The Microeconomy and the Government Chapter 10

The Role of Government The first question we need to ask is: Is there any role at all for government in the market economy?

The Role of Government Assume for a moment, a world of angels. A world in which individuals pursue their self-interest to maximize their utility … but a world in which no one would ever cheat to get ahead ... Everyone honors the shared standards of Commutative Justice. Need government?

Need Government ? Yes … Even angels would need judges to resolve honest differences of opinion among them, like the meaning of terms in contracts.

The Role of Government But…we are not angels (sneaky scum-bags) There are those among us who would lie, cheat, and steal to get market power …so they can enjoy a bigger piece of the (smaller) “pie” …at our expense!

The Role of Government Given that there are some among us who would do whatever it takes to get the advantage that comes with market power … Is there a role for government in solving this problem of market power?

Opposing Views No – government, as the greatest source of power in society, is a key source of the market power problem. An empowered government will take us down a “road to serfdom” (Friedrich von Hayek) Yes – if government is absent, the market, and society more generally, would degenerate into a chaotic power seeking “game” with no rules and no ref … a destructive "war of all against all” (Thomas Hobbes)

The Role of Government Government can certainly be a part of the problem … Remember Lize Venter’s South Africa? Conditions in North Korea Government is usually the greatest source of power in society, and that power can clearly be used as a means of oppression.

The Role of Government Abraham Lincoln believed in, “government of the people, by the people, for the people.” Such a government regulates (polices) destructive behavior without becoming a police state.

The Role of Government At a microeconomic level, “interventionists” want government to be there to police socially destructive behavior …While …“non-interventionists” see this as a slippery slope to a police state

The Role of Government There is some measure of agreement that government has a role in addressing what Milton Friedman refers to as “neighborhood effects,” or what we refer to as externalities. If so, government faces a challenge because designing policies to address externalities is not simple

The Role of Government Theoretically, solving an externality problem is simple … Make the externality emitter feel the effect so it’s no longer external…or…”Internalize the externality” Consider the negative externality case …

Solving a Negative Externality MSC = MPC + EC $ Level of Activity MPC EC LS Here’s the source of the problem : LP > LS Optimal Private and Social Level are different Here’s the problem MPB = MSB EB = 0 LP

Solving a Negative Externality The tax raises the private cost to the level of social cost MSC $ L MPC EC = TAX LP shifts left … until LP = LS LS Since EC is the source of the problem All that it takes to internalize this EC, is to measure it and impose a tax equal to the EC MPB Bingo! LP

Solving a Negative Externality Given the exact measure of EC, the tax moves the behavior to the socially optimal level. MSC $ L MPC EC = TAX LS Now LP = LS MPB LP

Solving a Negative Externality Note the phrase: “given the exact measure of EC” Therein lies the problem. The very signal we turn to in order to measure values is missing, the...price

Solving a Negative Externality Absent the price, to measure the EC we have to turn to a “proxy” an estimate that can be used as a substitute for the actual value. Proxies can be problematic… May not be agreed upon

For Symmetry: Solving a Positive Externality In the case of the positive externality the simplest solution is to internalize the externality Since the issue in this case is an external, unfelt benefit … a subsidy equal to the size of the positive externality would internalize it.

For Symmetry: Solving a Positive Externality MSC $ Level of Activity = MPB + EB MSB EB = SUBSIDY LS } MPB LP As a result we arrive at the social optimum

For Symmetry: Solving a Positive Externality Theoretically simple … but as in the negative externality case … very difficult in practice because the key piece of information to solve the puzzle is missing … An accurate measure of the size of the externality

Debate on the Role of Government It’s not easy to govern, even with the best of intentions … so some think we shouldn’t try because we can’t be so wise to know solutions to such complex problems … we’ll just make things worse while others believe it’s essential to try because, absent government, power will become a struggle among factions and failure will be inevitable

Debate on the Role of Government The views at the poles of this debate are: Government is invariably part of the problem These folks oppose government intervention, they believe in laissez-faire Government is always a part of the solution. These folks are all about intervention. Most economists are somewhere between these extremes on the continuum

Debate on the Role of Government Clearly commutative justice is essential for efficient markets … the “race for wealth” must be fair if it’s to be most productive Is government to be trusted to use its power to ensure the race is fair? Or … Do we expect government to use its power to “fix” the race to a faction’s advantage? If not government, what institution will ensure commutative justice?

Debate on the Role of Government What about distributive justice? We saw before that even in the best of market conditions, GCE, markets don’t ensure distributive justice. How are we, as a society, to collectively decide what is distributively just? … And if we can agree on a standard, how do we achieve it without doing injustice to someone?

Debate on the Role of Government The role of government is a challenging question that is not answered “inside the model”. One has to bring one’s assumptions about government and markets, and one’s values, to the debate. …but, the model informs the debate by giving one a systematic way to assess the issues involved. This also needs to be considered with our next perspective on the economy: Macro