Information-related Problems

Unless firms and consumers are well informed, they may take actions that are not in their own interests. Unless decisions are made on the basis of good information, markets, will not work well. But in a free market economy, particularly a modern, complex free market economy, firms and consumers are not likely to be well informed about the consequences of all their decisions.

Private markets may not produce the right kinds and amounts of information. Firms have little incentive to study the long-term health hazards to which their workers are exposed, and if there were no penalties for fraud, producers of unsafe goods would have every incentive to conceal the flaws in their products. Furthermore, modern economies are so complex that few individuals can digest and evaluate all the information necessary to make fully informed decisions all the time. It may be efficient to have the government process some complex information on behalf of its citizens.

Governments have long recognized a need to protect poorly informed consumers from actions they would regret. Laws against fraud have been around for centuries. Modern governments generally regulate working conditions, inspect and grade foods, regulate the design and safety of consumer products, and require that certain products (such as foods and dangerous chemicals) have informative labels.

Monopoly and Market Power

Competitive markets generally work well, but markets where either buyers or sellers can manipulate prices generally do not. In particular, too little output will be produced and price will be too high in a market where a single seller controls supply.

A monopolist is the single seller of a good or service. Monopolists can earn high profits by restricting the quantity sold and raising the price. Because they are the only sellers, they have no fear of being undercut by competitors — and consumers end up paying more than they should.

Some monopolies are almost unavoidable. Most public utilities (gas and electricity, for example) are potential monopolies. The government can regulate such companies by controlling the prices they are allowed to charge, or it may elect to supply the products involved itself. Other monopolies may be artificial, brought about through manipulation by firms. Here governments intervene with competition laws, seeking to make competition more vigorous and to prevent monopolies or other attempts to control supply.

Any buyer or seller who has the ability to affect market price significantly is described as having market power or monopoly power. Government intervention to limit market power, for instance by preventing firms with market power from charging high prices, can improve the allocation of resources.

Income Redistribution and Merit Goods

The distribution of income that is generated by free markets has no ethical claim to being just or fair. Depending on who starts out with what resources, private markets can produce many different final distributions - different 'for whoms' - of resources and welfare. Private markets may produce a distribution in which the top 1 per cent of income-earners receive 40 per cent of total income in the economy, or they may produce an even distribution of income. Either way, government may want to intervene to affect the distribution of income, by taxing some and giving to others.

In practice, modern governments engage in large-scale redistribution of income. The share of transfers in government spending has increased all over the world in the period since 1960. Government spending on transfer payments, shown in Table 3-1, represents government redistribution of income - towards the elderly (through social security), the unemployed (through unemployment benefits), farmers (through price supports), and other beneficiaries. The rapid growth of transfer spending has been a source of controversy, with critics arguing that many government welfare programmes have harmed the people they were designed to help.

There is a difference between government intervention to affect the distribution of income and intervention to ensure the right level of production of public goods or to make market prices reflect externalities. In the latter cases the government is taking actions that at least in principle can make everyone in society better off. But when the government intervenes to affect the income distribution, it makes some people better off by making others worse off.

Governments are concerned not just with the distribution of income, but also with the consumption of particular goods and services.

Merit goods are goods that society thinks people should consume or receive, no matter what their incomes are. Merit goods typically include health, education, shelter, and food. Thus we - society - might think that everyone should have adequate housing and take steps to provide it. Is there an economic justification for government intervention in regard to merit goods? In a sense there always is, because the sight of someone who is homeless creates an externality, making everyone else unhappy. By providing housing or shelter for those who would otherwise be on the streets, the government make the rest of us feel better.

Society's concern over merit goods is closely related to its concern over the distribution of income. The difference in the case of merit goods is that society wants to ensure an individual's consumption of particular goods rather than goods in general. Some of the goods provided by the government (such as health and education) are merit goods.

With merit goods, as with public goods, government concern with consumption does not justify government production. Economic theory justifies policies that ensure that individuals consume the specified amounts of merit goods. It does not say that the government should produce these goods itself, nor does it say exactly how the government should intervene. One way would simply be to require that the right amounts of the goods be consumed. In the case of education, everyone has to go to school up to a certain age. But nobody has to go to a state school; any accredited school will do. In the case of housing, the government can build low-income houses and rent them at a subsidized rate, provide rent supplements, or simply specify minimum housing standards.

The most difficult question that has to be answered in discussing both merit goods and the distribution of income is how society or the government decides who should get what. Any one person can have a perfectly sensible viewpoint on these issues — for instance, that the more even the distribution of income the better, that the distribution of income we have is best, that people who work harder should be rewarded, that people who need more should get more, or that everyone should have decent housing and no one should starve. Translating these different opinions into a consistent view that is taken by the government and implemented in taxation and transfer policy is the impossible task of politics.

Recap

The discussion in this section provides some theoretical justification for government intervention in a market economy. However, governments do not make their tax and spending decisions on the basis of what economists say their role should be. Only by a huge stretch of the imagination could we say that in fact all government purchases of goods and services are purchases of public goods or merit goods, or that interventions in any particular market are designed only to remove externalities. It would take even more imagination to see government intervention that affects the distribution of income as resulting from a consistent view of the optimal distribution. We now discuss the mechanisms that democratic societies use to make their actual decisions about taxation and govern­ment spending.

Exercise 1. Answer the following questions:

1. How did Adam Smith understand the role of the market?

2. Do you agree that people pursuing their own interests promote the interests of society?

3. Why is government intervention necessary? Do you agree that the government can correct market failures?

4. How can the government affect different elements of the business cycle?

5. What can be done to stabilize the economy?

6. What is the difference between a private good and a public good? Give your own examples.

7. Why are private markets unlikely to provide public goods?

8. How can the government solve “the free-rider problem”?

9. What is the role of the government in providing public goods?

10. Should the government produce private goods? Why?

11. How does the author describe the ideal market?

12. Give your own examples of positive and negative externalities.

13. Why does the presence of externalities justify government intervention?

14. Why is it often difficult for firms and individual consumers to act in their own interests?

15. Do you agree that the government should process some information on behalf of its citizens? How can it do that?

16. Why do competitive markets generally work better than monopolies?

17. Why are monopolies dangerous for consumers?

18. How can the government control monopolies and regulate their activities?

19. Why should the government intervene to affect the distribution of income?

20. How does the government try to affect the answer to the “for whom” question?

21. Do you agree that the government should ensure that everyone has merit goods?

22. What does the author mean by saying that government concern with consumption does not justify government production?

Exercise 2. Comment on the following statement:

“In practice the government is even more likely to fail to allocate resources efficiently than are markets.”

Exercise 3. Define the following terms in English:

a market failure, a private good, a public good, a free-rider, an externality, a monopoly, a monopolist, merit goods

Exercise 4. Listening from Guide to economics, unit 10 – “Positive externalities”, track 29)

• What is a positive externality? (repeat or write down the definition)

• Which transactions in the list are mentioned as positive externalities?

1. Buying a new house

2. Fixing up an old home

3. Buying books

4. Paying for a course at a local college

5. Joining a gym

6. Going on holiday

Exercise 5. Summarize each subsection of the text (orally):

1. The Business Cycle

2. Public Goods

3. Externalities

4. Information-Related Problems

5. Monopoly and Market Power

6. Income Redistribution and Merit Goods

Exercise 6.

1. Which of the following items of government spending reflect (a) provision of public goods, (b) concern with merit goods, (c) concern with income distribution: (i) police patrols, (ii) old age pensions, (iii) unemployment benefit, (iv) free state primary schools?

2. Which of the following are public goods: (a) clean streets, (b) ambulance services, (c) the postal service? Discuss alternative ways of providing these services.

3. Name the two goods or services you buy from a monopolist. Should the government regulate the price? Does it?

4. Why should the European Commission seek to enforce tough standards reducing pollution of rivers by nitrates used as fertilizers in farming?

Exercise 7.

Compare the content of parts IV-1 and IV-3 by filling up the table:

Government
What does it do?	What should it do?

What conclusions can you draw from this table?

Exercise 8. Write a summary of sections IV-1 and IV-3 of the text.

Optional: Video (Economics TTC, Lecture 13 “Positive Externalities and Technology”)

IV-4. How Do Governments Decide?

The motivations economists ascribe to individuals and firms are simple. Firms are in business to make profits for their owners. Individuals are assumed to choose those combinations of goods that make them best off. These simple assumptions permit economists to explain most consumer and business decision-making.

Government decision-making cannot be explained so simply. Voters express their preferences by electing governments whose job is to make the basic decisions on spending and taxing, pass new laws, and establish new regulatory programmes. Thus, by voting, the electorate gets to express its preferences among alternative policy packages, though not on each issue.

The people who run the government - elected officials and civil servants - are not mere ciphers who simply do the bidding of society. They have their own objectives, in some sense trying like everyone else to maximize their own well-being. They may maximize their own well-being by doing what they believe is good for the public, or they may have much narrower goals, such as getting re-elected or advancing up the hierarchy. A well designed system is one in which the people who run the government are led to pursue the interests of society as they pursue their own goals, just as the invisible hand in competitive markets leads individuals pursuing their own interest to pursue society's interests.

Voting

If everyone were identical and of one mind, public decision-making would be easy. The most important problem that society solves through the political process is how to reconcile different views and different interests. In this section we discuss two features of majority voting.

The first is the paradox of voting, which concerns cases where majority voting will lead to inconsistent decision-making. The second is the median voter result, which shows how public choice will tend to avoid extreme outcomes.

The Paradox of Voting. Table 3-4 shows how voters 1, 2, and 3 rank three possible outcomes A, B, and C. For example, voter 1 likes A best, then B, then C. Let the group choose by majority vote between outcomes A and B. Voters 1 and 3 prefer A to В so the group will prefer A to В by two votes to one. Similarly, the group will vote two to one for outcome В rather than C. Since A is preferred to B and В preferred to C, you might expect the group to prefer A to C. But the first and third columns of Table 3-4 imply that the group would choose С rather than A by two voices to one. When individual preferences are as depicted in Table 3-4 majority voting will choose A over B, В over С; and С over A. Consistent decision-making will not be possible under majority voting.

This is a serious problem. Society cannot necessarily rely on majority voting to lead to consistent decision-making.² It also means that the decisions taken by society may well depend on the order in which it votes on them.

Table 3-4. The paradox of voting

EACH VOTER'S RANKING OF OUTCOMES A, B and С.

VOTER	A	В	С
1	1	2	3
2	3	1	2
3	2	3	1

Median voter

• • • • • ••• • • •• • • • • •••• •

£0 £250 £500 £750 £1000

Figure 3-1. THE MEDIAN VOTER. Each dot represents the preferred expenditure of each of 17 voters. The outcome under majority voting will be the level preferred by the median voter. Everybody to the left will prefer the median voter's position to any higher spending level. Everybody to the right will prefer it to any lower spending level. The median voter's position is the only position that cannot be outvoted against some alternative. Hence it will be chosen.

The Median Voter. Majority voting does not always lead to inconsistent public choice. Figure 3-1 shows for 17 voters how much between £0 and £1000 each would like to spend on the police. Each dot represents an individual voter's preferred amount.

We also assume that each voter will vote for a spending level close to his or her own preferred amount rather than for one that is further away. A voter who wants to spend £250 will prefer £300 to £400 and will prefer £200 to £100. Each person has single-peaked preferences, being happier with an outcome the closer it is to the peak or preferred level as judged by that individual.

Now suppose there is a vote on how much to spend on the police. A proposal to spend £0 would be defeated by 16 votes to 1. Only the voter represented by the left-hand dot in Figure 3-1 would vote for £0 rather than £100. As we move to the right we get more people voting for any particular proposal. Figure 3-1 emphasizes the special position of the median voter. With 17 voters, the median voter is the person who wants to spend the ninth-highest amount on the police. There are 8 voters wanting to spend more and 8 wanting to spend less. The median voter is the person in the middle on this particular issue.

What is special about the median voter? Suppose the vote is between the amount the median voter wants to spend and some higher amount. The 8 people wanting less than either will vote for the median voter's proposal, and so will the median voter. There will be a majority against higher expenditure. Bу an identical argument there will be a 9-8 majority against lower expenditure when the alternative is the amount wanted by the median voter. Hence the median voter's preferred outcome will be the one that is chosen by majority voting.

Thus, majority voting works when each individual has single-peaked preferences. The paradox of voting arises in Table 3-4 precisely because preferences are not single-peaked. Suppose outcome A is low expenditure, В is moderate expenditure, and С is high expenditure on the police. Voter 1 prefers low to moderate and moderate to high. Voter 1 has single-peaked preferences. So does voter 2, whose peak is at moderate expenditure. But voter 3 prefers high to low and low to moderate expenditure, even though moderate expenditure is closer than low expenditure to the best outcome of high expenditure. Voter 3 does not have single-peaked preferences.

This is why majority voting is likely to get into trouble when individual preferences are not single-peaked. In contrast, with single-peaked preferences the outcome is likely to be that most preferred by the median voter. Consistent public choice under majority voting on particular issues is more likely the more each voter feels that the next best thing is an outcome close to that voter's preferred outcome. On issues where voters feel they must make an all-or-nothing choice between very different alternatives, intermediate positions are a complete waste of time. The failure of preferences to be single-peaked may result in inconsistent public choices.