Role of Government*

1. Role of Government* Organic View Mechanistic View • Friedman and the “Classical Liberal” viewpoint. • Market Socialism • Paternalism Market Failures Welfare Economics *This lecture draws from H. Rosen’s text: “Public Finance”

2. Organic View • “Society is a natural organism. Each individual is a part and government is its heart.” • Social (common) well being matters, not individual well being. • Government’s goal is to guide individuals to accomplish societal goals.

3. Mechanistic View • Government created by individuals to better achieve individual goals. • Social goals not important except as a collection of individual goals. • Within the mechanistic view there can be differences about how to weigh the benefits for different individuals. When is it correct to transfer property from one person to another?

4. “Government as Referee” • Government defines and protects property rights. • Government arbitrates disputes (the courts). • It enforces contracts. • Also limits types of “legal” contracts. • Illegal activities • Bankruptcy • Anti-trust • Safety regulations • Government provides the legal framework within which all transactions occur.

5. Mechanistic View: “Classic Liberal” or “Libertarian” • Extreme within the mechanistic framework. • Government’s primary role is “referee” • Role of Government narrowly defined: • Define and enforce property rights and support the efficient functioning of markets. • Provide some “public goods.” • Correct some “market failures.” • When in doubt, do not interfere. “Government failures” might be worse than the “market failures.” • Skeptical of using government for redistribution.

6. Mechanistic View: “Social Democratic” • “Substantial government intervention is required for the good of individuals.” • Agree with libertarians that government should provide public goods and correct market failures. • In addition, government should do more. It might provide a “social safety net,” guaranteeing availability of certain goods or services. • Less concerned about “government failure.” • Supports using government to redistribute wealth.

7. Mechanistic View: “Paternalism” (Rosen, p. 180) • Even stronger than the “social democratic” view is the “paternalistic” view. • The paternalistic view argues that for certain decisions individuals do not maximize their own well being. • Therefore, for questions related to topics such as environmental planning – in particular with long term consequences. • “Merit goods” are defined as goods that ought to be provided even if people do not demand it.

8. Economic Theory: Welfare Economics Introduction Statement of Welfare theorems (general) Definitions Pareto Optimality Market failure Restatement of theorems (precise) Interpretations Caveats

9. Introduction to Welfare Economics Welfare Economics: “The branch of economic theory concerned with the social desirability of alternative economic states.” “The theory is used to distinguish circumstances under which markets can be expected to perform well” Welfare economics helps us define some circumstances under which we might want government intervention.

10. Welfare Theorems First theorem of welfare economics: A perfectly competitive market with no “market failures” reaches a “Pareto-efficient” allocation. Second theorem of welfare economics: Any Pareto-efficient allocation is consistent with perfect competition (with no market failures), given the correct initial endowments.

11. “Pareto Optimal” or “Pareto Efficient” • “An allocation where the only way to make one person better off is to make another person worse off is Pareto Optimal.” • A “Pareto Improvement” is a change that makes one person better off without making anyone else worse off. • If a Pareto improvement is possible, the current allocation is not Pareto efficient. • Example (parking)

12. Market Failures Imperfect Property Rights • Externalities: “An activity of one entity (firm or individual) that affects another entity in a way that is outside the market. • Public Goods • Non-rival • Non-excludible Asymmetric Information • Adverse Selection Imperfect Competition • Monopoly, oligopoly, etc.

13. Intuition • Market maximize total surplus (producer surplus plus consumer surplus). This is what we mean by “efficient.” • The criteria of efficiency ignores normative considerations (equity, for example). • When a market failure exists, there may be a role for government to correct that market failure. • Externalities and public goods might be thought of as specific cases of imperfectly defined property rights. • Economists might suggest “creating” a market for the externality (see Fullerton and Stavins).

14. First Fundamental Theorem of Welfare Suppose the following conditions hold: • Households and firms act as price takers • Full set of market for inputs and outputs (property rights are correctly defined) • Full information on the part of all buyers and sellers The first fundamental theorem of welfare states that a competitive market equilibrium is Pareto Efficient.

15. Practical problems • Need to find the correct level or value of the non-traded externality… • Looking ahead to the Coase theorem

16. Second Fundamental Theorem of Welfare • Any Pareto efficient allocation is supported by some competitive market allocation.

17. Applying views of government Can the following types of government intervention be justified by the concept of “market failure?” Are they consistent with a mechanistic view of government? • Prohibition of drugs • Prohibition of alcohol (for those under 21) • Prohibition of prostitution • Mandatory air bags for cars • Support for the arts • Mandate that flights be non-smoking or that restaurants reserve non-smoking sections.

18. Group IA: assignment Using the language of economics and the criteria for policy evaluation developed in the first two lectures… [Choose only one] • Consider the case to legalize marijuana. Present a detailed proposal supporting or opposing the legalization of marijuana. • Consider the case to legalize prostitution. Present a detailed proposal either supporting or opposing the legalization of prostitution.

19. Group IB: assignment Using the language of economics and the criteria for policy evaluation developed in the lectures and text, • Consider the case for mandates that flights be non-smoking and that that restaurants reserve non-smoking sections. Present a detailed proposal supporting or opposing such mandates.