Holcombe 06

CHAPTER

6The Economic Role of

the State

PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe

PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe 6-2

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


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


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


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


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


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


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


The Regulatory Agency The Regulatory Agency as a Cartelas a Cartel


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


The Equilibrium Level of The Equilibrium Level of RegulationRegulation


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


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


Reasons for Government Reasons for Government RedistributionRedistribution

Two general reasons: Provide a safety net Greater equality

Not necessarily the same thing Example: worldwide poverty


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


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


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


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


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


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


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


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

Holcombe 06

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