Unit 8: The Role of the Government in a Market Economy

8a. Explain how government intervention can solve market failures of public goods

  • What is market failure?
  • What are public goods? Can you give examples of some?
  • Why is it difficult for private companies to provide public goods?
  • What is the free rider problem of public goods?

As we have introduced in Units 2 and 4, markets are not always efficient and can lead to market failure. When markets fail, the allocation of resources is not optimal, and there is a loss of social welfare. One of the causes of market failures is the existence of public goods. Public goods have two fundamental characteristics: non-excludability and non-rivalry. Non-excludability means that it's not possible to prevent people from using a good or service once it's provided. Non-rivalry means that one person's use of a good or service does not reduce its availability to others.

Due to the free rider problem of public goods, private firms are not incentivized to market public goods. Consequently, the government often intervenes through government spending on public goods financed through taxesand by charging small fees for the use of public goods.

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8b. Explain how governments redistribute income through transfer payments

  • What is the relationship between income distribution and efficiency?
  • What are the factors that contribute to a skewed income distribution?
  • What is the difference between means-tested and non-means-tested transfer payments?

The efficiency of resource allocation in a private market hinges on the initial income distribution. A skewed distribution raises concerns about equitable resource allocation. Various elements, including luck, inherited wealth, unequal talent distribution, and market fluctuations, contribute to an unequal income distribution. 

Because most consider helping the poor a public good, most governments around the world make some effort to redistribute income through two types of programs: means-tested and non-means-tested transfer payments. Means-tested transfer payments are based on the recipients' income levels, such as Medicaid in the United States. The non-means-tested transfer payments are allocated to specific groups of individuals based on criteria other than income. Examples include Social Security, Medicare, and unemployment benefits.

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8c. Differentiate between regressive, proportional, and progressive taxes

  • How do governments pay for the goods and services they provide?
  • What is the most important source of government revenue?
  • What is the ability-to-pay principle?
  • What is the difference between proportional, progressive, and regressive tax systems?

Governments need a source of revenue to provide public goods, services, and resources to lower-income sections of the population. In most countries, taxes are the main source of government revenue. Hence, policymakers need to decide on the type of tax system to adopt. Most tax systems link the amount of taxes people pay to the amount of income they receive (based on the ability-to-pay principle).

In this regard, we can distinguish between the following tax systems:

  • Proportional tax – tax is a fixed percentage of income.
  • Progressive tax – the government takes a higher percentage of income for higher incomes (as income rises).
  • Regressive tax – the government takes a higher percentage of income for lower incomes (as income falls).

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8d. Explain public choice theory and public interest theory

  • What are the main choices that should be made in the public sector realm?
  • What are the main features of public choice theory and public interest theory?

How choices should be made in the public sector is the subject of intense academic and political debates. There are two main competing perspectives: public choice theory and public interest theory.

The basis of public interest theory lies in the belief that policymakers should work to identify and implement solutions that maximize the overall well-being of society. In contrast, public choice theory suggests that public sector individuals are driven by self-interest rather than a collective goal of maximizing net benefits for society. 

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8e. Explain the Coase theorem and the conditions needed for private bargaining to achieve efficiency

  • Who was Ronald Coase?
  • Why do we study the Coase theorem?
  • What are the conditions that need to be met for the Coase theorem to apply?

The Coase Theorem argues private bargaining can result in an efficient allocation of resources when certain conditions are met, even in the presence of externalities. For example, if property rights are clearly defined and transaction costs are low, the parties affected by externalities can negotiate and reach an optimal outcome without the need for government intervention.

Property rights are considered to be clearly defined if ownership and control over resources are comprehensibly established. Transaction costs, which are the costs associated with conducting and enforcing agreements, must be low to facilitate efficient bargaining. 

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Unit 8 Vocabulary

Be sure you understand these terms as you study for the final exam. Try to think of the reason why each term is included.

  • ability-to-pay principle
  • Coase Theorem
  • income distribution
  • market failure
  • means-tested
  • non-excludability
  • non-means-tested
  • non-rivalry
  • progressive tax
  • proportional tax
  • public choice theory
  • public interest theory
  • regressive tax