1. The Microeconomy and the Government
Chapter 10

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

3. 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?

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

5. 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!

6. 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?

7. 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)

8. 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.

9. 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.

10. 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

11. 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

12. 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 …

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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.

19. 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

20. 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

21. 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

22. 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

23. 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?

24. 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?

25. 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