CHAPTER 6 The Economic Role of the State PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 6-2 The Economic Role of the State  Market economy requires that property rights be well-defined and protected  Government has 3 possible roles:  Protection of individual rights  Public production  Regulation

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 6-3 Protection of Rights  A market economy presupposes rights are protected  Government protects rights through:  National defense  Police  Courts  Government has monopoly on legitimate use of force

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 6-4 How Much Protection is Optimal?  Is not an all-or-nothing proposition  Optimal point is where marginal cost of protection equals marginal benefit from protection  Provides little practical guidance

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 6-5 Government Production  Market inefficiencies lead to possibility of government regulation or production  Main theoretical justifications for government production:  Externalities  Public goods

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 6-6 Government Regulation  Regulation may be a more efficient substitute for government production  Problems with Government Regulation  Information  Politics

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 6-7 The Capture Theory of Regulation  Regulatory agencies are “captured” by regulated industries  Special interests vs. general public  Example: regulated utility  General public lacks incentive to become informed  Special interests have incentive because of concentrated regulatory benefits

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 6-8 The Regulatory Agency as a Cartel  Government regulation can create a regulatory cartel creating:  Regulatory barriers to entry  Regulating prices  Result is inefficient  Lower output = higher prices

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 6-9 The Regulatory Agency as a Cartel

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 6-10 The Equilibrium Level of Regulation  Special interests don’t get everything they want  Regulation benefits some at the expense of others  Politicians must weigh marginal political costs vs. marginal political gains

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 6-11 The Equilibrium Level of Regulation

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 6-12 The Transitional Gains Trap  Regulation provides transitional profits  Profits eventually competed away  Deregulation creates transitional losses  Example: Airline Regulation  Increases difficulty of eliminating harmful regulations

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 6-13 Redistribution  Largest single activity undertaken by United States government  Many stated reasons for redistribution  Actual redistribution policies will reflect impact of the political process

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 6-14 Reasons for Government Redistribution   Two general reasons:   Provide a safety net   Greater equality   Not necessarily the same thing   Example: worldwide poverty

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 6-15 Politics and Redistribution  Bulk of government transfers go to the middle class in the United States  Examples:  Social Security  farm programs  Product of political process based on majority rule

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 6-16 Stabilization  Government’s other activities may be constrained by stabilization policy  Stabilization tools:  Monetary policy  Fiscal policy

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 6-17 Can The Government Perform These Functions?  May be problems with government allocation of resources  Information problems  Limited market data  Unrevealed preferences  Policy conflicts  Trade-off between efficiency and equity

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 6-18 Will The Government Perform These Functions?  Public policy is not decided by expert  Public policy determined through political process influenced by:  Special interests  Public sentiment

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 6-19 The Free Rider Problem  Individuals can consume collective benefits without paying  Even when individuals do contribute, they have an incentive to shirk  Shirking reduces the production of the collective good  Incentive to understate demand for collective good  Example: National defense

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 6-20 The Holdout Problem  Occurs when one person in a group has the power to prevent collective action  Example: Highway construction

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 6-21 Solutions To The Holdout Problem  Private solutions  Substitute to alternative locations if possible  Contingency contracts  Hiding motives  Public Solution  Eminent Domain

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 6-22 Consent and Coercion  Certain situations require government coercion to achieve efficiency  If everyone is better off because everyone is coerced, everyone would agree to be coerced  Incompatible within Paretian framework