THE ROLE OF GOVERNMENT IN THE ECONOMY
THE ROLE OF
GOVERNMENT IN THE
ECONOMY
Under Ideal Market Conditions
• The gov’t has almost no role as long as
society only cares about efficiency
• If the market system works very well,
the outcome will be efficiency in the
use of scarce resources
– That state of the world in which all
opportunities to make someone better off
without making anyone worse off are
exhausted
• Efficiency means not wasting
resources
– all resources allocated so that no more of
one type of good can be produced
without having to produce less of another
type of good.
– This concept of production efficiency can
be illustrated with a Production
Possibilities Curve
Consumption Goods
Cap
ital
Go
od
s
0
Efficient
Inefficient
Production Possibilities Curve
In the Real World
• Conditions are not ideal (The market
causes too few or too many resources to
be allocated to an economic activity.
• Society cares about more than efficiency
– cares about economic stability and fairness
– wants to ensure that the environment is safe and
clean
– wants to impose certain paternalistic
requirements on consumption• merit/demerit goods
Market Failure
• Market failure describes a situation in
which the unrestrained market system
is inefficient, wasteful and leads to over
production or under production of
goods and services.
• That is, it allocates too few or too much
resources to a specific economic
activity.
Major Instances of Market Failure
– Businesses tend to experience severe business
fluctuations – recessions, economic booms
– Inability of market forces to deal with spill-
over (third party) effect - externalities
– Market forces cannot provide public goods and
does a poor job of providing merit goods
– Market forces lead to unequal distribution of
income and wealth
– Market forces fail to deal with growth of
monopolies
The Roles of Government
1. Stabilization by smoothing out the ups and
downs in overall business activity through fiscal
and monetary policy. The aim is to:
2. Allocation by dealing with externalities,
providing merit, and reducing or eliminating
demerit goods
3. Redistribution using a redistributive tax
structure to redistribute income and provide
welfare
Stabilization of the Economic
Environment
• The aim is to:– Maintain full employment
– Keep prices steady
– Achieve an equilibrium on the balance of payment
– Sustain economic growth
– Prevent environmental damage
– Redistribute income and provide welfare
Allocation
• The aim is to:
– Deal with or correct externalities
– Provide public and merit goods in
quantities required
– Prevent the growth of monopolies
Externalities
• An externality is a spill-over (third party) effect of
an economic transaction not accounted for by the
economic decision makers (i.e. the parties engaged
in the transaction).
• An externality could be negative or positive.
• Total (social) cost = Private cost + External Cost
• When only private (internal cost) is accounted for
and social cost is not accounted for, Negative
externality exist
• Total (social) Benefit = Private benefit +Social
benefit.
Externalities Cont’d
• Negative externality
– costs not accounted for by economic decision makers
• Social Cost is greater than private cost
• Leads to over production – i.e. firms produce more than
they can produce if they were taking care of (internalizing)
external cost.
• Positive externality
– benefits not accounted for by economic decision makers
• Social benefits is greater than private benefit
• Leads to under production – i.e. firms produce less than
they should produce if the total benefit was taking into
account
• Externalitycauses divergence
between what should be produced
and what is actually produced.
• Thus, market equilibrium is not
efficient
– that is, the market fails to achieve an
efficient state
– society stands to gain from government
correction of the externality
Pollution – Negative Externality
• Happens because of failure to define a
property right
• Air pollution
– lack of private property right to the
atmosphere
– factory uses the atmosphere as an input for
which it does not pay
– society incurs a cost not accounted for by the
factory
– too much of good produced
D
S
S1$
Q0
External cost
QmarketQeff
A
B
CABC = welfare loss triangle
= net social gain from
reducing output to Qeff
overproduction
Negative Externality From Pollution
• Education (Social Benefit)
– students receive private benefits from
education
– others receive benefit of associating with
educated person
– student cannot capture this public benefit• i.e. lacks property right needed to charge for this
service to others
– causes too little education to be
consumed
Q0
$
D
D1
S
Qmarket Qeff
A
B
C
= welfare loss triangle
= net social gain from
increasing output to Qeff
ABC
Positive Externality From Education
Externality Policies
• These are policies the government can employ to
deal with externalities.
• Pollution
– Employ the Pigouvian taxes• tax factory
– shifts S up to MSC
– how to measure value of pollution/amount of tax
– not common
» gas tax
– tax the product
» works in short run but no incentive to find less polluting technology
– tax the pollutant
» better long run incentives
• command and control
– require pollution reducing capital, clean
fuels, etc.• e.g., stack scrubbers
• lacks long run incentive to find better technology
• same rules for all firms regardless of costs
• easier to administer and politically more acceptable
– past reluctance to adopt market-based solutions like taxes
Cost-Benefit Analysis• CBA is an investment appraisal technique that analyses
the external cost and benefits alongside the internal
(private) cost and benefits of carrying out an economic
activity.
• It involves identifying monetary values for all the internal
and external costs and benefits of a project allowing a total
(social) price to be arrived at.
• To decide whether or not to locate a cement factory near a
community, a CBA has to be conducted before a final
decision is taken.
• The limitation of the CBA technique lies in “what is
actually measured” and “how the related monetary
value is identified”
Public Goods
• an apple is a PRIVATE good
• national defense is a PUBLIC good
• What distinguishes private goods from
public goods?
– private goods are EXCLUDABLE
– public goods are NONEXCLUDABLE• an apple is a private good because a consumer who does not
pay the price can be excluded from consuming it
• no one can be excluded from consuming public goods -- can
anyone not be protected by national defense?
– private goods are RIVAL in consumption
– public goods are NONRIVAL in
consumption• if I eat an apple, you cannot
• when I consume national defense, it’s still there for
you to consume
– therefore, it costs nothing to provide to additional
consumers
» therefore, the efficient price is zero
– since no one can be excluded from
consuming a public good, and since the
efficient price is zero, the private sector
would ordinarily not be able to provide it
• WARNING! A good is public or
private because of these
characteristics, not because the
government provides it or doesn’t
– governments provide all sorts of things,
including private goods• e.g., electricity, steel
– private sector sometimes finds ways to
provide public goods• e.g., TV broadcasting
• Government provides public goods
at zero price
• Funding out of general budget
– we pay taxes based on income,
consumption, etc., not on the amount of
public goods we consume• for example, a household earning $100,000 pays
more tax than a household earning $10,000 but both
consume the same national defense
• Quantity determined through
political process
Additional Characteristics of Public Goods1. Public goods are usually indivisible – i.e. they cannot be
produced and sold in small units very easily. E.g. You
cannot buy GH¢50 worth of street light.
2. They can be used by increasing numbers of people at no
additional cost. E.g. Once a light house is built,
additional ships can use it without any additional cost.
3. Additional users of public goods do not deprive other of
any of the services of the good. E.g. if you use a street
light, additional users are not deprived.
4. It is very difficult to charge people for a public good on
the basis of how much of it they use. E.g. It is very
difficult to determine how much a person uses or values
national defense. It is not sold in the mkt place
Merit and Demerit Goods
• Goods provision of which society wants to encourage (in the case of merit goods) or discourage– merit
• education
• housing
• health care
– demerit• tobacco
• alcohol
• Various subsidies and taxes are used by government to encourage the consumption of merit goods or discourage consumption of demerit goods.– housing allowances
– sin taxes on tobacco and alcohol
– National health insurance
• Direct provision– Subsidies on education
Merit Goods• A good can be described as a merit good if it is provided for
the benefit of the whole society at no direct cost to the user.
• Merit goods can have characteristics of both private and
public goods depending on the situation.
– sometimes characteristics depend on circumstances
• highways are nonrival as long as few drivers are on them but
become rival with congestion.
– sometimes a nonexcludable good becomes excludable when
technology changes
• Distance education
• Merit goods do not have any special characteristics, what is
a merit good varies from country to country.
• Merit goods are political decisions and different government
may classify different goods as merit and provide them free.
Demerit Goods
• Goods whose consumption is considered
harmful the consumer. E.g. Cigarette,
Alcohol, Cocaine etc.
• They could be goods classified by the
laws of a country as demerit. E.g.
Prostitution in Ghana.
• The only identifying feature of demerit
goods is that it is medically confirmed as
harmful to the user.
Redistribution of Income and
Welfare
• Society cares about equity or
fairness as well as efficiency
• Thus a role of government is to
create a more fair distribution than
the market produces
– distribution of income
– distribution of opportunity• education
• health
What is Fair?
• We know what an efficient allocation is
• We have no idea what a fair distribution is– equal income for all?
• The limitation is that many analyst believe that Redistribution creates inefficiency– distorts returns to productivity
– drives wedge between cost and value i.e. encourages equity at the expense of productivity
Mechanisms to Redistribute
• Via the tax structure
– progressive taxation
– negative income tax
• Transfers
– cash
– in-kind