Unit 8: The Role of the Government in a Market Economy
In this unit, we delve into how government intervention can address market failures, such as the existence of public goods, externalities, and income and wealth inequality. We analyze decision-making in the public sector, comparing public interest theory with public choice theory. Finally, we explore the Coase Theorem to determine whether private bargaining is preferable to government intervention when dealing with external effects.
Completing this unit should take you approximately 3 hours.
Upon successful completion of this unit, you will be able to:
- explain how government intervention can solve market failures of public goods;
- explain how governments redistribute income through transfer payments;
- differentiate between regressive, proportional, and progressive taxes;
- explain public choice theory and public interest theory; and
- explain the Coase theorem and the conditions needed for private bargaining to achieve efficiency.
8.1: Public Goods
We introduced public goods in Unit 4 when we talked about market failures. Public goods have two fundamental characteristics: non-excludability and non-rivalry. Non-excludability means it is difficult, or even impossible, to prevent individuals from using the good. In simpler terms, if a public good is available, everyone can enjoy its advantages, and it is challenging to prevent anyone from accessing it. Non-rivalry implies the consumption of the good by one person does not reduce its availability or usability for others.
What is the public good? Read this text on public choice theory and how rational voters conduct cost-benefit analyses of public issues. The theory of rational ignorance says that people will not vote if the costs of becoming informed and voting are too high or if they do not feel their vote will make a difference. However, a smaller group of voters may not elect candidates that enact policies to benefit the entire population.
Read this text to review the definition of a public good. Compare this definition with the free rider problem and identify sources of public goods. You can use the Prisoner's Dilemma introduced in Unit 7 to analyze the free rider problem. Why do we consider the public sanitation system a public good? Should the government pay for public goods? Why can governments provide public goods more successfully when they have strong institutions?
Watch this video to review the concepts of rival and excludable goods to better understand the characteristics of a public good. What is the "Tragedy of the Commons"?
Analyzing goods and services in terms of their rivalry and excludability helps us determine their optimum allocation. Read this short text on a 2 × 2 matrix to classify goods according to this criteria.
8.2: Government Revenue and Expenditures
According to De Mooij and Keen, it is difficult to come up with anything that has not been taxed at some point in history. Items like playing cards, urine, fireplaces, slaves, religious minorities, and windows all found themselves under the scrutiny of tax collectors. (Ruud De Mooij and Michael Keen. Taxing Principles Making the Best of a Necessary Evil. Finance and Development, 2014).
In this section, we examine both sides of the government budget – revenue and spending – as tools to solve market failures.
Read this text that explains government revenues and government expenditures. The text places the data on government revenues and expenditures in a historical context. You can find more recent official data on these variables from sources like the International Monetary Fund. Why are transfer payments a tool to redistribute income? Are you willing to pay higher State taxes to improve income distribution in the state where you live?
Government agencies need a source of revenue to provide public goods (government expenditures), subsidize innovation, and/or transfer Social Security checks. In most countries, taxation is the primary source of government revenue or funding. Although you have been paying taxes since your first store visit, the jargon surrounding taxes might be confusing. Watch this introductory video to grasp the main concepts.
Read this text to study the main principles of taxation and understand the differences between regressive, proportional, and progressive taxes within the context of the different types of taxes. Is the U.S. income tax progressive? What benefits do you receive from the taxes you pay?
Drawing upon what you have learned in this section and in the last section of Unit 3, explain the challenges in creating a tax system that is simultaneously fair and efficient.
8.3: Choices in the Public Sector
How are choices made in the public sector? This section briefly examines two competing perspectives on public sector choice. The first is driven by examining market failure. Choices in the public sector involve locating problems of market failure, determining efficient solutions, and finding ways to make the solutions work. This approach – the public interest theory of government – assumes that the goal of public policy is to allocate resources efficiently.
A more cynical person might disagree. An alternative approach considers public sector choices in the same way as we do in the private sector. Public choice theory assumes individuals only make choices to maximize their own utility – whether they are voters, politicians, or bureaucrats, these individuals seek solutions that align with their self-interest. Business owners may try to influence public sector choices to increase their profits. The effort to influence public policy choices to advance your own self-interest is called rent-seeking behavior.
Public Interest Theory says that government officials should make decisions that are best for everyone. They use tools like cost-benefit analysis to find the most efficient solutions for public goods like parks or schools. Sometimes, markets do not show the real value of these goods, so it is up to the government to figure that out.
On the flip side, Public Choice Theory argues that people in the government are also looking out for themselves. This theory explains why many people do not vote. Voting takes time and effort, and many feel their single vote won't make a difference. This is called rational abstention. Because not everyone votes, the outcome may not truly represent what the community wants.
8.4: Private Bargaining vs. Government Intervention
In October 2023, the first chapter of the latest open textbook on microeconomics is "Prosperity, Inequality, and Planetary Limits." Its introduction features a striking image of a massive bushfire raging out of control. These bushfires have become a common sight for many of us. This raises the question of whether inequality and environmental issues are private or public matters.
In this section, we introduce the Coase theorem, which posits that private bargaining can address market failures. In some cases, these actions are more effective than government policies.
Ronald Coase suggested that private negotiations might be more advantageous than government interference when addressing external impacts. He contended that the individuals engaged in the exchange typically possess more information required to achieve an efficient resolution than governmental entities.
Read this text, which explains the Coase theorem, why private bargaining might not work, and the principle of "the polluter pays." Note that Ronald Coase recognized the limitations of private bargaining due to unclear property rights and high transaction costs.
Watch this video on the Coase theorem and how, under specific conditions, the market can effectively manage externalities. Do you think the market system can address the climate emergency?
Unit 8 Assessment
- Receive a grade
Take this assessment to see how well you understood this unit.
- This assessment does not count towards your grade. It is just for practice!
- You will see the correct answers when you submit your answers. Use this to help you study for the final exam!
- You can take this assessment as many times as you want, whenever you want.