All Terrain Thinking

A Compendium of things I think are Important

Economics: It's not just whats' in your wallet

Government and the 'Imperfect' World

Government - you can't live with it, and you can't live without it. Americans have always had a love-hate relationship with government.  They have struggled with the questions: What should the government do? How big should the government be? How should we divide the responsibilities between the federal and local levels of government? How should it raise funds? Who should pay for government activities?  In this part of the course we will briefly address a number of these questions.  As we look at each issue you should not lose sight of the fact that strong ideological differences exist and there will always be heated disagreements on these questions. 

The debate over the functioning of the market system and the appropriate role of government is not likely to be resolved in our lifetimes, and you will need to read through the rhetoric to take reasonable positions on important, upcoming public policy votes.  For this reason we will examine in more detail a number of these market imperfections and potential 'fixes' for the imperfections.  Free-market economists (conservatives) tend to support the view that the imperfections of the 'real' world are minor, or that government involvement generally offers an inefficient solution to any imperfections.  Imperfect-market economists (liberals), meanwhile, tend to believe the fundamental assumptions of the competitive model are unrealistic and there are serious imperfections that produce inefficiencies warranting government intervention.   Now let's look at the questions.

We begin with the question: What should governments do? If you return to our discussion of the ideal world of perfect competition, the implication of the model was that a freely operating market system, where individual decision makers living and working with little government intervention, produce an efficient solution to society's basic economic questions.  But there is a wide gap between the ideal world of our earlier analysis and the real world in which we all live.  In this final component of the course we will focus our attention on that real world, examining potential imperfections that exist, and the implication of those imperfections.  The imperfections we will be examining are listed below.  Some, such as externalities, public goods, imperfect competition, and imperfect information are topics in microeconomics, while instability and inadequate growth are macroeconomic topics.  The study of inequality and poverty, meanwhile, has elements of both. 

• imperfect competition
• externalities
• public goods
• imperfect information and decision making
• instability
• inadequate growth
• inequality

From the earliest days of this nation the need for some form of government has been recognized.  It became obvious early that there were some goods the market system simply would not provide in adequate amounts and the government therefore needed to get involved.  We needed a government to provide security, to fund the military to protect us from international threats, and police and fire departments to protect us from domestic threats. The private sector could not be expected to provide an adequate amount of security.

The problem stems from the nature of the product / service. Security belongs to the class of goods we would describe as public goods. These goods possess two properties which create problems for the market. First, the consumption of a public good does not subtract from another person's consumption. If I get security, my neighbor will not need to get less - a property we would call nonrivalrous consumption. Second, it is difficult to exclude someone from consumption of a public good - what we would call nonexcludability. If the government finances a military organization that provides security to Americans, then it would be impossible to identify some people, maybe those living in Miami. Fl, who would not be covered. This would certainly not be the case if you bought a TV, a product the market system has no difficulty providing. You could easily exclude others from watching your TV and the more you used your TV, the less time there would be for others.

As similar situation arises when we speak about technological change, a key feature of an advanced economic system.  In fact, technological change can be thought of as one of the primary causes of economic growth and therefore all of society tends to benefit from the technological change.  But technological change is the result of innovations that flow from hard work of individuals and firms, and why would people work long hard hours innovating?  If the idea would be available to all, if there was no restriction on copying the work, the potential innovators would have a limited incentive to investigate.  As a result the government has stepped in and established patents which protect innovators with the goal of increasing the rate of innovation.

We also saw there may be times when we cannot expect adequate competition in the marketplace.  In 1998 we heard much about the suits against Microsoft and Intel for dominating the markets for operating systems and memory chips, much as we heard about the suits against AT&T and IBM in the 1980s and 1970s.  What is the basis for the widespread support for competition? What is it that is wrong with monopoly and imperfect competition?  In two words - inequity and inefficiency - an answer grounded in the analysis of monopoly and imperfect competition in this part of the course.  Imperfect competition, of which monopoly is the strongest example, is seen as inferior to competition because monopolies earn economic profit.   Some resource earns more in monopoly than it earns in any other endeavor so there is an inefficiency in the outcome.  For example, what do you think would happen to the prices of xerox copies if the copy center at the Emporium closed an the campus was served by only one copy center?  I am sure that you could anticipate the impact - University students and faculty would begin paying more for our copies than we had in the past.  The extra would go to the owner of the shop - what we would describe as economic profit.  At University there would be fewer copies made at higher prices, and we would expect output to increase if there was entry into the industry of a new supplier.  In this sense we would talk about imperfect competition as being inefficient.  

The argument is not, however, this one-sided. There are some who do not see market concentration as necessarily a bad. They suggest that we need to relax our assumptions concerning the cost side of the ledger, that the cost curves for monopolists will be lower than those for competitors and innovation is more likely to take place in larger firms capable of financing large R&D expenditures. And finally there is the case of the natural monopoly, those industries where the average cost curve is falling.  This means the least cost level of output would be very large - enough so that there may be only room for one seller in the market. We will talk more about this in a later section on the government's role in the economy.

Recognizing the potential problems associated with imperfect competition, the government stepped into the picture through direct regulation of industry and the establishment of antitrust legislation.  In 1887, at the height of the Robber Baron era, the Interstate Commerce Act established the ICC, the nation's first federal regulatory commission. This legislation, which was a direct outgrowth of the power over price that had been exerted by the railroads, gave the commission power to protect consumers from an array of anticompetitive practices.  If we were not to have adequate competition among the firms in an industry, then we would need to regulate their behavior.

In addition to regulating noncompetitive industries, the US government became actively involved in promoting competition. In 1890, as the country moved through the industrial revolution which brought with it the mega factories and corporations, the Sherman Act was passed - the first piece of the nation's anti-trust legislation. The US government was now in the business of promoting competition and penalizing those who conspired to reduce competition or restrain trade.

The provision of public goods and the promotion of competition in the markets was not enough, however, to ensure efficiency and the solution to our social problems. By the 1960s, buoyed by overwhelming public support earned by the profession's victory over the business cycle and economic growth (macroeconomic topics), the economics profession turned its attention to new areas. If we could cure the business cycle, couldn't we do the same with poverty and pollution. President Lyndon Johnson launched the war on poverty with much fanfare in the 1960s.  Michael Harrington, whose book The Other America, was a popular text around campus in the 1960s, opened up for all to see the pockets of poverty that had been hidden from view. The market system may be efficient, but there was no reason to believe the distribution was equitable or defensible.  Inequality and poverty were simply too large to be ignored.

This was also a time to turn our attention to the deterioration of the environment. Just as we could 'prove' that good intentioned decision makers could not be expected to provide enough security, we could also 'prove' they could be expected to provide too much pollution. There was a flaw in the system that would contribute to excessive levels of pollution. The market system did not adequately deal with situations where market transactions failed to adequately capture all of the benefits and / or costs - where we had an externality.

As an example consider an individual's purchase of a car. The price covers all of the producer's cost, including profit. But what about the person who lives down wind from the steel plant producing the steel for the car? We could expect this profit seeking firm to chose a mix of inputs that minimizes cost -  the firm would fill the air and water with waste generated by production rather than spend money investing in technology to reduce / eliminate the waste. This was the least cost method of production, and we should expect nothing less from our competitive firms.  Unfortunately from society's point of view, and the view of those individuals living downwind or downstream from the steel mills,  auto buyers were clearly not building into their calculations all costs. The result was clearly less than optimal - an opening for government action.

The action came in 1969 with passage of the National Environmental Policy Act which established the EPA. This was followed by the Clean Air and Clean Water Acts in the early 1970s in which the government raised the price of using / abusing the environment. By 1980 the government, partly in response to the Love canal disaster in Buffalo, NY, passed the Superfund legislation designed to clean up the land.

There were also macroeconomic issues.  At the height of the Great Depression a full twenty five percent of the labor force was out of work, and this prompted economists to question the ability of the macroeconomy to provide full employment without government involvement.  There have also been questions concerning the government's involvement in promoting economic growth.  According to some economists, economic growth is too important to be left to the market system.  In both cases, the short-term cycles and long-term growth, the result has been a debate over the proper role of the government.  Should it attempt to fine-tuning the economy, softening the downside of the recession, and should it promote economic growth.  And if you say yes, the obvious next issue, one we will discuss at length in the course, is what would be the appropriate tools.  

Which brings us to today. All of these issues remain with us, but our approach has changed rather dramatically. The battle over the environment continues as we can see with the furor raised over the tightening of Clean Air standards in 1996. The move toward regulation of the economy has turned around as we move toward deregulation. We see this in the Telecommunications Act of 1997 and the deregulation of electric utilities. And finally, the war on poverty has become a war on welfare, while the provision of education, long thought to be a public good, is being challenged by many who call for markets and competition.

Now it is time to look more closely at these issues.  We will begin with the issue of imperfect competition and then move to the problems of externalities and public goods. 

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