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Lesson 8: Setting the Rules: Costs and Benefits of Government Action

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Key Terms

Voluntary exchange Incentives Externalities
Opportunity cost Public choice Special interest groups
Taxation Public goods Lobbying

National Content Standards Addressed

Standard 10: Institutions

Institutions evolve in market economies to help individuals and groups accomplish their goals. Banks, labor unions, corporations, legal systems, and not-for-profit organizations are examples of important institutions. A different kind of institution, clearly defined and well enforced property rights, is essential to a market economy.

  • Property rights, contract enforcement, standards for weights and measures, and liability rules affect incentives for people to produce and exchange goods and services.

Standard 16: Role of Government

There is an economic role for government in a market economy whenever the benefits of a government policy outweigh its costs. Governments often provide for national defense, address environmental concerns, define and protect property rights, and attempt to make markets more competitive. Most government policies also redistribute income.

  • Governments pay for the goods and services they use or provide by taxing or borrowing from people.
  • Public goods and services provide benefits to more than one person at the same time, and their use cannot be restricted only to those people who have paid to use them.
  • If a good or service cannot be withheld from those who do not pay for it, providers expect to be unable to sell it and therefore will not produce it. In market economies, governments provide some of these goods and services.
  • Markets do not allocate resources effectively if (1) property rights are not clearly defined or enforced, (2) externalities (spillover effects) affecting large numbers of people are associated with the production or consumption of a product, or (3) markets are not competitive.
  • An important role for government in the economy is to define, establish, and enforce property rights. A property rights to a good or service includes the right to exclude others from using the good or service and the right to transfer the ownership or use of the resource to others.
  • Governments provide an alternative method to markets for supplying goods and services when it appears that the benefits to society of doing so outweigh the costs to society. Not all individuals will bear the same costs or share the same benefits of those policies.

Standard 17: Costs and Benefits of Government Programs

Costs of government policies sometimes exceed benefits. This may occur because of incentives facing voters, government officials, and government employees, because of actions by special interest groups that can impose costs on the general public, or because social goals other than economic efficiency are being pursued.

  • Citizens, government employees, and elected officials do not always directly bear the costs of their political decisions. This often leads to policies whose costs outweigh their benefits for society.
  • Incentives exist for political leaders to implement policies that disperse costs widely over large groups of people and benefit relatively small, politically powerful groups of people.
  • Incentives exist for political leaders to favor programs that entail immediate benefits and deferred costs; few incentives favor programs promising immediate costs and deferred benefits, even though the latter programs are sometimes economically more effective than the former programs.

Key Ideas:

1. Review:

  • Voluntary trade creates wealth.
  • The necessary conditions for wealth-creating trade:
    • both parties expect to gain;
    • both parties are willing to trade at the terms (prices) presented; their participation in the exchange is voluntary; and
    • both parties have the authority to transfer the rights to the goods, services or resources involved in the trade; their property rights are clearly defined and secure.
  • People’s willingness and ability to engage in wealth-creating exchange depends on the institutional rules of the game established and enforced by government.

2. The rule of law provides an institutional foundation that encourages voluntary trade. Nations where the rule of law is firmly established reap greater benefits from voluntary trade than those without the rule of law.

  • Defining and enforcing laws is an important role of government; however the mere existence of laws is not sufficient to establish the rule of law.
    • The rule of law exists when the rules that govern behavior and interactions among individuals and groups of individuals apply to both the governed and the governing.
    • The rule of man exists when laws are applied at the discretion of the governing.
    • Under the rule of force, people own what they can defend. The allocation of goods is in accord with individuals’ ability to manage violence, rather than in accord with the highest-valued uses of those goods.
    • Resources are consumed in the process of managing violence and the wealth of society is lower than under the rule of law.
      • Examples of the rule of force are found in the illegal drug trade today, for example, in the United States and Mexico. The rule of force is also observed in Zimbabwe, where lawless bands of marauders take land from the farmers who have cultivated it for many years, and in Russia, where force is often used to settle commercial disputes.
  • By establishing secure property rights, the rule of law promotes voluntary exchange. When the rule of law does not exist, the resulting uncertainties reduce willingness to trade.
    • People living in nations without the rule of law experience lower standards of living and are more likely to be extremely poor.

3. Government provision of goods and services is subject to the same guidelines as private production: it should take place only when marginal benefit exceeds marginal cost.

  • The opportunity cost of government spending at the margin is private spending.
  • The opportunity cost of government spending on a particular program is the foregone benefit of increased spending on another program.
  • For public goods, the marginal benefit of government provision can exceed marginal cost.
    • Marginal benefit does not exceed marginal cost for all goods and services provided publicly. Some goods and services provided for the public by government are not public goods in an economic sense.
    • Public goods are “non-rivalrous” in consumption and “non-exclusive” in production.
      • Non-rivalrous, non-exclusive goods and services are unlikely to be provided privately because it is not profitable to do so when there are incentives for people to be free-riders.
        • The “free-rider” problem exists when consumers cannot be excluded and therefore have no incentive to pay for the good or service.
        • Because private businesses are unlikely to produce them, public goods the government is the economically efficient provider.
    • Publicly-provided goods are paid for by taxes. The opportunity cost of using tax revenue to provide goods and services is the foregone benefits of the next best use (either government or private) of that money.
      • Because taxation is involuntary, taxpayers undertake actions to minimize the burden they bear. This is costly and it implies that for government programs to be efficient, they must generate more than one dollar of benefits for each dollar of taxes, because the marginal benefit must also cover the social cost that arises when people try to minimize the burden of the taxes they must pay.
    • Technology may change the argument for government production of specific public goods over time.
    • The benefits of government provision of goods or services exceed the costs when government is the least cost provider. However, government engages in many activities that do not meet this criterion.
    • Government actions may improve the functioning of markets. Government may enact laws against monopolies and cartels to protect open markets and maximize the gains from trade.
    • Politicians and government officials respond to incentives. Thus, government actions may also work against the efficient allocation of resources in open markets though regulations and other restrictions (e.g., ban on advertising).

4. Public Choice theory explains that the incentives facing officials and citizens encourage an active role for government in the economy even in the absence of government comparative advantage and make government especially responsive to special interest groups.

  • The benefits and costs of specific government activities are not evenly distributed.
    • Special Interest Groups and Lobbyists: The benefits of political actions are concentrated and the costs are diffuse.
    • Ordinary Citizens: The costs of political actions are concentrated and the benefits are diffuse.
    • Elected officials have an incentive to be most attentive to those groups that help to keep them in office – special interest groups, groups of people (such as senior citizens) who are more likely than other to vote, and organizations willing to fund campaigns and political advertising.
  • Because the lawful use of force is a role of government, use of that force to reallocate wealth may be inevitable—and costly to society, reducing overall wealth.
  • Rules may be necessary to keep government activities limited in the presence of the imbalance between special interest groups and ordinary citizens.
    • “Government is the great fiction through which everybody endeavors to live at the expense of everybody else.” Frédéric Bastiat (1801 – 1850)

Ideas To Take Away From This Lesson

  • Government facilitates wealth-producing voluntary exchange by establishing and enforcing the rule of law that secures property rights.
  • At the margin, the opportunity cost of government spending is private spending.
  • Government is the efficient provider of “public goods.”
  • The marginal benefits of government taxation and subsidies may outweigh the marginal costs when significant externalities exist.
  • The incentive to expand government activities beyond those for which the benefits exceed the costs is explained by Public Choice theory.