Information-related Problems

Unless firms and consumers are well informed, they may take actions that are not in their own interests. Unless decisions are made on the basis of good information, markets will not work well. But in a free market economy, particularly a modern, complex free market economy, firms and consumers are not likely to be well informed about the consequences of all their decisions.

Private markets may not produce the right kinds and amounts of information. Firms havelittle incentive to study the long-term health hazards to which their workers are exposed, and if there were no penalties for fraud, producers of unsafe goods would have every incentive to conceal the flaws in their products. Furthermore, modern economies are so complex that few individuals can digest and evaluate all the information necessary to make fully informed decisions all the time. It may be efficient to have the government process some complex information on behalf of its citizens.

Governments have long recognized a need to protect poorly informed consumers from actions they would regret. Laws against fraud have been around for centuries. Modern governments generally regulate working conditions, inspect and grade foods, regulate the design and safety of consumer products, and require that certain products (such as foods and dangerous chemicals) have informative labels.

Monopoly and Market Power

Competitive markets generally work well, but markets where either buyers or sellers can manipulate prices generally do not. In particular, too little output will be produced and price will be too high in a market where a single seller controls supply.

A monopolist is the single seller of a good or service. Monopolists can earn high profits by restricting the quantity sold and raising the price. Because they are the only sellers, they have no fear of being undercut by competitors — and consumers end up paying more than they should.

Some monopolies are almost unavoidable. Most public utilities (gas and electricity, for example) are potential monopolies. The government can regulate such companies by controlling the prices they are allowed to charge, or it may elect to supply the products involved itself. Other monopolies may be artificial, brought about through manipulation by firms. Here governments intervene with competition laws, seeking to make competition more vigorous and to prevent monopolies or other attempts to control supply.

Any buyer or seller who has the ability to affect market price significantly is described as having market power or monopoly power. Government intervention to limit market power, for instance by preventing firms with market power from charging high prices, can improve the allocation of resources.

Income Redistribution and Merit Goods

The distribution of income that is generated by free markets has no ethical claim to being just or fair. Depending on who starts out with what resources, private markets can produce many different final distributions - different 'for whoms' - of resources and welfare. Private markets may produce a distribution in which the top 1 per cent of income-earners receive 40 per cent of total income in the economy, or they may produce an even distribution of income. Either way, government may want to intervene to affect the distribution of income, by taxing some and giving to others.

In practice, modern governments engage in large-scale redistribution of income. The share of transfers in government spending has increased all over the world in the period since 1960. Government spending on transfer payments, shown in Table 3-1, represents governmentredistribution of income - towards the elderly (through social security), the unemployed (through unemployment benefits), farmers (through price supports), and other beneficiaries. The rapid growth of transfer spending has been a source of controversy, with critics arguing that many government welfare programmes have harmed the people they were designed to help.

There is a difference between government intervention to affect the distribution of income and intervention to ensure the right level of production of public goods or to make market prices reflect externalities. In the latter cases the government is taking actions that at least in principle can make everyone in society better off. But when the government intervenes to affect the income distribution, it makes some people better off by making others worse off.

Governments are concerned not just with the distribution of income, but also with the consumption of particular goods and services.

Merit goods are goods that society thinks people should consume or receive, no matter what their incomes are. Merit goods typically include health, education, shelter, and food. Thus we - society - might think that everyone should have adequate housing and take steps to provide it. Is there an economic justification for government intervention in regard to merit goods? In a sense there always is, because the sight of someone who is homeless creates an externality, making everyone else unhappy. By providing housing or shelter for those who would otherwise be on the streets, the government make the rest of us feel better.

Society's concern over merit goods is closely related to its concern over the distribution of income. The difference in the case of merit goods is that society wants to ensure an individual's consumption of particular goods rather than goods in general. Some of the goods provided by the government (such as health and education) are merit goods.

With merit goods, as with public goods, government concern with consumption does not justify government production. Economic theory justifies policies that ensure that individuals consume the specified amounts of merit goods. It does not say that the government should produce these goods itself, nor does it say exactly how the government should intervene. One way would simply be to require that the right amounts of the goods be consumed. In the case of education, everyone has to go to school up to a certain age. But nobody has to go to a state school; any accredited school will do. In the case of housing, the government can build low-income houses and rent them at a subsidized rate, provide rent supplements, or simply specify minimum housing standards.

The most difficult question that has to be answered in discussing both merit goods and the distribution of income is how society or the government decides who should get what. Any one person can have a perfectly sensible viewpoint on these issues — for instance, that the more even the distribution of income the better, that the distribution of income we have is best, that people who work harder should be rewarded, that people who need more should get more, or that everyone should have decent housing and no one should starve. Translating these different opinions into a consistent view that is taken by the government and implemented in taxation and transfer policy is the impossible task of politics.

Recap

The discussion in this section provides some theoretical justification for government intervention in a market economy. However, governments do not make their tax and spending decisions on the basis of what economists say their role should be. Only by a huge stretch of the imagination could we say that in fact all government purchases of goods and services are purchases of public goods or merit goods, or that interventions in any particular market are designed only to remove externalities. It would take even more imagination to see government intervention that affects the distribution of income as resulting from a consistent view of the optimal distribution. We now discuss the mechanisms that democratic societies use to make their actual decisions about taxation and govern­ment spending.

Exercise 1. Answer the following questions:

1. How did Adam Smith understand the role of the market?
2. Do you agree that people pursuing their own interests promote the interests of society?
3. Why is government intervention necessary? Do you agree that the government can correct market failures?
4. How can the government affect different elements of the business cycle?
5. What can be done to stabilize the economy?
6. What is the difference between a private good and a public good? Give your own examples.
7. Why are private markets unlikely to provide public goods?
8. How can the government solve “the free-rider problem”?
9. What is the role of the government in providing public goods?
10. Should the government produce private goods? Why?
11. How does the author describe the ideal market?
12. Give your own examples of positive and negative externalities.
13. Why does the presence of externalities justify government intervention?
14. Why is it often difficult for firms and individual consumers to act in their own interests?
15. Do you agree that the government should process some information on behalf of its citizens? How can it do that?
16. Why do competitive markets generally work better than monopolies?
17. Why are monopolies dangerous for consumers?
18. How can the government control monopolies and regulate their activities?
19. Why should the government intervene to affect the distribution of income?
20. How does the government try to affect the answer to the “for whom” question?
21. Do you agree that the government should ensure that everyone has merit goods?
22. What does the author mean by saying that government concern with consumption does not justify government production?

 

Exercise 2. Comment on the following statement:

“In practice the government is even more likely to fail to allocate resources efficiently than are markets.”

 

Exercise 3. Define the following terms in English:

a market failure, a private good, a public good, a free-rider, an externality, a monopoly, a monopolist, merit goods