Tags: fiscal policy
Tags: fiscal policy
March 7, 2008
This might not be such a great time for the economy, but it is a good time to be an economist. Not surprisingly, when things are good, being an economist is less interesting; at least, it results in fewer calls to comment on public events. But we who toil under the inappropriately applied moniker, “dismal science,” do much more than speculate about “are we or aren’t we in recession?” In recent years, some economists—other than the Federal Reserve Chairman—have even developed what one would call a following, based on the popularity of their writing, research or, dare I say, opinions.
Most of us, however, will continue to do whatever it is that we do in relative obscurity for the foreseeable future. However, having a forum in which to speak (viz., this column), the current state of the economy (in particular, the fiscal health of the states—although a case could be made for adding the national fiscal situation), and all of the mystery about just what it is economists do, presents too great an opportunity to ignore. Herewith, some thoughts by an economist on the role of the public sector—or as you all call it, government.
Outside of centrally planned and totalitarian economies (both of which have seen better days), the case for government intervention—When should governments interfere?—can be summarized very succinctly:
To elaborate, we live in society organized according to the principles of a capitalist, free market economy. The market mechanism sets prices, brings together buyers (Demand) and sellers (Supply) and generally results in the efficient allocation of resources. Some may not agree with what is produced, how much, and for whom, nor with perceived inequities; but provided that market mechanisms function properly, things are as they should be.
Of course, markets do fail—for a variety of reasons. Although most of us do not immediately think of market failures, so-called public goods (e.g., national defense, local police, nautical aids to navigation, air traffic control) provide many well-known examples because they demonstrate the features of non-rivalry—your use or consumption of a good does not reduce my ability to achieve similar benefits without additional cost—and non-excludability—that is, there is no mechanism to limit my ability to gain said benefits without paying for them. Market failures lead to what is known as the free rider problem, where people avoid paying because they know they will be able to benefit anyway. Have you seen those hand-written signs, “Restrooms for Customers Only”? That’s someone trying to eliminate free riders. Public broadcasting membership campaigns also attempt to reduce the number of free riders. And so on. Beyond free ridership, another problem faced by public goods is that they would not be produced in sufficient quantity (that is, efficiently allocated) if left to private producers because of the inability to capture revenue equal to all of the benefits. The ability to find a restroom that you can use while out and about serves a public benefit that private shop owners don’t always feel like paying for. Public radio is another example—since there is no requirement to pay for it, fundraising efforts often appeal to a sense of civic duty.
The market failures just described—where producers and consumers do not bear full costs nor recoup the full benefits of activities because of an inability to capture private, public, or social costs and benefits in the same way—result in externalities or spillovers. In such cases, the goods or activities in question may occur in excess—litter and pollution are classic examples of negative externalities -- or may not be produced up to the level of adequacy or efficiency. Private underinvestment in knowledge-producing activities, such as research and development, is an example of positive spillover, where all of the benefits (in particular, public benefits) do not accrue to the investor/inventor. While strong intellectual property rights such as patents may protect investors and inventors, they may also limit societal benefits.
Variations of the imbalance between costs and benefits arise also due to imperfect information, asymmetric information, or uncertainty, and may relate either to the price or quality of goods or services or both. As with previously identified accounting breakdowns (where all private and public costs or benefits are not captured), these situations—poor information, one-sided information flows or lack of information—are also examples of market failures. As in other cases, the result is usually the inefficient allocation of resources.
The final example of market failure I will mention relates to imperfect competition—that is, monopolies. As a result of the cost structure of particular industries and some firms, situations arise where monopolies occur or may even be desirable from the perspective of efficiency (so-called natural monopolies). Market failures relating to monopolies enable firms to control prices irrespective of supply and demand conditions (whereas under perfect competition, with functioning markets, firms are price takers, not price setters).
Thus far, we have looked at market failures. The other consideration before governments intervene is to understand whether or not such meddling (I use the pejorative lovingly) will be effective. Will it restore efficiency? To determine that requires a particularly good grasp of the accounting—all of the public and private costs and benefits—entangled in the market failure….
I would love to discuss cost-benefit analysis, but my time on the soapbox is ending for the week. Too many thoughts or opinions from an economist at one time, and one risks becoming another economics joke. My preference would be to become another joking economist.
[NOTE: The genesis for this article is, ironically, a publication by GLA Economics, the economics research unit of the Greater London Authority. The irony, as I see it, is that the Mayor of London is Ken Livingstone. Notwithstanding his nickname, “Red Ken,” in 2000 Livingstone became the first Mayor of London and the first directly elected mayor in the United Kingdom. Since that time, there has been no turning back—London’s economy and quality of life, as well as preeminence as a world leader and status as a world class destination have all grown significantly.]
Market failures and government intervention: besides those mentioned above, there are many other examples. Here are a few you might recognize:
Littering fines: What they are: Negative externalities. Your trash ruins my enjoyment of the park, not to mention adversely affecting nearby property values. What’s supposed to happen: Fines are a negative incentive meant to reduce the amount of a particular activity.
Small business loans: What they are: Asymmetric information. Small businesses often find it difficult to borrow for a variety of reasons—lack of collateral, no track record, unusual profile. What’s supposed to happen: Government reduces risk for lenders through a variety of loan programs, often administered by the traditional market mechanism for borrowing—i.e., banks.
Government assistance for education and training: What it is: (1) A positive externality. Employers don’t want to train workers only to have them “jump ship” to use newly acquired skills where they earn more money. Similarly, elementary education is a public good, with few private incentives to provide it. (2) Imperfect information and uncertainty—individuals fear spending too much on training or education when they are poorly informed or uncertain about future returns on their investments. What’s supposed to happen: (1) Government provides assistance directly to employers to encourage them to provide training or education subsidies to individuals to encourage them to return to school. (2) We also know that government is the primary investor in elementary education, for which the positive spillovers are enormous—as is the case for most (but not all) education.
Phew! That may seem like a heavy meal to digest late on a Friday afternoon. Why not just skip to the chocolate cake? Without relying on econospeak and stating that a recession represents a reallocation of resources and restores equilibrium, efficiency, blah, blah, blah, let’s just say that there are many reasons to be hopeful today. First, with respect to the economy, the U.S. has always shown a remarkable ability to rebound. While concerns about equity must be taken seriously, this remains a land of new opportunities and new ideas. As for government, Philadelphia has an administration that is still in its infancy and that has sparked the interest, enthusiasm, and optimism of a great many people. Meanwhile, the national election is front-and-center news (with Pennsylvania looming even larger during the primary season than originally anticipated). For all these reasons, as well as elections past and present, this seems like a very good time to think about government and to examine its role from a variety of perspectives. After all, for some individuals this is even a better time to be a politician than an economist!
The United States invariably does the right thing, after having exhausted every other alternative.
—Winston Churchill
-- Rich Stein, Director of Research
RSS Feeds