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CHAPTER
6The Economic Role of
the State
PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
6-2
PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
The Economic Role of the The Economic Role of the StateState
Market economy requires that Market economy requires that property rights be well-defined and property rights be well-defined and protectedprotected
Government has 3 possible roles:Government has 3 possible roles: Protection of individual rightsProtection of individual rights Public productionPublic production RegulationRegulation
6-3
PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
Protection of RightsProtection of Rights
A market economy presupposes A market economy presupposes rights are protectedrights are protected
Government protects rights through:Government protects rights through: National defenseNational defense Police Police CourtsCourts
Government has monopoly on Government has monopoly on legitimate use of forcelegitimate use of force
6-4
PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
How Much Protection is How Much Protection is Optimal?Optimal?
Is not an all-or-nothing propositionIs not an all-or-nothing proposition Optimal point is where marginal cost Optimal point is where marginal cost
of protection equals marginal benefit of protection equals marginal benefit from protectionfrom protection
Provides little practical guidanceProvides little practical guidance
6-5
PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
Government ProductionGovernment Production
Market inefficiencies lead to Market inefficiencies lead to possibility of government regulation possibility of government regulation or productionor production
Main theoretical justifications for Main theoretical justifications for government production:government production: ExternalitiesExternalities Public goodsPublic goods
6-6
PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
Government RegulationGovernment Regulation
Regulation may be a more efficient Regulation may be a more efficient substitute for government productionsubstitute for government production
Problems with Government Problems with Government RegulationRegulation InformationInformation PoliticsPolitics
6-7
PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
The Capture Theory of The Capture Theory of RegulationRegulation
Regulatory agencies are “captured” Regulatory agencies are “captured” by regulated industriesby regulated industries
Special interests vs. general publicSpecial interests vs. general public Example:Example: regulated utility regulated utility
General public lacks incentive to General public lacks incentive to become informedbecome informed
Special interests have incentive because Special interests have incentive because of concentrated regulatory benefitsof concentrated regulatory benefits
6-8
PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
The Regulatory Agency The Regulatory Agency as a Cartelas a Cartel
Government regulation can create a Government regulation can create a regulatory cartel creating:regulatory cartel creating: Regulatory barriers to entryRegulatory barriers to entry Regulating prices Regulating prices
Result is inefficientResult is inefficient Lower output = higher pricesLower output = higher prices
6-9
PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
The Regulatory Agency The Regulatory Agency as a Cartelas a Cartel
6-10
PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
The Equilibrium Level of The Equilibrium Level of RegulationRegulation
Special interests don’t get everything Special interests don’t get everything they wantthey want
Regulation benefits some at the Regulation benefits some at the expense of othersexpense of others
Politicians must weigh marginal Politicians must weigh marginal political costs vs. marginal political political costs vs. marginal political gainsgains
6-11
PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
The Equilibrium Level of The Equilibrium Level of RegulationRegulation
6-12
PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
The Transitional Gains The Transitional Gains TrapTrap
Regulation provides transitional Regulation provides transitional profits profits
Profits eventually competed awayProfits eventually competed away Deregulation creates transitional Deregulation creates transitional
losseslosses Example:Example: Airline Regulation Airline Regulation
Increases difficulty of eliminating Increases difficulty of eliminating harmful regulationsharmful regulations
6-13
PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
RedistributionRedistribution
Largest single activity undertaken by Largest single activity undertaken by United States governmentUnited States government
Many stated reasons for Many stated reasons for redistributionredistribution
Actual redistribution policies will Actual redistribution policies will reflect impact of the political processreflect impact of the political process
6-14
PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
Reasons for Government Reasons for Government RedistributionRedistribution
Two general reasons: Provide a safety net Greater equality
Not necessarily the same thing Example: worldwide poverty
6-15
PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
Politics and Politics and RedistributionRedistribution
Bulk of government transfers go to Bulk of government transfers go to the middle class in the United Statesthe middle class in the United States Examples:Examples:
Social SecuritySocial Security farm programsfarm programs
Product of political process based on Product of political process based on majority rulemajority rule
6-16
PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
StabilizationStabilization
Government’s other activities may Government’s other activities may be constrained by stabilization policybe constrained by stabilization policy
Stabilization tools:Stabilization tools: Monetary policyMonetary policy Fiscal policyFiscal policy
6-17
PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
Can The Government Can The Government Perform These Perform These
Functions?Functions? May be problems with government May be problems with government
allocation of resourcesallocation of resources Information problemsInformation problems
Limited market dataLimited market data Unrevealed preferencesUnrevealed preferences
Policy conflictsPolicy conflicts Trade-off between efficiency and equityTrade-off between efficiency and equity
6-18
PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
Will The Government Will The Government Perform These Perform These
Functions?Functions? Public policy is not decided by expertPublic policy is not decided by expert Public policy determined through Public policy determined through
political process influenced by:political process influenced by: Special interestsSpecial interests Public sentimentPublic sentiment
6-19
PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
The Free Rider ProblemThe Free Rider Problem
Individuals can consume collective Individuals can consume collective benefits without payingbenefits without paying
Even when individuals do contribute, Even when individuals do contribute, they have an incentive to shirkthey have an incentive to shirk Shirking reduces the production of the Shirking reduces the production of the
collective goodcollective good Incentive to understate demand for Incentive to understate demand for
collective goodcollective good Example:Example: National defense National defense
6-20
PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
The Holdout ProblemThe Holdout Problem
Occurs when one person in a group Occurs when one person in a group has the power to prevent collective has the power to prevent collective actionaction Example:Example: Highway construction Highway construction
6-21
PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
Solutions To The Holdout Solutions To The Holdout ProblemProblem
Private solutionsPrivate solutions Substitute to alternative locations if Substitute to alternative locations if
possiblepossible Contingency contractsContingency contracts Hiding motivesHiding motives
Public SolutionPublic Solution Eminent DomainEminent Domain
6-22
PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
Consent and CoercionConsent and Coercion
Certain situations require Certain situations require government coercion to achieve government coercion to achieve efficiencyefficiency
If everyone is better off because If everyone is better off because everyone is coerced, everyone would everyone is coerced, everyone would agree to be coercedagree to be coerced
Incompatible within Paretian Incompatible within Paretian frameworkframework