The Role of Government
Sometimes the unrestrained operation of markets yields undesirable results. Too many of some goods and too few of other goods get produced. This section discusses the sources of market failure and how society’s overall welfare may be improved through government intervention in the market.
Establishing and Enforcing the Rules of the Game
Market efficiency depends on people like you using your resources to maximize your utility. But what if you were repeatedly robbed of your paycheck on your way home from work? Or what if, after you worked two weeks in a new job, your boss called you a sucker and said you wouldn’t get paid? Why bother working? The market system would break down if you could not safeguard your private property or if you could not enforce contracts. Governments safeguard private property through police protection and enforce contracts through a judicial system. More generally, governments try to make sure that market participants abide by the rules of the game. These rules are established through government laws and regulations and also through the customs and conventions of the marketplace. For example, the U.S. Bureau of Weights and Measures is responsible for the annual inspection and testing of all commercial measuring devices used to buy, sell, and ship products.
Promoting Competition
Although the “invisible hand” of competition usually promotes an efficient allocation of resources, some firms try to avoid competition through collusion, which is an agreement among firms to divide the market and fix the price. Or an individual firm may try to eliminate the competition by using unfair business practices. For example, to drive out local competitors, a large firm may temporarily sell at a price below cost. Government antitrust laws try to promote competition by prohibiting collusion and other anticompetitive practices.
Regulating Natural Monopolies
Competition usually keeps the product price below the price charged by a monopoly, a sole supplier to the market. In rare instances, however, a monopoly can produce and sell the product for less than could competing firms. For example, electricity is delivered more efficiently by a single firm that wires the community than by competing firms each stringing its own wires. When it is cheaper for one firm to serve the market than for two or more firms to do so, that one firm is called a natural monopoly. Since a natural monopoly faces no competition, it maximizes profit by charging a higher price than would be optimal from society’s point of view. A lower price and greater output would improve social welfare. Therefore, the government usually regulates a natural monopoly, forcing it to lower its price and increase output.
Providing Public Goods
So far this book has been talking about private goods, which have two important features. First, private goods are rival in consumption, meaning that the amount consumed by one person is unavailable for others to consume. For example, when you and some friends share a pizza, each slice they eat is one less available for you. Second, the supplier of a private good can easily exclude those who fail to pay. Only paying customers get pizza. Thus, private goods are said to be exclusive. So private goods, such as pizza, are both rival in consumption and exclusive. In contrast, public goods are nonrival in consumption. For example, your family’s benefit from a safer neighborhood does not reduce your neighbor’s benefit. What’s more, once produced, public goods are available to all. Suppliers cannot easily prevent consumption by those who fail to pay. For example, reducing terrorism is nonexclusive. It benefits all in the community, regardless of who pays to reduce terrorism and who doesn’t. Because public goods are nonrival and nonexclusive, private firms cannot sell them profitably. The government, however, has the authority to enforce tax collections for public goods. Thus, the government provides public goods and funds them with taxes.
Dealing With Externalities
Market prices reflect the private costs and private benefits of producers and consumers. But sometimes production or consumption imposes costs or benefits on third parties on those who are neither suppliers nor demanders in a market transaction. For example, a paper mill fouls the air breathed by nearby residents, but the price of paper usually fails to reflect such costs. Because these pollution costs are outside, or external to, the market, they are called externalities. An externality is a cost or a benefit that falls on a third party. A negative externality imposes an external cost, such as factory pollution, auto emissions, or traffic congestion. A positive externality confers an external benefit, such as getting a good education, getting inoculated against a disease (thus reducing the possibility of infecting others), or driving carefully. Because market prices usually do not reflect externalities, governments often use taxes, subsidies, and regulations to discourage negative externalities and encourage positive externalities. For example, a polluting factory may face taxes and regulations aimed at curbing that pollution. And because more educated people can read road signs and have options that pay better than crime, governments try to encourage education with free public schools, subsidized higher education, and by keeping people in school until their 16th birthdays.
A More Equal Distribution of Income
As mentioned earlier, some people, because of poor education, mental or physical disabilities, bad luck, or perhaps the need to care for small children, are unable to support themselves and their families. Because resource markets do not guarantee even a minimum level of income, transfer payments reflect society’s willingness to provide a basic standard of living to all households. Most Americans agree that government should redistribute income to the poor (note the normative nature of this statement). Opinions differ about who should receive benefits, how much they should get, what form benefits should take, and how long benefits should last.
Full Employment, Price Stability, and Economic Growth
Perhaps the most important responsibility of government is fostering a healthy economy, which benefits just about everyone. The government through its ability to tax, to spend, and to control the money supply attempts to promote full employment, price stability, and economic growth. Pursuing these objectives by taxing and spending is called fiscal policy. Pursuing them by regulating the money supply is called monetary policy. Macroeconomics examines both policies.
Sometimes the unrestrained operation of markets yields undesirable results. Too many of some goods and too few of other goods get produced. This section discusses the sources of market failure and how society’s overall welfare may be improved through government intervention in the market.
Establishing and Enforcing the Rules of the Game
Market efficiency depends on people like you using your resources to maximize your utility. But what if you were repeatedly robbed of your paycheck on your way home from work? Or what if, after you worked two weeks in a new job, your boss called you a sucker and said you wouldn’t get paid? Why bother working? The market system would break down if you could not safeguard your private property or if you could not enforce contracts. Governments safeguard private property through police protection and enforce contracts through a judicial system. More generally, governments try to make sure that market participants abide by the rules of the game. These rules are established through government laws and regulations and also through the customs and conventions of the marketplace. For example, the U.S. Bureau of Weights and Measures is responsible for the annual inspection and testing of all commercial measuring devices used to buy, sell, and ship products.
Promoting Competition
Although the “invisible hand” of competition usually promotes an efficient allocation of resources, some firms try to avoid competition through collusion, which is an agreement among firms to divide the market and fix the price. Or an individual firm may try to eliminate the competition by using unfair business practices. For example, to drive out local competitors, a large firm may temporarily sell at a price below cost. Government antitrust laws try to promote competition by prohibiting collusion and other anticompetitive practices.
Regulating Natural Monopolies
Competition usually keeps the product price below the price charged by a monopoly, a sole supplier to the market. In rare instances, however, a monopoly can produce and sell the product for less than could competing firms. For example, electricity is delivered more efficiently by a single firm that wires the community than by competing firms each stringing its own wires. When it is cheaper for one firm to serve the market than for two or more firms to do so, that one firm is called a natural monopoly. Since a natural monopoly faces no competition, it maximizes profit by charging a higher price than would be optimal from society’s point of view. A lower price and greater output would improve social welfare. Therefore, the government usually regulates a natural monopoly, forcing it to lower its price and increase output.
Providing Public Goods
So far this book has been talking about private goods, which have two important features. First, private goods are rival in consumption, meaning that the amount consumed by one person is unavailable for others to consume. For example, when you and some friends share a pizza, each slice they eat is one less available for you. Second, the supplier of a private good can easily exclude those who fail to pay. Only paying customers get pizza. Thus, private goods are said to be exclusive. So private goods, such as pizza, are both rival in consumption and exclusive. In contrast, public goods are nonrival in consumption. For example, your family’s benefit from a safer neighborhood does not reduce your neighbor’s benefit. What’s more, once produced, public goods are available to all. Suppliers cannot easily prevent consumption by those who fail to pay. For example, reducing terrorism is nonexclusive. It benefits all in the community, regardless of who pays to reduce terrorism and who doesn’t. Because public goods are nonrival and nonexclusive, private firms cannot sell them profitably. The government, however, has the authority to enforce tax collections for public goods. Thus, the government provides public goods and funds them with taxes.
Dealing With Externalities
Market prices reflect the private costs and private benefits of producers and consumers. But sometimes production or consumption imposes costs or benefits on third parties on those who are neither suppliers nor demanders in a market transaction. For example, a paper mill fouls the air breathed by nearby residents, but the price of paper usually fails to reflect such costs. Because these pollution costs are outside, or external to, the market, they are called externalities. An externality is a cost or a benefit that falls on a third party. A negative externality imposes an external cost, such as factory pollution, auto emissions, or traffic congestion. A positive externality confers an external benefit, such as getting a good education, getting inoculated against a disease (thus reducing the possibility of infecting others), or driving carefully. Because market prices usually do not reflect externalities, governments often use taxes, subsidies, and regulations to discourage negative externalities and encourage positive externalities. For example, a polluting factory may face taxes and regulations aimed at curbing that pollution. And because more educated people can read road signs and have options that pay better than crime, governments try to encourage education with free public schools, subsidized higher education, and by keeping people in school until their 16th birthdays.
A More Equal Distribution of Income
As mentioned earlier, some people, because of poor education, mental or physical disabilities, bad luck, or perhaps the need to care for small children, are unable to support themselves and their families. Because resource markets do not guarantee even a minimum level of income, transfer payments reflect society’s willingness to provide a basic standard of living to all households. Most Americans agree that government should redistribute income to the poor (note the normative nature of this statement). Opinions differ about who should receive benefits, how much they should get, what form benefits should take, and how long benefits should last.
Full Employment, Price Stability, and Economic Growth
Perhaps the most important responsibility of government is fostering a healthy economy, which benefits just about everyone. The government through its ability to tax, to spend, and to control the money supply attempts to promote full employment, price stability, and economic growth. Pursuing these objectives by taxing and spending is called fiscal policy. Pursuing them by regulating the money supply is called monetary policy. Macroeconomics examines both policies.
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