Download Market failures • If markets "work perfectly well", governments should

Market failures
• If markets "work perfectly well", governments should just play
their minimal role, which is to:
(a) protect property rights, and
(b) enforce contracts.
• But usually markets fail. This happens when:
(a) price rigidities
(b) market power
(c) public goods/bads and externalities
(d) asymmetric information.
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• Price rigidities mean that markets do not clear;
• monopolistic power means that firms and households are not
price-takers and there are price markups;
• public goods/externalities means that some goods are not
marketable and it cannot be specified who uses what and by
how much;
• asymmetric information means that agents are not equally
informed so there are adverse selection and moral hazard
problems.
• All of them lead to misallocation of social resources and a
socially sub-optimal outcome.
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• If there are such market failures, there are arguments for a
more extended role for the government that includes:
(a)
(b)
(c)
(d)
(e)
the provision of public goods,
provision of social security and protection,
stabilization the macro-economy,
regulation (e.g. ensuring competition),
redistribution of wealth and income, etc.
• Thus, the government plays three roles: allocative, stabilizing
and redistributive.
• The government is an institution that has special powers (e.g.
the power to tax and regulate). Details about aims, choices and
constraints later.
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Policy failures
• Policy intervention introduces its own failures. Although the
exact effects vary depending on the type of policy, here are
some general problems.
(a) Policy instruments are distorting. That is, they distort
private agents' incentives to work, save, etc. For instance,
(i) We need tax revenues to finance public goods. But tax
revenues require income taxes that discourage work,
saving, etc. See the so-called Laffer curve.
(ii) Policy intervention can fix one thing, but can worsen
something else. Examples: policymakers may decrease
unemployment, but at the cost of higher inflation. Or they
may spend on public goods, but crowd out private
investment or exports. Or they may reduce nominal
interest rates but fuel inflation.
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• Thus, in general, economic policy can be ineffective in terms of
the real economy or even destabilizing (check the size and sign
of policy multipliers).
(a) Policy instruments may work with time lags, so that
stabilization policy can eventually become destabilizing.
(b) Optimal policies can be time inconsistent. That is, what
is optimal for policymakers today, it may not be optimal
tomorrow. For instance, they may promise low inflation,
but go for inflation surprises once nominal wage
contracts have been signed. Or, they may promise low
tax rates to encourage investment but, after investment
has taken place, they tax more than promised initially.
Note that this problem presupposes some conflict of
interests, although this can be hidden. It does not
presuppose that policymakers are not well-meaning.
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• All the above places citizens/voters above the state. In
addition, however, the state can be above the citizen/voter in
the sense that government officials and bureaucrats may have
the discretionary power to pursue their one interest at the
citizens’ expense. In other words, government officials and
bureaucrats may not be benevolent (i.e. they have their own
objectives). For instance, government officials may want to stay
in power as along as possible and hence use public policy for
private use (see electoral and partisan business cycles, rent
seeking, bribes, corruption, etc).
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Therefore,
• There is a tradeoff: economic policy can correct market
failures, but it introduces its own distortions.
• Check out, not only the direct positive effects, but also the
indirect, general equilibrium effects that usually work the
opposite way. Thus, think general equilibrium!
• The effects of government intervention, and hence the socially
optimum government size, are not monotonic depending on
the mix between the associated cost and efficiency.
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Aims, instruments/choices and constraints of government
• The government is like any other economic agent in the sense
that it has aims or objectives (benevolent or not), controls (the
policy instruments) and constraints (the decentralized
economy).
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Aims or goals of government
• Protection of property rights so as markets can function
(minimal role of the state).
• Internalization of externalities via taxes/subsidies, and
provision of public goods. This has to do with the so-called
allocative efficiency. Note that this is not sufficient to justify
the creation of the state; however, the state is probably the
lowest transaction costs institution for providing public goods
and eliminating externalities.
• Stabilization of the economy. Governments attempt to stabilize
the economy from shocks. Shocks are not bad per se: they are
bad only when there are market failures that do not allow the
economy to cope with these shocks in an efficient way.
• Fairness. Redistribution of income and wealth via
taxes/transfers.
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All the above reflects voters’ preferences. Thus, it refers to the
activities of a benevolent government. But policy is also (mis)used
for other reasons which have to do with non-benevolent aims.
Examples include:
• Electoral and partisan motives.
• Rent seeking, corruption, etc, on the part of government
officials and politicians. Bureaucratic behavior can be
explained by budget maximization, which translates into
higher salaries and more power. This is the analogue of firm
theories that managers want to maximize the corporation’s
size.
In general, there is a tradeoff between market and policy failures
and this tradeoff determines the “optimal” size of the public
sector.
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Policy instruments
To play its role and achieve its objectives (see above), the
government needs policy instruments (fiscal policy instruments,
monetary policy instruments, regulation and industrial policy).
• Monetary policy instruments: Interest rates, exchange rates,
monetary aggregates, etc.
• Fiscal policy instruments: Government spending, tax rates,
public debt and seigniorage.
• Other policy instruments (regulation, etc).
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