Lection 7. Government and Efficiency

Lection 7. Government and Efficiency Main problems:PublicGoodsinGeneralQuasi-PublicGoodsExternalitiesPublicGoodsandExternalitySocialCostsandBenefitsSocialOptimum

The case for government intervention may not look very good. In the discussions so far, we have learned that (if we make certain assumptions) • An efficient allocation of resources is an allocation that satisfies the rule marginal benefit=marginal cost. • For each individual, the marginal benefit curve is the demand curve. • For each firm, the marginal cost curve is the supply curve. Thus, when quantity supplied equals quantity demanded, we have an efficient allocation of resources. Efficiency and the Role of Government

One important category of exceptions comes from the classical economists of the 19th century. Adam Smith wrote "The third and last duty of the [government] is that and erecting or maintaining those public institutions and those public works, which, although they may be in the highest degree advantageous to a great society, are, however, of such a nature, that the profit could not repay the expense to any individual or small number of individuals, and which it therefore cannot be expected that any individual or small number of individuals should erect or maintain." In modern economics these are called "public goods." Smith didn't provide any examples, but John Stuart Mill gave the example of a lighthouse. According to Mill, it would be impossible to try to charge seamen according to their use or benefit from the lighthouse, and might therefore be most convenient for the government to provide the lighthouse and pay for it out of tax moneys. This is one aspect of a "public good:" for some reason, it is difficult or impossible to charge those who benefit from it. It is easy to see how this would be difficult for charge for the lighthouse service. Try to visualize toll booths for the purpose out in the ocean! Another thing about the lighthouse is that its cost does not depend on the number of ships that use it. The lighthouse is absolutely indivisible, and the cost of keeping it up is fixed. This is another aspect of a "public good" in general. The cost of a "public good" is independent of the number of people it serves. This is an extreme case of "economies of scale." We recall that indivisibility causes economies of scale in general, but in this extreme case there is just one possible scale of operation -- one lighthouse -- and so long as it operates it costs the same, no matter how many ships it warns off the rocks. Exceptions: TheLighthouse 1

Here is a picture of the costs and benefits for the lighthouse. Because the cost of the lighthouse is indivisible, the cost curves for the lighthouse are rather special. Long run marginal cost is always zero, and long run average cost is a downward-sloping hyperbola. In place of the "demand" curve we have the marginal benefits curve. Remember, in a competitive market, demand is identical to marginal benefit. Since it is impossible to charge those who benefit from the lighthouse, the term "demand" is not quite appropriate here.

Notice that the marginal cost curve and the marginal benefit curve intersect at Q, where the marginal benefit curve touches the horizontal axis. That's because the marginal cost is always zero. This is the efficient rate of use of the lighthouse' services. When the marginal cost is zero, it is efficient to use the service to the point where the marginal benefit is also zero. This corresponds to a price of zero. That is, the lighthouse is used and priced efficiently when it is provided for free. This can only be true when the marginal cost of the good is zero, of course. • Wedrawtwoconclusions. Since it is impractical to try to charge the ships for the use of the lighthouse, there is no good alternative to government provision of lighthouses. If the government does provide lighthouses without charge, they will in fact be used at the efficient rate where the marginal benefit equals the marginal cost -- zero.

We can now define a "public good" in general. Following the example of the lighthouse, modern economics defines a "public good" as a good that shares the two key characteristics of the lighthouse: It is not practically possible to charge for the use of the good The cost of the good is indivisible, so that its marginal cost is zero • Most economists would include the traditional governmental services, such as defense and the maintenance of law and order, in this category. Some economists find many other examples of public goods in a modern economy. There is a good deal of controversy on this. • Economic theory tells us that a public good will not be provided by profit-oriented private suppliers, and sure enough, no-commercial radio and TV are mostly public radio and TV. There are a few radio and TV stations supported by charitable contributions -- mostly devoted to religious programming. But no-commercial broadcasting fits the theory of public goods in this way as well: profit oriented business doesn't supply no-commercial broadcasting. PublicGoodsinGeneral

However, public goods like the lighthouse really are very special cases. A public good really is at one end of the specrum. Private goods, the kind we have been studying for most of this course, are at the other end of the spectrum. • We could define a private good as a good that has the following two characteristics. These characteristics are the opposite of the characteristics of a public good: Beneficiaries can be charged for their use of a private good without difficulty, and if they do not pay they can be prevented from enjoying any benefit. The marginal cost of the good is positive and at least as great as the average cost • The middle ground of the spectrum are the quasi-public goods. A quasipublic good is almost a public good, but not quite. That is, quasi-public goods share the following two characteristics: It is difficult or costly to charge the beneficiaries in some or all cases, but it is possible to charge at least some of them The marginal cost of the good is less than the average cost (that is, there are economies of scale) but not zero • It seems there are many more quasi-public goods than public goods. In saying that private goods are at one end of the spectrum, we are not saying that private goods are unusual. Probably most goods are private goods. The food we eat, the clothing we wear, our houses or apartments and furniture and cars are all examples of private goods. In neoclassical economic theory, certainly, both public goods and quasi-public goods are exceptional. But quasi-public goods are a less extreme and more common kind of exception. QuasipublicGoods

In the case of "public goods," it is practically impossible to charge people for the benefits they get from the "public good," and that creates a problem. Since the beneficiaries of the public good do not pay for the benefits they get, a profit-oriented market economy will not supply the public good, and that is inefficient. That point can be generalized somewhat. In general, when there are goods, services, and resources that people can get without paying for them at a market equilibrium price, inefficiency will be the result. The term for this in economics is "externality." Externality

Economists define "externalities" and "external costs and benefits" as follows: Definitions: • When some people bear costs that they are not paid or compensated for, these costs are said to be external costs. • When some people get benefits that they do not pay for, these benefits are said to be external benefits. • In general, if there are either external benefits or external costs, we say that there are externalities. • The idea is that the decision-maker, who does not pay for the costs nor get paid for the benefits, doesn't take them into consideration in deciding how resources shall be allocated. He has no motive to produce benefits that he doesn't get, nor to cut back on costs that he doesn't pay. The benefits and costs are "external" to his maximization of his own net benefits. • In general, if there are "external" costs or benefits or both, we say that there are "externalities," and we can expect markets to be inefficient when there are "externalities." ExternalCostsandBenefits

SocialCostsandBenefits • External costs and benefits are the costs and benefits that decision-makers do not take account of, so market decisions on the allocation of resources do not reflect the external costs and benefits. But, of course, external costs and benefits are only part of the total costs and benefits of any decision. • The costs and benefits that decision-makers do take account of, because they pay the costs and enjoy the benefits, are called private costs and benefits. These are the kinds of costs and benefits we have discussed in earlier chapters in this series. Inturn • Social costs are the sum of private and external costs • Social benefits are the sum of private and external benefits. • Let's sum up this terminology in a table: • Social costs and benefits are so-called because they are the total costs and benefits for everybody in society. Economists do not think of society as an independent actor that can gain benefits or suffer costs. Rather, the social costs are the sum total of all costs to individuals in society, regardless of whether the costs are paid by the person who decides whether they will be incurred. Similarly, social benefits are the sum total of all benefits to individuals in society, regardless of whether the beneficiaries decide how much benefit will be produced.

SocialOptimum • The economist's concept of "optimum allocation of resources" is a social optimum. That is, the idea is to maximize the net benefits for everybody in society. , regardless of who enjoys the benefits or pays the cost. In the ideal P-competitive economy, this is no problem. Everyone maximizes their private benefit, but since everyone pays for any benefits they receive, and bears only the corresponding costs, the result of this private-benefit maximization is that social net benefits are maximized. • When there are externalities, however, this is no longer true. In maximizing their private net benefits, people will overlook some (external) costs and benefits, and maximization of private benefits will no longer lead to maximization of social net benefits. • Recall the rule for the for a socially optimal allocation of resources is still the equimarginal rule, MB=MC. However, we now have two kinds each of costs and benefits. We will abbreviate • MSC (marginal social cost) • MSB (marginal social benefit) • MPB (marginal private benefit) • MPC (marginal private cost) Using these definitions, we can state the rule for a social optimum, and the problem of externality, more precisely. The rule for a socially optimal allocation of resources is MSB=MSC and the problem is that rational self-interested decision-makers operate according to a different rule MPB=MPC So now let's look at some examples -- practically important ones.

A FishStory When a fisherman catches a fish and sells it, that fisherman gets a private benefit -- the revenue from selling the fish. But there is a cost -- because there are fewer fish to reproduce, there will be less fish caught (ceteris paribus) in the next and future years. This cost is spread out over all the fishermen and consumers of fish, and thus is "external" to the individual fisherman's decision how many fish to take. The individual fisherman does not take into account the influence of his fishing on the fish that will be available to other fishermen in the future -- it he isn't going to catch them, why should he care? The result is that he does not limit his catch in such a way as to conserve the fish population to reproduce, and this is why fisheries are overexploited. • As usual, we will express some of these ideas with diagrams. Starting from an industry marginal cost (supply) diagram, we will change the diagram to reflect the difference between private and social cost. As usual we have the quantity of output on the horizontal axis. In this case the quantity of output is measured in tons of fish caught. On the vertical axis we have the marginal cost per ton of fish caught. Hereisthepicture. • In the diagram, the difference between MPC and MSC is the market value of fish that might be caught in the future (discounted to present value) if one less fish were taken this year. This opportunity cost is the marginal external cost of fish caught and therefore the difference between the marginal private cost and the marginal social cost.

Now let's put "supply" and "demand" together. We will add a marginal benefit curve to the last diagramm In the diagram, the marginal benefit, MB, is also the demand curve for fish and the marginal private and marginal social benefit. Applying the equimarginal principle, MC=MB, the socially optimal output is Q1. However, fishermen -- balancing marginal private benefit against marginal private cost, MPC -- choose Q2. "Too many" fish are caught, and society as a whole has overallocated resources to fishing. Now let's look at an example with external benefits.

Government policy

Let's consider how regulation would improve the allocation of resources to fishing. Fishermen would be legally limited in how much fish they can catch. There are some real difficulties in making this work. The regulators have to figure out about how large a catch would be efficient and find ways to be sure that the fishermen do not evade the regulations and catch more fish anyway. The objective would be to reduce the catch of fish and still have the limited quantity of fish caught in the least costly manner. All the same, regulation has been the favorite response of government (perhaps because it is cheap and/or easy to understand) and as a result we have a good deal of experience in making regulations work not too badly. Regulation

Taxes on a particular economic activity discourage that activity. Usually, that's considered a disadvantage, but if the economic activity has external costs, a tax can be a way of raising the private cost up to the same level as the social cost, and thus moving the activity back toward its optimal level. Conversely, subsidies could be useful if the activity has external benefits. The subsidy would decrease the private cost and bring it into agreement with the social cost, encouraging an efficient increase in the activity. Thus, fishermen would pay a penalty tax to bring the private cost of fishing up to the social cost, and public transportation would be subsidized to bring the cost down and raise ridership toward the optimal level. Economists have often favored these approaches, because they work more like markets -- we like the carrot better than the stick, as a rule -- but governments have not been very committed to, or successful at, putting them into practice. This is especially true of penalty taxes, which are, after all politically unpopular. What about the impact on the government deficit? In principle, the penalty taxes might more or less balance out the subsidies -- perhaps even balance out to zero. But it's hard to imagine a government with the self-discipline this would require. Some economists and many citizens would worry that a tax that started out as a way of discouraging inefficient activity would end up as a government cash cow. TaxesandSubsidies

Economists have proposed that market principles could be put to work by appropriate regulations, and there have been some trials. For example, the fish catch could be limited by licenses. Each license would entitle the holder to catch a limited number of fish of a certain species. However, the licenses would be salable, so that larger-scale efficient fishermen could buy up licenses from the smaller fishermen, and fish at an efficient scale. And at least the little guys would have something -- the market price of the license -- to apply toward the retirement fund. Market-BasedRegulation

Central PLANNING LIBERAL VIEWS • Public goods, quasipublic goods, and externalities are the real world of the market system. • These 'problems' are so pervasive that the only hope for an efficient allocation of resources is for the government to take control of the allocation of resources, do the statistical work necessary to discover the social costs and benefits, solve for the optimal allocation of resources, and direct the managers of the economy to realize it. • It's true that this is very difficult -- the Soviet Union clearly never came anywhere close. But even if the plan is pretty far off from the optimum, it can't be much worse than a market economy riddled with inefficiencies due to externalities and underprovided public goods. • The deterioration of the Soviet economy in its last years makes this last point pretty difficult to swallow, of course, but this is one possible interpretation of public goods and externalities. • Public goods, quasipublic goods, and externalities are fairly common in the real world. • They are common enough that it is necessary to take proposals for government intervention in the economy on a case-by-case basis. Government action can never be ruled in or ruled out on principle. Only with attention to detail and prudent judgment based on the facts of the case can we hope to approach an optimal allocation of resources. • That means the government will always have a full agenda for reform -- and in some cases, as in deregulation, that will mean undoing the actions of government in an earlier generation. This is not evidence of failure but of an alert, active government aware of changing circumstances. "

Lection 7. Government and Efficiency