream) Non-excludable A good, service or resource is non-excludable if it is impossible to prevent a person from enjoying its benefits. (SAPS, SANDEF) Rival A good, service or resource is rival if its consumption by one person decreases its consumption by other people. Non-rival A good, service or resource is non-rival if its consumption by one person does not decrease its consumption by other people.

Classifying Goods and Resources A Fourfold Classification: Private Goods Private goods are both rival and excludable. It can be consumed by only one person at a time and only by those who have bought it or own it. Public Goods Public goods are nonrival and nonexcludable. It can be consumed by everyone at the same time and no one can be excluded.

Classifying Goods and Resources Common Resources Common resources are rival and nonexcludable. It can be used once but no one can be preventedfrom using what is available. Natural Monopoly Special case: If a good is nonrival (MC=0), but also excludable, it is produced by a natural monopoly.

Two Problems Public goods create a free-rider problem  the absence of an incentive for people to pay for what they consume. The market economy under produces these goods because it is impossible to exclude non-payers from enjoying them. Common resources create the problem/tragedy of the commons  the absence of incentives to prevent overuse and depletion of a resource. The market economy over uses these resources because no one has an incentive to conserve them.