Government’s Role and Government Failure Chapter 5 This chapter will discuss how government’s power to coerce can be economically beneficial; difficulties associated with managing and directing the government; and government failure and why it happens. Government’s Role and Government Failure Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Government’s Economic Role Government’s right to coerce Force and economic efficiency Correcting for market failures Positive externalities Negative externalities Reducing private-sector economic risks The government’s ability to force people to do things can be used to increase economic efficiency. When it comes to both public goods and products offering positive externalities, the government can improve economic efficiency by using involuntarily collected tax money to subsidize production. Products that generate negative externalities are overproduced by the private sector. The government can reduce this overproduction and improve economic efficiency by using involuntary policies such as direct controls, pollution taxes, and cap-and-trade schemes to force producers to bear higher costs. The government also reduces private sector economic risks by outlawing various forms of theft, deception, discrimination, etc… LO1

Directing and Managing Government No invisible Hand Massive Size and Scope The Need for Bureaucracy The Need for Paperwork and Flexibility The Information Aggregation problem Lack of Accountability Governments face many problems when trying to organize millions of employees to carry out thousands of tasks. Government economic policies are not self-correcting; Correcting inefficient government policies is hampered by government’s massive size and scope; Since 536 elected officials could never directly supervise 4.4 million people, government relies on many layers of supervisors to manage government affairs.; The bureaucracy is regulated by detailed rules and regulations at the cost of massive amounts of paperwork; Top officials make inefficient choices because they do not have enough information to compare marginal benefits and marginal costs; Thousands of programs may be poorly run without affecting the reelection chances of incumbent politicians. LO1

Government Failure Inefficient outcomes caused by government Voting problems Principal-agent problem Special-interest effect Rent seeking behavior Government failure refers to economically inefficient outcomes caused by shortcomings in the public sector. One cause of failure is voting problems. The principal-agent problem are conflicts that arise when tasks are delegated by one group of people (principal) to another group of people (agents). Efficient public decision making is often impaired by the special-interest effect: any outcome of the political process whereby a small number of people obtain a government program or policy that gives them large gains at the expense of a much greater number of persons who individually suffer small losses. Also, the appeal to government for special benefits at taxpayers’ expense is called rent-seeking. LO2

Clear Benefits, Hidden Costs Unfunded Liability Social Security program Medicare Chronic budget deficits Economic inefficiency Debt Crisis Balanced-budget laws Some critics say that vote-seeking politicians will ignore economic rationality by failing to weigh costs and benefits when deciding which programs to support. A government creates an unfunded liability when it commits to making a series of future expenditures without simultaneously committing to collect enough tax revenues to pay for those expenditures. For example, the government does collect Social Security taxes to help defray the expected future costs of the program, but the current tax rates will not generate nearly enough revenue to pay for all of the expected outlays. A government runs an annual budget deficit when its tax revenues are less than its spending during a particular year. To make up for the shortfall, they must borrow money. Chronic deficits can pose several economic challenges. Many state and local governments have balanced-budget laws to make deficits illegal. No such law exists at the national level, however. LO2

Misdirection of Stabilization Policy Two types of macroeconomic stabilization: Fiscal policy Monetary policy Politicization of Fiscal and Monetary Policy Central banks in charge of monetary policy Governments often attempt to smooth out business cycles by using fiscal and monetary policies. Fiscal policy attempts to use changes in tax rates and spending levels to offset the business cycle. Monetary policy attempts to use changes in interest rates to regulate the economy. Both of these policies are subject to politicization. To prevent some of this, most countries have put politically independent central banks in charge of monetary policy . LO2

Limited and Bundled Choice Only two or three choices for candidates for election Bureaucracy and Inefficiency Public agencies less efficient than private businesses The test of profit and loss Government employees often gain political clout and bureaucrats justify their continued employment Public agencies are generally less efficient than private businesses. The market system imposes a very obvious test of performance on private firms: the test of profit and loss. But there is no clear-cut test, like this, for public agencies. Economists assert that government employees often gain political clout to block attempts to eliminate their agencies. Also, critics point out that government bureaucrats tend to justify their continued employment by looking for a new problem to solve. LO2

Inefficient Regulation and Intervention Regulatory Capture Railroad industry Deregulation Government’s poor investment track record Loan guarantees The Solyndra Subsidy Socializing losses, privatizing gains Several forms of government regulation and intervention have been known to generate outcomes that are less beneficial than intended. A government agency has suffered from regulatory capture if its regulations and enforcement activities come to be heavily influenced by the industry it is supposed to be regulating. The classic example is that of railroad regulation during the 19th and 20th centuries. One potential solution is for the government to engage in deregulation by intentionally removing most or all of the regulations governing an industry. Researchers have found that low and negative rates of return are the norm for government investments. LO2

Corruption Abuse trusted powers for personal gain Two basic forms of corruption: Government official bribed to do part of his job Government official demands a bribe to do something illegal Political corruption is the unlawful misdirection of governmental resources of actions that occurs when governmental officials abuse their entrusted powers for personal gain. Political corruption comes in two basic forms. One, a government official must be bribed to do what he should be doing as part of his job. Two, a government official demands a bribe to do something that he is not legally entitled to do. LO2

Imperfect Institutions Criticisms of public sector inefficiency Markets and government are both imperfect Difficult to assign a good or service to either the public sector or the private sector The public sector is subject to deficiencies in fulfilling its economic function. Because markets and governments are both imperfect, it is sometimes difficult to determine whether a particular activity can be performed with greater success in the private sector or in the public sector. LO2

Global Perspective The Global Corruption Barometer is an international survey done in 2010 and 2011 that asked individuals whether they or anyone in their household had paid a bribe in any form in the last 12 months. The results are from 10 countries selected from the 100 surveyed. LO2

“Government Failure” in the News FEMA made payouts for hurricane Katrina victims on as many as 900,000 claims that contained invalid social security numbers or false names and addresses A 2011 audit revealed that the Federal government had paid $600 million in retirement benefits to deceased Federal retirees In 2011, $765,828 was spent to subsidize an IHOP restaurant and $113,277 to aid in historical preservation of video games The media is always reporting on pork barrel politics when they publicize the waste of public funds.