GOVERNMENTS AND MARKETS IN A DEMOCRATIC SOCIETY Unit 12 GOVERNMENTS AND MARKETS IN A DEMOCRATIC SOCIETY

OUTLINE Introduction The Government as an Economic Actor Democracy as a Political Institution The Limits of Governments

A. Introduction

The Context for This Unit As discussed in previous units, institutions and policies are important in determining economic outcomes. Governments are crucial for establishing institutions and policies. How does the government work? Why are some institutions and policies chosen, but not others? What effect do political systems (e.g. democracy) have on the institutions and policies chosen?

This Unit A closer look at governments and their powers Democracy: what it is and how it can affect economic outcomes The limits of governments: why some policies are infeasible

Markets and prices Benefits of using markets: Markets allow each of us, pursuing our private objectives, to work together, producing and distributing goods and services. Markets allow us to interact with people in ways that we can mutually benefit from, specializing in the things we are relatively good at doing. When markets work well, prices send messages about the real scarcity of goods and services.

Should markets allocate everything? Arguments against using markets for everything: Repugnant markets: creating a market for certain goods/services would violate ethical/social norms e.g. slavery Other institutions may be more effective e.g. governments, families Market mechanisms may crowd out norms of social preferences Merit goods: goods that should be available to everyone, independently of their ability to pay e.g. education

B. The Government as an Economic Actor

The government: An economic actor Government = the only entity within a territory that can dictate what people must do/not do, and can legitimately use force and restraints on an individual’s freedom to achieve that end. The government is different from other economic actors: Much larger – size of most governments have grown over time. Engage in activities that can improve quality of life for citizens

Government = Part of the solution Governments adopt policies to address the inefficiency and unfairness that sometimes results from private economic interactions. They pursue this objective by a combination of methods: Incentives – altering the costs/benefits of activities through taxes, subsidies, and other expenditures Regulation e.g. antitrust policy Persuasion or information - Altering available information or expectations about what others will do, to promote coordination Public provision – includes merit goods and transfers

Government = Part of the problem Any organization with enough power to address the problems of efficiency and fairness also has the power to do great harm. Examples include using force to silence opponents and acquiring huge incomes for officials and leaders to use privately. Well-governed societies place limits on government power: Democratic elections – bad governments can be dismissed Constitutional restrictions on what the government can do Governments therefore operate within constraints, like other economic actors.

C. Democracy as a Political Institution

Defining democracy Democracy: A form of government with 3 political institutions: Rule of law – all individuals are bound by the same laws Civil liberties – the rights of free speech, assembly, and the press Inclusive, fair, and decisive elections – fair elections in which no major population group is excluded from voting and after which the losing party leaves office. No government perfectly satisfies these 3 criteria. But how a government actually works also depends on political preferences and electoral competition.

Accountability: Summary There are similarities and differences between the profit-maximizing behaviour of monopoly firms and the rent-maximizing behaviour of a governing elite. ‘Exit’ and ‘voice’ can make power accountable to those affected.

Democratic spending priorities Democratic governments differ in their spending patterns. One reason is that political institutions differ, even among democracies.

D. The Limits of Governments

Government failure Government failure: A failure of political accountability. Market failures and unfairness still persist in democracies, due to: Economic infeasibility – there may not be a feasible set of policies that sustain a fair and efficient outcome. Administrative feasibility – economically feasible policies may be impossible in practice due to the limited information and capabilities of government officials. Political feasibility – governments may choose not to adopt feasible policies because of opposition by certain groups.

Economic infeasibility An economically feasible policy must be a Nash equilibrium. Policies can change the Nash equilibrium (violate ceteris paribus). Example: Chile in the 1970s. Salvador Allende was elected president of Chile. He promised to nationalize many private firms and offer more public services. The wealthy, worried about higher taxes and losing their assets, stopped investing in the Chilean economy.

Administrative infeasibility Administrative infeasibility arises due to: Limited information – affects ability to design appropriate policies. Limited capacities – lack of technology or institutions needed for implementation, and/or the ability to collect taxes Fiscal capacity = the ability of a government to impose and collect taxes at low administrative (and other) costs. Example: Educational reform may be impossible given the skills of the current teaching force.

Political infeasibility Democracies hold periodical elections to address the principal-agent problem of making elected officials accountable to the public. However, like employees subject to periodic review, officials have incentives to undertake projects whose desired objectives will become visible before the next election (short-termism). Citizens are far from having an equal say in policy matters. Wealthy citizens may have disproportionate voice because of campaign contributions, their influence over investment, and their control over the electronic and print communication.

Summary 1. The government as an important and powerful economic actor 2. Democracy as a political institution Effect of democracy on economic outcomes The limits of democratic governments: economic, administrative infeasibility

Conclusion Political processes determine institutions – the rules of the game that govern economic and social interactions. Institutions determine how the ‘pie’ (mutual gains) is split. The economy is made of actors that do the best they can given their constraints, while also seeking to change these constraints. Economics helps us understand how government policies can increase the size of the pie and ensure its fair division. It also helps us understand how capitalism and democracy together can change people’s constraints, and make good policies politically possible.