• The issue of externalities is often cast in the language of market failure.

  • The idea is that the market process fails to achieve some optimal standard.

  • It also suggests that government corrective action can propel the market system closer to some hypothetical optimum.

• Good intentioned people often assume that government officials will have the information and the incentive to improve real world economic coordination problems.

  • But there is the possibility that government policy might make matters worse.

• "Economists who analyze market failure have a moral obligation to also analyze government failure."

• What shall we leave to the market, and what are appropriate tasks for government?

Private versus public?

• The market is usually characterized as the private sector.

  • Governments occupy the public sector.

• This doesn't mean that business managers pursue private interests whereas the government pursues the public interest.

  • The senator who claims that the public interest guides all his decisions is guided by a personal interpretation of the public interest.

  • Senators may be less interested in gaining money, but they're more interested in gaining personal power.

Competition and individualism

• The market sector is often called the competitive sector.

  • But there is competition within the government too, as every election year demonstrates.

• Sometimes we're told that individualism is the distinguishing characteristic of the market sector.

  • But what is individualism?

Economic theory and government action

• The economic way of thinking attempts to explain the workings of society on the assumption that all participants want to advance their own interests and try to do so in a rational way.

  • Why shouldn't this apply to the social processes that control government activities?

• Government can use negative as well as positive incentives.

• Demand curves also exist for government-provided goods, because these goods are scarce, so they must be rationed.

  • This counters the tendency to think of the government as a heaven-sent power that can resolve difficulties magically.

  • It makes our expectations of government more realistic.

• Every participant in the process of government has expectations of what voters or the president can do.

  • Those expectations reflect property rights: what people think they can get away with.

The right to use coercion

• Government possesses a generally conceded and exclusive right to coerce adults.

  • The right is generally conceded, but not universally.

  • It's an exclusive right because "people don't have the right to take the law into their own hands"

  • It's the right to coerce adults because parents generally have the right to coerce children.

• To coerce means to induce cooperation by threatening to violently reduce people's options

  • To persuade means to induce cooperation by promising to expand people's options.

• It is only to government that we grant the right to secure cooperation by threatening to withdraw options, to reduce people's freedom, to take away some of their rights.

• Coercion has a bad reputation because it implies authority, and many of us react with automatic hostility to claims of authority.

• The reason laws expand our freedom is because they also coerce others.

  • We are all safer because we accept the coercion of laws.

Is government necessary?

• Do we have to use coercion?

  • If voluntary exchange is the principal mechanism of coordination in our society, why isn't it the only means through which we induce cooperation?

• What would happen if there were no government at all?

Excluding non-payers

• Why do people pay for food instead of providing it out of taxes?

• If there were no government, people who wanted protection could purchase it from private security agencies or by buying a gun.

  • If food is more basic necessity than security, why is one provided and the other is not?

• The reason is externalities.

  • Patrol officers who guard my neighbor's house also provide somewhat security to my house.

  • Patrol officers can't exclude non-payers.

• So the solution is to provide service to all equally.

The free-rider problem

• When people can obtain a good whether they pay for it or not, they have less incentive to pay.

  • Free riders: people who accept benefits without paying their share of the cost of providing those benefits.

  • "The problem would go away if each of us will only..."

• Economists encounter resistance when they try to persuade people that each will not do what is in the interest of all unless it is in the interest of each.

• This doesn't mean that people are entirely selfish.

  • Neither markets nor government could exist among people with no ability to empathize, to internalize at least some of what others experience.

Positive externalities and free riders

• Positive externalities are benefits that decision makers do not take into account when making their decisions.

  • Will anyone have the incentive to create those benefits, or will everyone hope to receive them as spillover benefits?

• Spillover benefits and free-riding tendencies do create some serious social problems.

  • Coercion through government is one way of dealing with these problems.

  • Government can be viewed as an institution for reducing transaction costs through the use of coercion.

Law and order

• High transaction costs make it difficult to exclude non-payers from spillover benefits.

  • To prevent free riders from destroying the incentive to supply police protection, gov employs coercion.

  • It supplies the service to everyone and pays for it with involuntary contributions called taxes.

• Uniform and consistently enforced rules make it much easier for everyone to plan with confidence.

  • The ability to plan confidently is what distinguishes a cooperating society from a chaotic mob.

National defense

• National defense is a classic example of a benefit that can't be provided, except at a prohibitive cost, exclusively to those who pay for it.

  • Free-riders would make it impossible to rely on voluntary contributions to finance a system of national defense, so societies resort to collecting through taxation.

• But gov also relies on persuasion and voluntary cooperation for people to join the armed forces.

  • Why will gov sometimes use coercion and other times persuasion?

Roads and schools

• People will acquire education only up to the point at which the marginal cost to themselves equals the marginal benefit to themselves.

  • By using taxes to subsidize education, gov lowers its cost to potential students, so they can acquire more education than they otherwise would.

• This leads to the question whether the use of coercion to prevent undersupply does not lead to oversupply.

Income redistribution

• Another important category of government action is the provision of special benefits to impoverished people.

  • This issue is not left to voluntary philanthropy because charity is subject to the free-rider problem.

The regulation of voluntary exchange

• What about other government activities that need regulation? Why is coercion used to control the terms on which people are allowed to engage in voluntary exchange?

• There is a widely held belief that the powerful will take advantage of the weak unless government regulates certain kinds of voluntary exchange.

  • This is the paternalistic argument.

  • It has often been abused by special interests precisely to take advantage of the weak.

• The demand for government regulation of sellers often originates from sellers that want to restrict competition.

Government and the public interest

• Persuasion always precedes coercion, because government will not act until particular people have been persuaded to act.

• A surprising number of people assume that government acts in the public interest.

• Government acts on the information actually available to them, which is limited and biased.

Information and democratic governments

• None of us knows enough to cast an adequately informed vote.

  • Most citizens cast their vote, equipped with prejudices, some hunches, some poorly tested bits of information and vast areas of total ignorance.

• A voter who wanted to make a personal sacrifice for the greater good could do far more in social service volunteer than by gathering information to vote adequately.

  • One single person's vote is diluted.

  • A lot of people rely on the hope that others will do the investigating of information, and will vote adequately, so they themselves don't do enough research.

• Some defenders of democracy aren't discouraged by the incompetence of citizen voters.

  • They rely on elected legislators to acquire information that must be available if a decision is in the public interest.

The interests of elected officials

• Even if we assume legislator's votes are adequately informed, should we assume they will be votes in the public interest?

• Elected officials can't afford to look too far ahead because results must be available by the next election.

  • An emphasis on the short run makes it difficult for governments to deal effectively with recessions and inflation.

  • They will also tend to discount heavily the value of future costs, they will crowd into the period before the election as many benefits as possible.

• The interest in providing information for legislators is concentrated in special-interest groups.

• Example: a costly project of implementing a light-rail system.

Concentrated benefits, dispersed costs

• The few who have much to gain invest vast resources in trying to influence the political process.

• The logic of the situation within democratic political processes is to concentrate benefits on the well-organized and well-informed few who gain the most and disperse the costs on the unorganized and ill-informed mass who have little to gain individually.

Positive externalities and government policies

• Government policies will tend to be dominated by special interests.

  • Government will lean toward actions that harm many people just a little bit, rather than actions that displease a few people very much.

  • Government policies will be guided not by the public interest, but by an endless succession of extremely partial interests.

• Expenditures cannot be reduced because no one wants their project to be cut.

• This does not imply that social workers have no regard for the public interest, only that they all have some regard for their own interests.

The prisoners' dilemma

• Example in the book: bowling vs doing my duty

  • Choosing recreation over duty will be the dominant strategy for everyone else too, with the consequence that we will not get good government even though everyone is willing to contribute.

• Prisoners' dilemmas would not exist in the absence of transaction costs.

The limits of political institutions

• "There is no country in which everything can be provided for by the laws in which political institutions can prove a substitute for common sense and public morality"

• People tend to idolize the government

  • Maybe they confuse nation with government, and extends reverence from one to the other

  • Maybe they think that all social problems result from human behavior, that human behavior can be altered by law, so if government makes the laws, government can solve all social problems.

Summary

• Economic theory assumes that the actions of government follow from the decisions of citizens and government officials who are paying attention to the marginal costs and marginal benefits to themselves of alternative courses of action.

• The distinguishing characteristic of government is its generally conceded exclusive rights to use coercion. To coerce means to induce cooperation by threatening to reduce people's options. Voluntary cooperation relies exclusively on persuasion, which secures desired behavior by promising additional options.

• Coercion is useful to the members of a society because it can sometimes secure the production of goods that everyone values at more than the cost of supplying them, but which would not be supplied through purely voluntary cooperation. A supply failure of this sort is likely to occur when there is no low-cost way of confining supply of a good to those who pay for it or of preventing demanders from becoming free-riders.

• Coercion may be able to secure the supply of such goods by lowering the transaction costs. The traditional activities of government turn out on examination to be largely actions aimed at reducing transaction costs and overcoming free rider problems.

• The coercive activities of government presuppose voluntary cooperation. Persuasion precedes coercion because, in the last analysis, citizens and government officials must be persuaded to employ coercion in particular ways. This implies that the limits on the effectiveness of voluntary cooperation that justify coercive action by government are limitations also on the effectiveness of the government's coercive action.

• Positive externalities thoroughly permeate the political process in a democratic government. They make it unlikely that citizen voters will be adequately informed or that elected or appointed officials will be consistently act in the way that the information available to them tells them they ought to act.