• A modern market economy cannot exist in a vacuum.

• Government not only enforces its own rules but also enforces contracts and other agreements and understandings among the numerous parties transacting with one another in the economy.

• In order to support itself, a government must also collect taxes, which in turn influence economic decision-making by those affected by those taxes.

• Market transactions take place within a framework of rules, and require someone with the authority to enforce those rules.

• Beyond these basic functions, which virtually everyone can agree on, governments can play more expansive roles, all the way up to directly owning and operating all the farms and industries in a nation.

• Controversies have raged around the world, for more than a century, on the role that government should play in the economy.

• One of the most basic functions of government is to provide a framework of law and order, within which the people can engage in whatever economic and other activities they choose, making such mutual accommodations and agreements among themselves as they see fit.

• The individuals who work for government in various capacities tend to respond to the incentives facing them, just as people do in corporations, in families, and in other human institutions and activities.

• Government is neither a monolith nor simply the public interest personified. To understand what it does, its incentives and constraints must be taken into account, just as the incentives and constraints of the marketplace must be for those who engage in market transactions.

Law and Order

Corruption:

• Like the role of prices, the role of a reliable framework of laws may be easier to understand by observing what happens in times and places where such a framework does not exist.

• Countries whose governments are ineffectual, arbitrary, or thoroughly corrupt can remain poor despite an abundance of natural resources, because neither foreign nor domestic entrepreneurs want to risk the kinds of large investments which are required to develop natural resources into finished products that raise the general standard of living.

• Whatever the merits or demerits of particular laws, someone must administer those laws—and how efficiently or how honestly that is done can make a huge economic difference.

• The costs of corruption are not limited to the bribes collected, since these are internal transfers, rather than net reductions of national wealth in themselves, because scarce resources have alternative uses, the real costs are the foregone alternatives—delayed or aborted economic activity, the enterprises that are not started, the investments that are not made, the expansion of output and employment that does not take place in a thoroughly corrupt society, as well as the loss of skilled, educated, and entrepreneurial people who leave the country.

Social Order:

• A market economy operates better in a country where honesty is more widespread, it is also true that free markets tend to punish dishonesty.

• Business transactions among strangers are an essential part of a successful modern mass economy, which requires cooperation—including the pooling of vast financial resources from far more people than can possibly know each other personally.

• While government can do little to create honesty directly, in various ways it can indirectly either support or undermine the traditions on which honest conduct is based.

• Those who create incentives toward widespread dishonesty by promoting laws which make honest behavior financially impossible are often among the most indignant at the dishonesty—and the least likely to regard themselves as in any way responsible for it.

• When laws and policies make honesty increasingly costly, then government is, in effect, promoting dishonesty, such dishonesty can then extend beyond the particular laws and policies in question to a more general habit of disobeying laws, to the detriment of the whole economy and society.

The Framework of Laws:

• If the application of the law varies with the whims of kings or dictators, with changes in democratically elected governments, or with the caprices or corruption of appointed officials, then the risks surrounding investments rise, and consequently the amount of investing is likely to be much less than purely economic considerations would produce in a market economy under a reliable framework of laws.

• A framework of dependable laws has encouraged both domestic and foreign investment, as well as attracting immigrants with skills lacking locally.

• While impartiality is a desirable quality in laws, even laws which are discriminatory can still promote economic development, if the nature of the discrimination is spelled out in advance, rather than taking the form of unpredictably biased and corrupt decisions by judges, juries, and officials.

• Dependability is not simply a matter of the government’s own treatment of people; it must also prevent some people from interfering with other people, so that criminals and mobs do not make economic life risky and thereby stifle the economic development required for prosperity.

• Governments differ in the effectiveness with which they can enforce their laws in general, and even a given government may be able to enforce its laws more effectively in some places than in others.

Property Rights:

• Among the most misunderstood aspects of law and order are property rights, while these rights are cherished as personal benefits by those fortunate enough to own a substantial amount of property, what matters from the standpoint of economics is how property rights affect the allocation of scarce resources which have alternative uses.

• Property rights need to be assessed in terms of their economic effects on the well-being of the population at large, these effects are ultimately an empirical question which cannot be settled on the basis of assumptions or rhetoric.

• Property rights create self-monitoring, which tends to be both more effective and less costly than third-party monitoring.

• Despite a tendency to think of property rights as special privileges for the rich, many property rights are actually more valuable to people who are not rich—and such property rights have often been infringed or violated for the benefit of the rich.the benefit of the rich.

• By infringing or negating property rights, affluent and wealthy property owners are thus able to keep out people of average or low incomes and, at the same time, increase the value of their own property by ensuring its growing scarcity as population increases in the area.

External Costs or Benefits

• An external cost or benefit caused by a producer that is not financially incurred or received by that entity; governments try to enact laws to offset their effects

• Economic decisions made through the marketplace are not always better than decisions that governments can make.

• There are things that government can do more efficiently than individuals because external costs, external benefits, or indivisibilities make individual decisions in the marketplace, based on individual interests, a less effective way of weighing costs and benefits to the whole society.

• While externalities are a serious consideration in determining the role of government, they do not simply provide a blanket justification or a magic word which automatically allows economics to be ignored and politically attractive goals to be pursued without further ado.

Incentives and Constraints:

• Government is of course inseparable from politics, especially in a democratic country, so a distinction must be made and constantly kept in mind between what a government can do to make things better than they would be in a free market and what it is in fact likely to do under the influence of political incentives and constraints.

• Before having the government solve a problem and expand its role, the incentives and constraints need to be examined. Or else the government will get bigger and more powerful.

• When thinking of government functions, we often assume that particular activities are best undertaken by government, rather than by non-governmental institutions, simply because that is the way those activities have been carried out in the past.